Dr Con Keating in Tayyabs
In the course of my recent work on value for money metrics, I have come across several schemes which apply life styling to older ages and many have argued that these strategies merit a benchmark which differs from the traditional 80/20 Equity-Debt construction.
The expression ‘life-styling’ refers to portfolios which progressively move their asset allocation away from equity to debt as the member’s age increases and retirement approaches. The objective is to minimise the volatility of the portfolio’s value at retirement, which of course, was previously the prime determinant of the member’s retirement income.
There are difficulties with creating benchmarks for ‘life-styling’ in that this practice applies at the level of the member’s allocation, not the overall consolidated fund. It is also far from clear why this strategy should be treated differently from any other strategy where comparison is made to the available investment opportunity set.
The process of moving progressively to higher bond allocations will carry with it the. prospect of a smaller ‘pot’ value at retirement than would be expected with the standard 80/20 portfolio. The question the becomes: is this lower pot value warranted by the risk avoided.
This may be investigated quantitively. I set up a simple model, where debt securities have an expected return of 4% and volatility of 10%, with equities having an expected return of 7% and volatility of 20%. The correlation between them is 0.4. The returns distributions are assumed to be -Normal. The portfolio allocation is then modified from an initial 80/20 to all bond in steps of 5% until is reaches 100% debt after 17 years.
At this time the expected value of the 80/20 benchmark is some 20.45% higher than the ‘life-styled fund. The likelihood of the 80/20 benchmark delivering a return below the ‘life-style’ expected value is 14.24% and the expected loss relative to that value is 7.63%. By contrast, the lifestyle fund has a 50% likelihood of a return below its expectation with a value of 6.74%. If we define risk as the product of the likelihood and magnitude of an event, then the risk of the ‘life-style’ strategy is 3.37% while that of the benchmark 80/20 portfolio is just 1.08%. It appears that in this instance ‘life-styling’ is a case of reckless prudence in risk management.
The loss events of the ‘life-styling’ and benchmark portfolios are not independent of one another; they have a degree of dependence by construction. 32.8% of the benchmark portfolio’s problematic returns will be associated with underperformance by the ‘life-style’ portfolio; a case of damned if you did or damned if you did not follow the strategy.
In the vast majority of outcomes, the pension saver is far better off invested in the 80/20 Benchmark; The ‘lifestyle’ portfolio only exceeds the expected value of the Benchmark 80/20 portfolio in 2.04% of circumstances.
Of course, this is one simple illustration and we might vary any or all of the model assumptions, the expected returns on debt or equity, their correlations or the speed at which ‘life-styling’ is introduced. We might even introduce more complex rules, path-dependent strategies, such as moving to bonds only after a strong equity return, but these will all bring with them only variations in degree of the problem illustrated here.
If we add to this concerns that we may currently be in a debt bubble induced by monetary and quantitative easing, with the implications of that for future debt returns and volatility, ‘life-styling’ appears to be far from conservative and indeed unlikely to deliver the benefits usually claimed for it.
I agree with this and have serious doubts about ‘lifestyling’. How can an automated process take true account of an individual’s ATR/CFL and ‘feelings’ about long-term investment? Mind you, I’m not sure, either that the old 60/40 or 80/20 asset allocation models are much help either in today’s distorted markets!
Perhaps we rely to much on the intrinsic human reliance on what I believe economists call ‘futurity’ where we base assumptions about the future on past experience. I happen to think that prior experience has ceased to be a valid guide to the future and that the World Economic Forum’s idea that global equities are likely to return 3.45% p.a. in the future and bonds 0.15% pa. might be rather nearer the mark!
I’ll stick to my boring old investment trust companies that, I hope, will continue to throw off decent and rising dividends at a modest cost of ownership and use cash and NS&I instead of much in the way of bonds.
