Last year’s investment losses have caused serious headaches for pension trustees, whether defined contribution (DC) or defined benefit.
For those individuals in DC nearing retirement, investment losses coupled with rising inflation have made it even harder to make what is already one of the most important financial decisions – when, and how, to take their pension.
A recent survey from Legal & General found that 2.5 million people planned to delay their retirement due to the impact of the UK’s cost of living crisis, by an average of three years. Of these, an estimated 1.7 million expected to work “indefinitely” beyond normal retirement age.
Corporate Adviser’s data from the end of September 2022 found that the average at-retirement default fund fell by more than 9 per cent over the previous 12 months, after accounting for a 0.5% charge. Older savers typically suffered bigger investment losses than younger savers in default funds, which declined by 8.58 per cent after charges on average.
Many DC savers will be in lifecycle or target date funds that are designed to lower investment risk as they get nearer to retirement. However, this generally involves moving from an equity-heavy allocation to one more tilted towards fixed income or cash – investments that are generally more negatively affected by rising inflation or interest rates.
“While historically bonds have performed well during equity bear markets, markets saw a perfect storm across both equities and bonds in 2022,” says Ouaile El Fetouhi, head of portfolio engineering and analytics at Natixis IM. “It was the worst year for equities since 2008 and the worst year for bonds in multiple decades.”
On top of this, the impact of September’s “mini-budget” on UK government bond prices added to the market turmoil, he adds.
Where does this leave those looking to retire in 2023?
Drawdown dilemma
Of the various groups of pension savers affected by last year’s market movements, those in drawdown will have felt it most keenly. Investment losses have directly impacted their spending plans, as have rising prices.
“Drawdown strategies generally need to balance two competing effects: having enough money to maintain a desired lifestyle while making sure that there is enough money left in the pot for the future,” says Natixis’s El Fetouhi. “Flexibility in the drawdown strategy was clearly critical to navigate the environment last year and preserve the future value of any investment portfolio.”
The relatively dramatic movements in government bond prices have also shifted the annuity market substantially. Average annuity rates increased by 44 per cent during 2022 to the end of November, according to Canada Life, and hit a 14-year high point in October.
A healthy retiree purchasing a 30-year guaranteed annuity for £100,000 would have received an additional £59,940 in income over the life of the annuity if they purchased it in November compared to January 2022, Canada Life’s data show.
This may have gone some way to offsetting investment losses, where savers were planning to buy an annuity with their fund, says Jesal Mistry, senior DC investment director at Legal & General Investment Management (LGIM).
“While the fall in the value of their savings may cause alarm among members, the investment strategy is actually doing what it should – preserving the annuity purchasing power of the member’s pot,” he adds.
Diversify, diversify, diversify
Most experts advise schemes against betting big on inflation going in one direction or another, or making major asset allocation decisions based on last year’s results. Instead, trustee boards should seek to ensure their investment portfolios are diversified enough to capture positive market movements while smoothing out the impacts of negative periods.
As Emma Matthews, head of investment at Now: Pensions, explains: “It is difficult to time economic and market environments. Our approach is to spread our holdings across a range of investments that perform differently in different economic environments rather than trying to predict which assets will perform strongly in the current [or] future environment. This diversification is designed to provide stable growth, above the rate of inflation, without too much volatility over the long term.”
Now: Pensions’ performance has suffered lately compared to its peers, but it has recently adjusted its glidepath to increase risk in its diversified portfolio after the market falls, and lengthen the period over which members are de-risked from fully invested into cash at retirement.
One way in which schemes can diversify is by adding private markets exposure. Previously almost exclusively available to larger defined benefit pension funds and other major institutional investors, asset classes such as private equity, private debt and infrastructure are increasingly accessible to DC schemes.
Innovative work by large DC providers such as Nest has demonstrated that illiquid assets are no longer out of reach for such schemes. In addition, the advent of the long-term asset fund (LTAF) structure has brought a new DC-friendly way of investing in private markets with a much lower risk of funds being ‘gated’ due to poor liquidity.
As El Fetouhi explains, asset classes such as infrastructure and some kinds of private debt can provide schemes with access to inflation-linked cash flows while also adding to diversification and a potential premium when compared to public markets.
Mark Powley, DC investment consultant at Isio, says that while his company has not seen clients embracing the LTAF as yet, “this is clearly an area we expect to see gain traction over the year ahead as suitable funds gain [regulatory] approval”.
Listed fixed income may also be due a reappraisal after the significant movements in price and yields, according to some experts. Geographical diversification and currency exposures may be worth considering for some drawdown strategies, Isio’s Powley says, “in order to target the absolute returns required but for a lower level of risk than in the growth phase”.
On currency, LGIM’s Mistry explains that a weaker pound helped investors with overseas exposures – typically DC schemes have a heavy overseas bias to their equity exposure. However, given the difficulties inherent in forecasting currency market movements, schemes should consider “taking a more balanced view”.
Natixis’s El Fetouhi adds that geographical diversification could also help combat the effects of inflation, as rising prices are likely to be felt differently in different countries and regions, while central banks may diverge in their interest rate policies.
In addition, El Fetouhi explains that there may be an investment opportunity in short-term bonds. A higher rate of return in this asset class could reduce the need to “take further duration risk to capture the term premia”, he says.
The way forward
In January this year, the Pensions Regulator (TPR) published guidance encouraging trustees to review their governance arrangements and other areas, such as the remit of their investment advisers, scheme demographics, and how investment strategies are decided upon and implemented.
David Fairs, outgoing executive director of regulatory policy, analysis and advice at TPR, said at the time that, while there was “no one-size-fits-all answer”, trustees should review arrangements and “take appropriate action”.
However, such action may not need to be drastic. Trustees can make use of financial advisers and free services from organisations such as the Money and Pensions Service to help members who may be reconsidering their retirement plans. Ensuring appropriate diversification and quality member communications are also important.
“We would suggest that while 2022 was tough, it doesn’t require a factory reset,” says LGIM’s Mistry. “It is important to take the time to understand what worked and what didn’t and look to prepare DC strategies for the future. It is vital that strategies are formed from an informed basis – not just potluck or following the crowd.”