Colm Fagan
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On 7 February last, I made a presentation to the Society of Actuaries in Ireland, which I claimed would set out a “new and radically different approach" to drawdown under group defined contribution pensions arrangements (modesty isn’t my strong suit!). The full presentation and commentary can be found under the "past events" heading on the website of the Society of Actuaries, www.actuaries.ie. The following is a summary of the presentation.
The presentation identified three key defects with drawdown at present: (1) high charges; (2) low investment returns; (3) no security of income.
High Charges
High charges are a consequence of DC members having to leave their occupational schemes on retirement. They lose the valuable discounts the trustees have negotiated for active service members. They also have to cash in their existing holdings and take out new individual arrangements, Approved Retirement Funds (ARF’s). A 2016 report of the Pensions Council reckoned that charges on individual insurance-based arrangements were equivalent to a yield reduction of between 1.5% and 2% per annum. The presentation proposed to address the problem of high charges by allowing members to stay in the scheme post retirement and to draw down from their accumulated funds within the scheme. An easy win.
Low Investment Returns
This nut is not so easy to crack. Low investment returns are caused by ARF holders choosing low-risk investments. In November 2015, a Working Party of the Society of Actuaries in Ireland reported that over 40% of insured ARF’s were 100% in cash. There is a straight trade-off between risk and reward: the higher the risk, the greater the reward. It follows that the straightforward solution to the problem of low investment returns is to encourage ARF holders to invest in higher risk instruments, such as equities and property. But is it right to encourage people who are well into their third age to take the high risks that are inextricably linked to high rewards? The presentation looked first at how much investment returns could be enhanced by investing in equities and property, and then examined how the associated risks could be mitigated.
The Equity Risk Premium (ERP)
The presentation examined various approaches to estimating the Equity Risk Premium, defined as the extra return expected to be earned on average (a very important qualification, of which more anon) by investing in equities, property, and other "real" assets. The conclusion was that it was reasonable to expect an average ERP of 4% to 6% per annum in future. The ERP can be enhanced still further by investing in private equity and other illiquid investments. Some experts believe that returns on private equity are 3% per annum or more higher than on unquoted equities.
Higher Returns Mean Higher Volatility
Higher expected returns carry a high price tag. In the 32 years since January 1986, the stock market rose by an average of over 8.5% per annum, but it fell more frequently than one month in every three. In other words, the odds of being poorer one month after investing were shorter than 2/1 against. In 12 months out of 384, market values were down by more than 8% in the space of a month. That included one month (October 1987) when market prices fell by more than 25%.
Not only can sharp falls be experienced, but they can be quite prolonged. I reckoned that £1,000 invested in the UK stock market in December 1999, with dividends reinvested, would have delivered a lower return than if it had been left in the post office between then and October 2013. (A fund management charge of 1% per annum was assumed in the calculation, and an average interest rate of 3% per annum for post office savings.) Given that result, it is worth asking why should one risk the stock market, and all the volatility that goes with it, if there is a possibility that you could earn more in the post office, even over quite a long period.
Human nature is a contributory factor to high levels of risk aversion. Behavioural economists have found that people give twice as much weight to losses as to gains. We can all relate to that: we hate losing money. Hindsight bias is another feature of behavioural economics: advisers (think financial advisers) who expect to have their recommendations scrutinised with hindsight are driven to extreme reluctance to take risks.
We are thus faced with a conundrum: investment in real assets such as equities and property delivers much higher long-term returns than bonds - of the order of 4% to 6% per annum on average - but the associated short-term risks and risk aversion, which is part and parcel of being human, militate strongly against investment in such assets. The psychological objections to high risk investment are particularly relevant for people into their 60s, 70s and 80s - and maybe even into their 90s. It is simply wrong to ask them to bear too high a level of risk.
Smoothing
Smoothing was the proposed solution to this conundrum. The presentation recommended that a high proportion of the fund be invested in equities and property, with returns smoothed to ease the pain of downturns. The presentation set out the principles that should guide whatever smoothing formula was devised.
The formula should be utterly transparent, with no scope for subjectivity and no actuarial black boxes. When applied to historic data, the formula should mitigate - ideally eliminate entirely - negative movements in smoothed values, but at the same time it should faithfully reflect long-term trends.
The proposed smoothing formula gave just 1.5% weighting to the current month’s market value and 98.5% weighting to the previous month’s smoothed value increased by one month's interest. Applying the formula, the graph below shows what smoothed prices would have looked like over the last 32 years for the UK stock market. The graph looked similar for the US stock market.
