An alternative to lifestyling in defined contribution

Panellists discussed a paper authored by Columbia Threadneedle Investments' Christopher Mahon – Lifestyling: the Achilles heel in DC pensions – and debated whether too much derisking was a bad thing.

The roundtable – chaired by PP editor Jonathan Stapleton and held in association with Columbia Threadneedle Investments – also looked at some of the implications from the Chancellor's Mansion House speech on DC megafunds; last year's Autumn Budget and discussed the FCA's Value for Money consultation.

Christopher, can you start us off with some background to our discussion?

Christopher Mahon (Columbia Threadneedle Investments): Let me begin by quoting Rachel Reeves' Mansion House comments that for too long, pensions have been regulated for risk and not enough for growth. Her solution is size and consolidation, but it is also interesting to look at why that risk aversion came about in the first place.

One example of excessive risk aversion is highlighted in our research – Lifestyling: the Achilles heel in DC pensions. Lifestyling dates to before 2015; it is tied to the income generation, low-risk endpoint that regulators used to have as their requirement. Yet even since pension freedoms scrapped the annuity requirement, de-risking and lifestyling still remain the orthodoxy.

I want to challenge that safety first orthodoxy in DC, and our research has three ways of highlighting the drawbacks. The first looks at the returns of the median saver. Median returns end up being about 2.3% lower per year on average on lifestyled products, which compounds out over a typical five-year period of derisking to a sizeable £12,000 hit on a retirement pot of £100,000. From the point of view of trying to support UK growth it also means that there is less investment to support growth – about a £25bn hit.

The second point is looking at how the limited benefits of lifestyling failed to offset the costs through recent market crashes. In every five-year period of our analysis, the low-risk cohorts underperformed the high-risk cohort – and that includes the five years ending Q1 2020, the maximum market stress point of Covid. The costs of being derisked for so long failed to make up for the protection of lifestyling during that extreme event.

The third angle is around alternative options. Australia is often held up as a best-in-class DC system. Yet their trustees do not have to lifestyle. Only around a third of pension fund trustees choose lifestyling, and around two-thirds choose not to. In other words, other systems approach this challenge of pre-retirement differently.

What are your thoughts on lifestyling? Are we derisking excessively?

Stephen Budge (LCP): The thinking around derisking definitely needs to evolve. The impact it had, particularly through the Liz Truss and rising interest rate period, highlighted the need to rethink asset allocation, how we support members and think about risk in retirement.

On one side, we have a mix of single employer trusts, where trustees view retirement as their endpoint because the member will move on to somewhere else to access their benefits, and the other being the master trust world, which focuses on longer-term income and investments.

Your view on the speed of de-risking comes back to defining the investment horizon in that period approaching retirement. For single employer trusts, they are likely to still have that derisking thinking. Contrast that with those that are going to support the member for retirement as well, you can argue that their investment horizon is much longer.

Sophia Singleton (XPS Group): Derisking is anchored in this history of annuities, but there is another factor, which is that many people are still encashing at retirement. Trustees are also, rightly, thinking about members' behaviours and their reaction to volatility as they come to that retirement point. Members do not want to see volatility when they are planning their retirement.

That is not to say those strategies are right. What will drive the change to more return within strategies is more people going into to and through solutions, so that they do not have that single point of decision-making about what they do with their whole pot. They can start drawing down and stay invested. That will be the turning point that will free us from too much caution and will really help members.

James Monk (Fidelity International): There is a diverse set of objectives when it comes to retirement, and it is really important to allow members the flexibility to meet their own needs. Volatility management is very useful in helping people make decisions. Christopher mentioned Australia, where funds have a higher allocation to less-liquid assets, which brings a greater level of flexibility. Also, there is a natural shift in objective from growth to income, so that lends itself to a slightly different portfolio on approach to retirement as well.

William Chan (Legal & General Investment Management): There are some funds invested 100% in equity. No one would advocate that a 65-year-old holds 100% equity. Australia is a bit different, where the single default fund average is about 75-80% growth, with illiquid / private markets allocations providing a smoothing effect against mark-to-market pricing during large global shocks.

Lifestyling probably does need to happen in a default approach that's 100% equity. The key point is what you derisk into and whether it is a higher growth level relative to current UK defaults.

Jerry Butcher (Scottish Widows): We're currently looking at our approach to lifestyling. We still have lifestyling, but we are trying to work out whether we can keep customers in growth assets for longer.

A lot of our customers encash. That behaviour will likely evolve as DC pots get bigger, but as things currently stand, a lot of customers encash. We also currently see a lot of customers draw down faster than is sustainable, so we must work with that as well as have a view of the future.

It could theoretically be the case that, in future, we might look towards a cohort analysis, where you consider size of pot or other characteristics and derisk through that lens. For example, where a customer cohort can afford to take more risk and absorb more volatility and, therefore, you have a solution for that cohort. However, that's difficult in practice, because customers may have multiple pots and you might not be able to see their entire wealth – so how do you assess which cohort they should be in? You could also see a future where it is more of a pooled approach, that allows more risk taking in aggregate, but it is not clear whether the industry is going to move that far.

