This article was first published on linked in It’s well worth following Stefan and indeed linking in to him as he has a range of good articles on that platform. A new one is coming on pension choice – always a hotly debated subject at NOW pensions!
Almost everyone agrees that it is a good idea to reduce investment risk when approaching retirement. Yet there is not yet a consensus on how much risk should be taken take off the table. If we view the state pension as a financial asset, when combined with private pension savings, it would seem that most savers are de-risking too much.
This is a classic example of framing. In traditional economic and financial analysis, framing is considered irrelevant, but in practice it heavily influences the perception of risk when making decisions. Let’s have a closer look at life cycle investing.
The traditional life cycle narrative
From an initial assessment, a narrative of life cycle investing seems to make sense; our human capital (future earnings) can be seen as a safe asset yielding monthly dividends. A young person can therefore hold a lot of equity risk (preferably leveraged) since most of their wealth are in their future earnings. An old person, on the other hand, has little to no future earnings left and should therefore be defensive when investing their financial wealth.
This narrative is augmented by the belief that equity risk is diversified over time, since equity returns are assumed to be mean reverting. In other words, a long-term investor can maintain a significant allocation to equities given that short-term volatility will cancel out. This basic narrative is the foundation for most investment modelling tools.
The life cycle narrative is relatively easy for pension providers to operate. Most providers start with 100% equities for young people (AP7 in Sweden has taken it one step further and has a target weight of 125% in equities using leverage). In most cases, the portfolio is de-risked starting about 10 years before retirement and ends up, at retirement, holding something like one third in equities and two thirds in nominal bonds, with relatively short duration.
Real life risks
As a theoretical framework, or rule of thumb, it is not a bad framework. It is a crude budgeting tool that supports long-term planning, but we should not see it as more than that.
In many cases the yield on human capital is not that stable. In our life we face unexpected life events that could have a large impact our income. A career opportunity could result in a positive shock in future earnings, while having an accident that results in long-term disability could have a significant negative impact on future income. In addition, the yield on human capital is somewhat correlated with the financial markets, as the general level of unemployment increases in a recession/depression.
The main risk in financial markets is not short-term volatility. The real risk is that long-term returns fall significantly short of expectations. For example, earning 1% more annual return than expected for the first 30 years of contributing to your workplace pensions would result in 20% more savings. In addition, financial markets have the nasty tendency to ‘misbehave’ compared to the normative mean revision model, so we should not bank on future investment returns.
State pension – the forgotten pension asset
The state pension in the UK is an inflation-linked, lifelong annuity providing an retirement income of £9339 per year. The market price for a corresponding real annuity is around £330 000. Due to the triple lock, the state pension would be even more expensive if it was provided by an insurance company. By comparison, an average income earner paying the minimum auto enrolment contribution (8 percent) is expected to grow a pension pot of £230, 000 in today’s money value, assuming an average real investment return of 4 percent.
Adding the state pension to the workplace pension pot means that, at retirement, approximately 60% of the ‘holistic’ pension pot is invested the safest asset available – a lifelong real annuity provided by the government. Following the traditional lifecycle, the remaining 40% is invested two-thirds in short-term nominal bonds, and one-third in risky assets (equity). This implies that the average income earner, at retirement, will hold approximately 13% of their holistic pension pot. For those who have a smaller pot than the average income earner, the equity allocation would be even lower.
Yet it is not common practice to include the state pension, when considering the asset allocation for the workplace pension. The practical difficulty of putting an economic value on social security benefits, such as the state pension, might be one explanation. The mental compartmentalisation that leads to viewing workplace pensions as a standalone investment problem could be another. There are many more possible explanations.
An elegant framing
For simplicity, let’s have a look at a DC saver choosing a drawdown for the next 20 years. After that he/she will live from the state pension. This is a difficult investment problem since the individual is withdrawing money every month, the investment horizon is reducing year on year and the sequencing of investments returns will impact the outcome. A financial engineer can probably solve this in an elegant way, with automatically rebalancing etc, but it is not intuitive and requires continuous involvement from the saver.
Don Ezra has an elegant framing of the drawdown challenge, based on mental compartmentalisation. In the long run we don’t know what will happen given that financial markets are uncertain. To provide near-term income stability, he suggests holding the next 3 to 5 of years retirement income in safe assets (short-duration bonds), with the remaining savings invested in risky assets (stocks). Don frames the near-term income stability as insurance, since it helps sitting out short-term volatility but also, and perhaps more importantly, buys time for individuals to adapt to the new situation if risky assets fail to recover.
The mental compartmentalisation between short-term income stability and longer term risk-taking is an intuitive idea. In this example, it corresponds to an equity allocation of between 75 to 85 percent in the pension portfolio at retirement. It might come across as aggressive, but when the state pension is included, this corresponds to an overall equity allocation ranging from 30 to 35 percent. As time moves on, a natural de-risking will take place as the safe assets are replenished from the risky assets.
Risk is in the eye of the beholder…
…but how we perceive risk boils down to the framing we apply. It is not surprising that we are willing to accept a vague intangible concept as human capital but ignore the tangible state pension asset when determining the lifecycle for workplace pensions? From a holistic point of view, it seems like most workplace pension providers follow a lifecycle that de-risks too much for members approaching retirement.