The smoothing formula worked wonders. Whereas previously there were 12 occasions over the last 32 years when values fell by more than 8% in a month, including one month when they fell by over 25%, there were only two occasions over the same period when smoothed prices fell over a one-month period and on both those occasions the fall was less than 0.05%. In other words, smoothed prices never fell, when prices were rounded to one decimal place, not even in the infamous month of October 1987.
There remained one major problem. Whenever the smoothed value is less than the market value, there is a risk that new investors will pile into the fund to avail of the discounted price. For example, someone joining in the late 1990s could have bought in at less than 70% of market value. The converse is also true. Whenever the smoothed value is less than the market value, there is a risk that investors will leave the fund, pocketing more than the market value of their investments. Someone selling in the early 2000’s or in 2008/2009 could have netted 150% of market value. Continuing members lose out in both cases. They foot the bill for pay-outs at greater than market value, and they also subsidise new people coming in at less than market value, so it's vitally important to take effective action to reduce the risk of adverse selection to the absolute minimum.
The presentation proposed a number of safeguards to minimise the risk of adverse selection. New money would only be accepted from new retirees: people could not defer the decision on whether to join the smoothed fund until some time after retirement. Even with this restriction, it was also proposed that money would be allocated to the fund (at the smoothed price) evenly over two years. Withdrawals would have to follow a smooth progression (“it's a pension, not a piggybank"). On death, payment of the balance on a member's account would also be phased, not because of the risk that someone might commit suicide when market values were less than smoothed values, but because of the option available to dependants to take continuing income or a lump sum on death.
Despite these safeguards, there could still be a risk of adverse selection. The presentation looked at what would happen if new money fell by 50%, or dried up completely, whenever market values were less than 90% of smoothed values. Back tests over the last 32 years for both the UK and US stock markets indicated that, even on these extreme assumptions, adverse selection would not be a problem.
The same would not have been true for the Japanese stock market. A similar back testing exercise for Japan indicated that continuing investors would have been cleaned out completely if withdrawals were allowed at smoothed values rather than market values. The adverse result for the Japanese market was due partly to the massive bubble in the late 1980s followed by the crash in the early 1990s, but the failure of smoothing for Japan could be mainly attributed to the fact that markets stayed low for decades following the boom and bust.
It was concluded that the Japanese experience was an aberration, not a precedent, and that there was a negligible risk of a smoothed fund, which would be invested in a range of asset classes and across many geographies, suffering a fate similar to that experienced in Japan. This conclusion was supported by data from a December 2017 paper “The Rate of Return on Everything, 1870-2015", which analysed returns on real assets across 16 developed markets over the entire 145 year period since 1870.
Investment Strategy
It’s worth stating the context that determines the appropriate investment strategy for a fund managed on the proposed lines:
(1) future cash outflows are highly predictable.
(2) there is no risk of sudden unanticipated cash outflows, unlike banks, insurance companies, and even mutual funds;
(3) since only 1.5% weighting is given to the current month's market value, accurate estimates of current market values are not vitally important;
(4) payments to beneficiaries are paid gradually over a 20/30 year period, so a long-term focus is essential;
(5) smoothing of investment returns allows the investment managers to escape from the tyranny of short-term performance measurement, and allows them to focus on long-term performance.
Consideration of the above context leads inexorably to the conclusion that the investment strategy should be radically different from that normally recommended for pensions in drawdown.
First and most important, every single investment of the fund, without exception, should be selected with the aim of generating the desired target return of the risk-free rate plus 4% per annum, or more. This means that there is no room whatsoever for bonds in the portfolio. This completely contradicts the conventional wisdom that retirees should invest their age in percentage terms in bonds: 70% at age 70, 80% at age 80, et cetera. I concluded that the percentage in bonds should be zero at all ages.
Another consequence for the investment strategy of the criteria set out above is that up to 20%, possibly even more, of the fund can be invested in illiquid securities and property.
Needless to say, risks must be managed so as to avoid excessive exposure to specific industries, geographies, technologies, investment themes or economic outcomes. As readers of my "Diary of a Private Investor” column will know, a personal belief is that a surprisingly small number of investments - possibly even as low as a dozen - would be sufficient to ensure the required level of diversification, but I recognise that this view will not be shared by many investment professionals.
Ensuring Security of Income
The proposals so far have dealt with two of the three deficiencies noted at the start for DC pensions in drawdown: high charges and low investment returns. There remains the third deficiency: lack of security of income in retirement.