Overall, we still view lifestyling as appropriate at this point in time, given how customers behave.

Lok Ma (Law Debenture): DC investment weighs heavily on the trustee's mind. We have a very strong sense that the decisions trustees make directly affect what members receive.

Societal attitudes to risk are generally of massive risk aversion -- ‘better the devil you know' and ‘better safe than sorry'. If I look at the people I know and think who has achieved financial independence, one might ask whether it is down to education, work or luck. One of the key drivers, however, is being able to take rewarded risk repeatedly.

How does that translate into how trustees work? No member writes you a letter to say: ‘Thank you so much for taking all that risk. I am very much enjoying my massive pension pot'. What you get is: ‘I cannot believe you lost 12% last year. What are you going to do about it?' That membership risk aversion can influence trustee decisions.

Andrew Brown (Columbia Threadneedle Investments): An appropriate level of risk throughout a member's investment period, with meaningful targets and some degree of active asset allocation, could be an alternative to widely adopted approaches, instead of ramping up risk in the early years and then dialling it down towards a target retirement date, especially given that that a member is likely to require investment gains for a further 10, 15, 20 years or more.

In the absence of good levels of member engagement, we need to make assumptions, and the perceived risk required for members approaching retirement may need to be reconsidered.

In terms of equity market risk, we should be mindful that auto-enrolment has grown up in a time of unusually strong stock market returns. Central bank and governmental interventions have been supportive for the asset class. Therefore, we still need to be somewhat wary of equity market risk and utilise the benefits of diversification.

If the current derisking approach is not optimal, what are the alternatives?

Christopher Mahon: At one extreme, you have the Australian model, where you stay fully invested all the way through retirement. Those are generally a risk-on profile – 55-60% equities, a further 15-20% in private equity, infrastructure and real estate with a very small amount in defensive assets. By contrast, the UK's default today is a model of about 25% equities as your endpoint. That's a very low amount, in my mind. There are a myriad of intermediate versions the UK could use instead.

Jerry Butcher: The characteristics of customers who invest in the default varies considerably, but we must base the approach on what most people do – considering the timing of cash flows, when and how quickly people are drawing down, and so on. You then have to make some kind of judgement about whether you optimise for the median returns outcome or downside outcomes. We continue to believe in a lifestyling approach based on current customer profile and behaviour but aim to have an appropriate level of exposure to growth assets throughout.

Lok Ma: Technology might be interesting – a technology-based way forward, with all the AI capabilities, to develop a glidepath tailored to each member's likely needs.

There are regulatory challenges around the divide between guidance and advice, but in the next ten years, I could see each member having a more tailored investment strategy based on the information we have about them.

To what extent will Mansion House proposals on DC, as well as the value for money (VFM) framework, impact DC default innovation and lifestyle strategies?

Sophia Singleton: You need to have return coming up to retirement, so we should not be taking too much return off the table. That return also has to be delivered in a diversified way. So, there is definitely a place for asset classes such as private markets and productive finance.

The question is whether the Mansion House changes will achieve that. Scale definitely helps with diversification, but is it automatic? We'll have to wait and see. In the meantime, schemes can and should look at how they can incorporate wider asset classes to deliver better risk adjusted returns.

Stephen Budge: The Chancellor says efficiency starts from pools of £25bn and improvement to the UK economy starts from £50bn. If that is the case, you can see why there is a drive for scale. My challenge though is that there will be a lot of turmoil and member savings moving around to meet these thresholds. That doesn't work very well if you are trying to deploy it into private assets. I am also nervous that we may remove some of the innovators in the market just driving for scale.

Andrew Brown: We are seeing a more mandated route to consolidation, which, unfortunately, will see some of the more innovative and smaller innovators rooted out.

It is likely they will have to consolidate, and that innovation can go with them to their acquirer, but we may find a similar experience to that of Australia; the herding instinct, where master trusts play it safe and invest in a similar way to each other.

James Monk: There was a lot of concern about UK-mandated investment in the run-up to the Mansion House speech, and, thankfully, the government listened to industry and said mandating was perhaps not the best route. It's interesting that they are potentially thinking about a very crude tool of consolidation which comes back to that mandated mindset.

At Fidelity, we have always had a single default; with no annuity and cash glidepaths. We are almost 10 years on from pension freedoms now. Annuity and cash glidepaths do not offer better outcomes and they do not deliver on member expectations. Members take the decision at retirement that offers them the best value in retirement, based on their personal circumstances at that point in time. As a result it is about also focusing on the simplicity of maximising pots at retirement to enable flexibility through affordability.

Jerry Butcher: We support what the government is trying to achieve. How they implement this is going to be really important. We would like to see a transition that does not force one structure over another, that maintains innovation in the market, and that encourages providers to be willing to do things that are different from the pack.

Is herding necessarily a bad thing, and if so, is that a real risk of this out of these proposals?

