Advisers to defined contribution (DC) schemes would do well to recognise investment risk management ...
Advisers to defined contribution (DC) schemes would do well to recognise investment risk management is not just about protecting the scheme member - it also protects the trustees and the sponsoring organisation, whether this is one or more employers, a trade body or professional association.
In the United States members of DC schemes dissatisfied with their funds' performance have taken trustees to court where they have accused them of failing to discharge their investment responsibilities satisfactorily. US court rulings indicate if trustees want to be free of the threat of litigation, they need to offer an appropriate fund choice and to educate members to use it wisely.
The success of DC schemes and plans in the UK will depend to a great extent on how well the provider manages the investment risk. Risk management techniques for DC products are still in their infancy and vary considerably. For these strategies to work, it is essential investors understand the difference between risk from inflation, risk to capital and the risk involved in pension conversion.
This is particularly important with funds which aim to protect members from stock market volatility. For example, some of the guaranteed funds which offer a link to stock market growth, yet also protect investors' capital from market falls, are not as cosy as they look. It is important to view product claims with caution as the small print often tells a different story from the headline claims. Potential growth may be limited and there can be penalties if a scheme member pulls out early.
Other options should also be explored. Global Asset Management (GAM), for example, uses a combination of multi-manager and single manager funds, some of which are based on financial instruments and aim to offer very low volatility throughout equity cycles. These typically achieve a 12-15% annual return irrespective of market conditions. State Street Global Advisers has also developed a range of what it calls 'long/short' (market neutral) funds for UK pension funds.
Market neutral funds are sophisticated asset management vehicles. Most guaranteed equity funds are not. Guaranteed equity funds were introduced in 1991, with the blessing of the government, as a way to tempt cash savers into stock market funds. Since then the market has grown rapidly and now incorporates a bewildering range of products, many of which can be held within a pension plan or can be used separately as a cautious investment for retirement.
Statistics are not yet available to show what proportion of pension fund premiums is directed into guaranteed funds. However, the appeal of this type of fund can be seen in the sales figures for guaranteed equity funds in the life market which reached £1.5bn in 1999. Big names here include AIG, Scottish Widows and Scottish Amicable. A few unit trust groups offer 'protected' funds (the regulators do not allow them to use the term 'guaranteed'). These include Deutsche (previously a Morgan Grenfell fund), Close Fund Management and Govett.
Derivatives can play an important role in protecting investors from unwelcome volatility, particularly in the years preceding retirement. However, derivative based guaranteed funds are not a universal panacea for DC investment risk, and those responsible for product design should consider how this type of fund can be used in conjunction with other risk management techniques such as with-profits contracts, within a 'lifestyle' asset allocation strategy. The lifestyle approach determines the asset mix for each member according primarily to age and the number of years to retirement.
Any strategy which tackles investment risk should have a clear objective. The two most obvious risks for DC scheme members is they will invest in the wrong type of assets at the wrong time and their fund will be decimated by a market crash just before retirement. With-profits and guaranteed funds provide different types and degrees of protection against market volatility whereas lifestyle is an overall strategy and is used to direct investors into appropriate asset classes throughout the investment term.
Whether used separately or in conjunction, these approaches to risk management share a common aim, namely to enable investors to benefit from the growth associated with exposure to real assets but at the same time to protect them from the full impact of a severe fall in the markets. The structure of with-profits funds is designed to suit the medium to long term investor, while derivative based guaranteed funds generally are not considered appropriate for this purpose due to the limits on the total return (these funds usually do not benefit from reinvested dividends) and the cost of derivative contracts.
The lifestyle strategy is used by many DC schemes and individual plans as a default option. Typically it would direct contributions into equities until the investor is about 10 years away from retirement. From this point new contributions are invested in a guaranteed fund or in gilts and cash. At the same time the rest of the member's fund is gradually switched from equities into these capital protection funds.
Most experts agree the lifestyle structure is the best default programme for investors who do not want to make their own asset allocation decisions or who might otherwise put too much into cash and bonds at an early age. There are drawbacks, however.
Some advisers argue that to start to pull out of equities 10 years before retirement takes the investor out of real assets too soon and at a time when regular premium plans in particular tend to benefit from the greatest growth. A five year phased switch out of equities might be preferable.
But perhaps the biggest problem is standard lifestyle programmes do not cope well with a variable retirement date. Few employees these days remain employed until the company normal retirement age. Many go early, either vo
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