The lifestyling we recently adopted finishes at target retirement age with 53% equity 7% bonds and 25% cash. Most don’t know until near retirement what their actual departure date will be or whether they will take an annuity, drawdown or a bit of both, so this compromise should mean no-one massively loses out on potential gains or suffers from huge equity volatility. We think most would find it even harder to make a decision if faced with very volatile funds at retirement; they’d prefer some stability even if this means reduced investment returns. Whilst the simplicity of the AgeWage score is attractive I do think it misses out on how scary the journey was to get to where you are.
It is dependant on how you measure risk for a retiree. Unfortunately we are against an idea that volatility is the measure of risk.
I think that using a 4% per annum investment return is a bit too high given today’s environment of low interest rates. However if the expected bonds return is lowered thana higher equity strategy makes even more sense!
I agree volatility is not the only risk faced by retirees but I do think it is a consideration.
If the intent is to use the pot for cash or an annuity, either in whole or part, then having a high chance of large movements at the valuation point results in a high chance of large variation in outcomes. Most of our retirees do take cash, many take the whole pot and a good proportion buy an annuity. We think most would prefer lower volatility at retirement to aid their financial planning in the period leading up to retirement even if this increases the risk of a lower pot at that point.
If the member decides to use drawdown, or delay retirement, then there is still a large proportion invested in equity with its attraction of higher likely returns.
Typo, sorry, bonds should be 22%
The Tata Steel UK workplace pension is with Aviva and the default pre-determined investment path (which is a low-involvement investment) is the Aviva Future Focus 2 Drawdown Lifestage Approach.
The objectives of this approach are:
It aims to provide growth in the early years, although the value of your pension pot could fluctuate. It is designed to prepare your pension pot for flexible access at your chosen retirement age i.e taking some of the money as and when you need it, either as cash sums or as flexible income (known as drawdown) or leaving your money where it is and making your choices later.
At your chosen retirement age, you will have a number of retirement options (even if you remain invested in this lifestage approach), however this lifestage investment approach has been designed to prepare for the particular retirement options stated above.
This approach is not designed to prepare for withdrawing all the money in your pension pot or buying an income for your lifetime (known as an annuity) at your chosen retirement age.
This is how it works:
In the early years (up to 10 years before your chosen retirement age) the approach invests in a medium risk fund (Aviva Diversified Assets Fund II), which aims to provide growth.
From 10 years to your chosen retirement age your money gradually moves into a low to medium risk fund (Aviva Diversified Assets Fund I), which aims to help minimise fluctuations in the value of your pension pot.
From 3 years to your chosen retirement age some of your money is gradually moved into the low risk Aviva Deposit fund in preparation for taking part of your pension pot as a cash sum.
Tata Steel UK employees have recently received notification from Aviva that the default pre-determined investment path name will soon be changing to ‘My Future Focus Universal Strategy’ and there will be a change to the composition of the funds within it. The funds’ assets, objectives, risk profiles and the glide path of the Future Focus lifestage approach will also change. Investing responsibly will be a part of ‘My Future Focus’.
Aviva are making these changes because they believe their customers will benefit from enhanced asset class diversification (the concept of ‘not putting all your eggs in one basket’). The funds will now access additional asset classes such as Emerging Market Bonds (bonds issued primarily by the governments of the countries designated as emerging), Property (commercial property such as offices and warehouses) and High Yield Bonds (bonds issued by companies with a lower debt rating).
Over the long term, Aviva expect this to lead to an improved outcome for their customers.
But lifestyling is not about investment returns. It’s about the avoidance of regret in the run up to retirement. And how do you measure that?
Bryn, the numbers annuitising from DC workplace savings is tiny. My friends in annuity broking tell me that the vast majority of money they annuitize currently sits in cash, equity or with-profits funds. Schemes that run life styling into bonds to avoid regret risk when annuities fall in value is tiny.
However, where people understand they are lifestyling into bonds to buy an annuity – I see your point.
I wonder how many people retiring in the past five years have consciously understood the connection between their investment strategy and their decumulation strategy. I have seen no research on this.
Henry, in your opinion would you say the Tata/Aviva workplace pension investment and decumulation strategy (mentioned above) is a good one?