One of the biggest worries facing a DC pensioner is "How much can I withdraw each year so that I don't run out money before I die?" It's no use telling them that they should plan for an average life expectancy of 26.4 years, or whatever the mortality tables say. For someone in drawdown, all that matters is their personal life expectancy, not some average dreamt up by the actuaries. Their personal life expectancy could be anywhere between zero and 40 years. There is a risk that they could draw down too much or too little.
The traditional solution to this dilemma of an unknown future lifespan is to buy an annuity, but this option carries a heavy cost:
(a) the money is invested in the low-yielding bonds and
(b) most of it is lost on early death.
The solution to the dilemma, as proposed in the presentation, was what I called the "Lifetime Income Fund" (LIF). The LIF works as follows: on retirement (say at age 65) the retiring member divides their retirement pot into 25 identical sub-pots. They cash one of the sub-pots every year for 25 years. Thus, at the end of 25 years, they will have cashed all their sub-pots and will have nothing left. In the meantime though, they have been contributing (say) 1% of their fund each year to a separate, pooled, LIF account, which is managed by the trustees. (The 1% contribution will vary slightly from scheme to scheme, depending on the gender and occupation mix of scheme members.) The yearly 1% contribution to the LIF can be considered as being similar to an additional management charge.
On surviving to the end of 25 years, i.e. to age 90, and having taken the last of their pension sub-pots, the Lifetime Income Fund rides to the rescue. It gives the member another sub- pot each year for the rest of their life. For example, suppose Joe retires at age 65 with a pension pot of €250,000. His pot is divided into 25 identical sub- pots, each of €10,000. The first year, he cashes his first €10,000. The second year, he cashes his second €10,000 plus whatever smoothed interest has accrued in the year, say €10,400 in total. The third year, he cashes his third sub-pot plus another year's smoothed return, making a total encashment of (say) €10,700; and so on in each subsequent year. If Joe dies at the end of year two, after cashing his first two sub-pots, the other 23 sub-pots, i.e. €230,000 plus two years’ interest, i.e. 107% of €230,000 in the above example, are paid to his estate.
Suppose on the other hand that Joe is still alive at age 90. He has cashed a sub-pot each year since retiring at age 65, taking his final (i.e. his 25th) sub-pot in his 90th year. By that time, the starting €10,000 in a sub-pot has increased with interest to (say) €30,000 (implying an average interest rate of 4.5% per annum, net of the 1% per annum contribution to the LIF, over the 25 years.) The following year, when Joe is in his 91st year, the LIF pays him €30,000 plus another year's interest, and so on each year for the rest of his life. This assures him a sub-pot every year for as long as he lives.
People who die before reaching age 90 pay for this largesse. The biggest “losers” are those who died shortly before reaching age 90; they paid 1% each year to the LIF but get nothing in return, other than the consolation (not to be sneezed at) of knowing that if they had survived for another few years, they too would benefit from the LIF.
Approximate calculations indicates that someone who lives to age 100 could expect under these proposals to receive a total income in retirement of more than 2 1/2 times what they would have got from an annuity.
The combination of
(1) allowing members to remain in the fund post retirement so that they continue to benefit from discounted charges,
(2) investing their money in assets expected to generate an average return of at least 4% per annum greater than the risk free rate;
(3) smoothing investment returns in order to alleviate, or possibly even remove completely, the pain of the higher volatility associated with those high returns; and
(4) establishing the "Lifetime Income Fund", which gives members the peace of mind of knowing they can run down their savings to zero and still enjoy a regular income for the rest of their days;
will transform the retirement landscape for DC pensions.
The presentation also looked at whether the proposed approach could be extended beyond people retiring from large group schemes, to include those retiring from small group schemes and individual arrangements, and also whether it could be extended to the accumulation phase pre-retirement. There are major challenges under all these headings. The same is not true for the government's proposed auto-enrolment scheme. The presentation concluded that the proposed approach was ideally suited to auto-enrolment, both pre-and post-retirement, provided that the rules are set appropriately at the start.
I now have the zeal of a missionary in promoting the proposed approach. I do not want it to be an academic exercise. I would appreciate whatever support AAM contributors can offer in promoting it to employers and trustees of DC pension schemes. I would also welcome questions and comments on the proposed approach.
I emphasise once again that this is a summary of my presentation of 7 February. Please refer to that presentation and accompanying commentary for further enlightenment, but come back to me if you still have questions.
I’m going to be out of contact for much of the next couple of days. Instead, I’ll be enjoying myself in Cheltenham! All tips gratefully accepted as I know nothing about horses!
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[The emoji belies the genuine seriousness of the question - what I really mean is if some really bad stuff occurs.]