In the UK pension industry risk management has always played a major role. The rise of defined contribution (DC) schemes as the main source of retirement income in the future gives reason to optimise risk management further, especially for people close to or in retirement. One area worth exploring is the relationship between risk and returns over entire market cycles, and how, contrary to traditional beliefs, lower risk, achieved through cost-efficient risk mitigation, often leads to higher returns.
Traditionally, many risk management strategies have focused on defensive allocations to mitigate potential losses. While this approach has its merits, it’s important to also consider that this often leads not just to a dilution of risk, but also to an equal dilution of returns.
This is very relevant for DC schemes. Pension members are happily living for longer and this means they still need growth during the later stages of their investment journey. Currently, in the UK a man aged 65 is expected to live for a further 20 years, and 13% can expect to survive until 95 years old (for women this figure rises to 20%).
Decumulation strategies for schemes are an area where the pension industry has been working diligently to find effective solutions. At the decumulation stage members tend to have very little equity exposure. This leads to low volatility but also to low growth. The allocation that cushions older members’ portfolios is often a defensive one, mostly consisting of bonds with very low default risks such as government bonds, and not a growth oriented allocation aiming to enhance long-term investment outcomes.
The biggest risk someone in decumulation faces is to run out of money. From an investment point of view this can happen in two ways: having too much risk in the portfolio and suffering from a large drawdown that, due to sequencing risk, won’t be recovered; or by being allocated too conservatively and not having enough growth in the portfolio.
This dilemma of having a long investment horizon of over 20 years and needing growth, but also not being able to tolerate volatility along the way means that many portfolios are much more exposed to risk number two: to slowly run out of money over time because the portfolio did not grow sufficiently. From the standpoint of the industry, potentially due to legal and reputational risks, the risk of running out of money slowly over time is clearly preferred to suffering a larger drawdown, even though both have the same outcome: the retiree running out of money.
But it doesn’t have to be this way. Risk management, when applied in the right way, can allow portfolios to have higher equity allocations and to enjoy more growth in the long run without increasing its risk or volatility.
Risk Management and Loss Reduction
At the heart of risk management lies the principle of loss reduction and the mathematics of compounding. A portfolio suffering a 50% drawdown requires a staggering 100% return to break even, while a 75% drawdown demands a 300% return. This disproportionate impact of large losses erodes the capital base, crucial for generating future returns, especially when facing sequencing risk.
History has shown that recovery periods in equity markets can be substantial, sometimes over 15 years or more, rendering the attainment of attractive returns over extended periods nearly unfeasible if caught up in one. In essence, portfolios with the highest long-term growth are often those with on average lower, but more consistent returns, achieved through cost-efficient risk management. The notion of “higher risk, higher (expected) return” may only be applicable in one period thinking, but not for compounding rates of portfolios over multiple periods.
The key lies in the geometric average of returns, as portfolios experiencing smaller drawdowns enjoy disproportionally higher compounding rates. Increasing an asset’s mean return along with its volatility often leads to diminished compounded growth, as significant losses have a more detrimental impact than the benefits of higher average returns.
Successful investment strategies, therefore, hinge on balancing good upside potential with minimized losses, particularly during market downturns, and need to adopt a multi-period approach across whole market cycles. Properly diversifying assets according to fundamental return drivers and incorporating cost-efficient hedging strategies can improve portfolio performance, even if it means sacrificing some gains during prosperous market periods. Critically though, a strategy like this allows for higher allocations in growth assets, like equities.
Option-based strategies
In recent years the investment landscape has undergone a fundamental transformation. The era of low interest rates and quantitative easing has given way to rising inflation volatility and resulted in unstable bond-equity correlations, rendering traditional diversification approaches between bonds and equities less reliable. In this context, option-based strategies with a hedging component are gaining prominence, offering both standalone returns and much-needed portfolio stabilization.
Effective diversification transcends historical correlation metrics, focusing instead on fundamental return drivers. True diversification proves its mettle not in market upswings but during downturns, by effectively limiting losses. Assets that show favourable correlation only in positive market conditions contribute little to a portfolio’s overall risk management.
Historically, diversification tends to disappoint precisely when it’s needed the most, as correlations among risky assets increase during market stress. In such scenarios, option-based strategies with explicit hedging elements can emerge as reliable safeguards.
The key with option-based hedging strategies is to be able to design them in a cost-efficient way to allow high degrees of upside participation in good years. When done cost-efficiently, they can contribute to higher portfolio returns over whole market cycles because they reduce risk. In the end the investment outcome over whole market cycles is determined by how much you make in good years compared to how much you lose in bad years.
Conclusion
The challenges faced by pension plan members during decumulation require careful consideration from both investment and policy perspectives. While recent reforms encouraged allocations to UK-based private assets, it is crucial to ensure that investment strategies prioritise achieving the best possible outcomes for plan members. There is a clear case for private assets in DC, but it is not transparent and liquid enough for most older members’ portfolios to be more than a small allocation.
Instead, by embracing the apparent paradox that lower risks achieved through cost-efficient risk mitigation in combination with higher growth asset allocations can lead to higher returns, and adapting to changing market conditions with appropriate diversification strategies, we can start unlocking growth in the decumulation phase. Members can get more exposure to the equities they need to keep growing their portfolios but without the unacceptable risks that would traditionally have gone along with this.