Christopher Mahon: It is a genuine risk that you end up with a very concentrated industry. Again, looking at Australia, it also has a consolidation agenda. The rumoured floor in Australia is about £15bn, which is lower than the proposed threshold in the UK. That is in a much more mature industry, where there are already about two dozen schemes at that level or above.

Australia may end up with 30 to 50 schemes, which is a much more competitive peer group. If you want to be top-quartile in that peer group, there are people to beat. If you end up with six in the UK, it is a different peer group, potentially with less competitive tension. Therefore, if you have only a small number, there are fewer incentives to be innovative.

Sophia Singleton: That point about competitive tension is important. We need to maintain that. The VFM framework helps, because it is shifting the focus away from cost to performance and value. But we do need to maintain enough providers in the market and allow new challengers to enter.

To what extent will a more definite endpoint help us come up with a more risk-on approach to retirement?

Stephen Budge: We have inertia to get people into retirement savings and auto-enrolment worked very well. The bit that we still have not sorted is retirement. With the government's focus and with the provider market developing, having the requirement to set proper default pathways around guided retirement will push for a lot more innovation, which is a really exciting opportunity to improve member outcomes.

James Monk: One of the main challenges in that space is that we have become addicted to pension freedoms. There absolutely needs to be a place for a very strong retirement default solution that help provide better outcomes for most people, but you start to get into slightly murky water if you lock them into a longevity pooled solution without their consent.

What are your key takeaways or concluding comments from this discussion?

James Monk: I am really heartened by Columbia Threadneedle Investments' report, because it puts a spotlight on an issue that perhaps represents a bit of a legacy mindset around the cliff edge to retirement. Retirement journeys are being reviewed, the risk profiles and the risk impact on outcomes, and to reframe how members engage with retirement. Finally, when you think about some of the trajectory on Mansion House, I am really heartened by the focus on value and how the limit on defaults is, hopefully, going to help us focus on that maximised pot objective and improve outcomes. I am really heartened. It is all positive.

William Chan: I echo the sentiments. Thank you for the research that has been done. We have been doing a lot of work in this area as well. Our main conclusion is that lifestyling still has a place for growth-heavy defaults when members are further away from retirement, but the endpoint is where the debate and discussion is – with questions such as ‘what is that endpoint?', ‘what does a scheme's demographics look like as members approach retirement' and ‘are pension schemes taking enough risk for members at retirement with those demographics and retirement trends in mind?' areas where we are going to do a lot more work.

Stephen Budge: It is good idea to challenge the thinking around the glidepath. That whole phase is something that needs to evolve beyond just investment in terms of wider member support to improve outcomes and the retirement journey for members. It is a great challenge.

Andrew Brown: I would echo that. When it comes to DC, it is optimising the investment decisions on behalf of members that is going to have the most material impact in the absence of greater contribution rates.

The most pressing issue is adequacy. The government has not really spoken too much about enhancing or increasing contribution rates – if we are going to get to where we want to be in DC, this will need to be addressed sooner rather than later.

Lok Ma: This feels like, for the first time in a while, the dawn of a new era in pensions. The government is willing to talk about it; providers are innovating. It feels like there is more scope to think about what is best and to challenge orthodoxy. Possibility is in the air, and I welcome it.

Jerry Butcher: I would agree with the comments so far. We are very supportive of Mansion House and where the government is trying to get to. How it implements it will be really important. I agree on the importance of the adequacy point, though I can link that to the government's objectives in terms of productive finance. There are a lot of questions as to whether we are going to get the demand side right and the supply of attractive investment opportunities right as well. Overall, I can see what they are trying to achieve, and we are very supportive of that.

From a lifestyling perspective, Christopher, your paper and this discussion are really timely, because, as I have alluded to, we see a case for taking a bit more risk for longer in our lifestyling, and we are evolving in that direction. We do not think that we are going to move to a model where we do not have lifestyling right now, because of the profile of our members, what they understand when they look at their investments, and how they behave in retirement. We know that we will need to continue to evolve in the future as the market evolves, the government's view evolves and member dynamics and characteristics evolve. It is really timely to have this discussion, so thank you.

Sophia Singleton: Yes, it is really good timing. We are at a very positive turning point for DC schemes when it comes to the retirement discussion. We have talked a lot about current members' behaviour, but, over the next 10 years, DC is going to become the dominant source of retirement savings, and so income will, hopefully, become the focus rather than encashment. That means that investment strategies will need to change, so we should definitely be looking at the lifestyling approach and how we can adapt that. To the point about adequacy, we are not saving enough. Therefore, assets need to be punchier and to return more in order to help bridge that gap. All of this feeds into improving those retirement outcomes.

Christopher Mahon: Our observation is that scale and derisking are two different things. The government is absolutely right to talk about scale, but, at some point, it has to talk also about excessive derisking too. Derisking within the DB system is well-known and well-articulated, and the purpose of this was to start that conversation about de-risking in DC and ask whether it too has gone too far.

This roundtable was held on 28 November 2024 in association with Columbia Threadneedle Investments