Reckless conservatism is destructive to DC pension outcomes, so prioritise equities within default funds to drive better returns. That is the headline message from Stéphanie Payet, private pensions analyst at the OECD.
At the same time, decumulation solutions should look to insure longevity risk, with one option being to combine programmed withdrawals with deferred annuities bought at retirement, says the Paris-based organisation’s DC pensions expert.
Author of several chapters of the OECD Pensions Outlook policy publication, Payet has been conducting deep analysis of the different investment strategies of money purchase systems around the world. The paper addresses the age-old challenge for DC investment strategy, balancing risk and return, and assessing just how much equity allocation drives better outcomes.
Its conclusions reflect the experience of the different DC strategies operated in the UK – that higher equity allocations will generally outperform more cautious, balanced ones over the longer horizon of pension savers. Beware an overcautious approach is the conclusion.
Risk and return
Payet says: “Countries should avoid investment regulations that favour investment strategies that are too conservative, particularly for the default option.”
Payet’s analysis highlights a huge level of caution in DC schemes around the world, certainly when compared to the UK, although equity exposure has increased significantly over the past 20 years in many countries.
At the end of 2022, total equity exposure was below 10 per cent in Albania, the Czech Republic, Finland, the Maldives and Nigeria. It was over 60 per cent in Estonia, Hong Kong and Lithuania, with Poland having the highest equity exposure at more than 80 per cent. The UK system was not included in the report, but our growth-phase allocations average more than 85 per cent in equities, falling to just over 50 per cent five years from state pension age. Some US DC options have 100 per cent equity exposure at the growth phase.
But there were also big variations in terms of domestic versus overseas equities, with Poland, Portugal and Latvia having foreign allocations of less than 10 per cent.
Equities rule
Analysis of 20 years of pension fund data across multiple nations shows increasingly high annual real returns for higher equity exposure. Funds with 100 per cent US equity exposure achieved amongst the highest real annualised returns, ranging between 6.9 per cent and 9.7 per cent between 2013 and 2022. The geographical location of equity allocations not surprisingly played a big role in the dispersion of these returns, with some funds opting for a global approach while others fully invested domestically.
The UK’s auto-enrolment rollout could not have been better timed, starting in 2012, just as the world was shaking off the pain of the global financial crisis.
Future plans
The OECD Pensions Outlook is published every two years and covers all types of asset-backed pension plans – i.e. plans where assets accumulate to finance future retirement income. Going forward, some of the content will feed into implementing guidelines for the OECD recommendations for the good design of DC pension plans. This recommendation is a high-level document with 10 general principles around things like coverage, financial incentives, investment, communications and payout strategies.
The 2026 edition will cover new ground including financial advice and guidance for retirement, and getting the level of additional contributions right.The OECD is also examining how providers build their glide paths for life-cycle investment strategies.
Tail-end risk
Creating general principles for decumulation is hard enough – doing it across multiple countries is even more complex, given the particular state pension, housing and other factors in each territory. As a result, OECD principles are by their very nature high level.
When it comes to decumulation, the one key message the OECD can share that applies to all nations is the need to manage longevity risk.
“Solutions that mix flexibility at the beginning of the payout period and then protection from longevity risk at the end could be a good solution,” says Payet.
The flex-then-fix approach currently leading the debate in the UK involves insuring that tail-end risk by buying an annuity at around 15 years into retirement.
The OECD’s recommendation is that the deferred life annuity is bought at around 80 or 85, depending on the country, but purchased at the time of retirement to overcome the issue around cognitive decline. This also reduces fraud risk and undue influence from other individuals as people become more vulnerable as they age.
Pricing continues to be an issue for this approach in the UK and it remains to be seen whether this model can be adopted.
ESG battleground
One key battleground for the OECD is in the application of environmental, social and governance (ESG) principles to pension investments.
Last month saw a blistering attack on the OECD made by Justin Danhof, a senior policy advisor at the Employee Benefits Security Administration (EBSA), the body within the US Department of Labour that oversees pensions and benefits for more than 150 million Americans.
Speaking at an OECD conference in Paris, Danhof said “anyone that oversees private pension dollars must act for the exclusive purpose of providing benefits to participants and beneficiaries. As such they are duty bound to maximise risk-adjusted financial return to the exclusion of all other pursuits”.
Attacking ESG and “its companion acronym DEI”, Danhof said: “ESG, at its core, looks a lot like a Marxist march through corporate culture. What is the point of Marxism? The complete destruction of capitalism.” Danhof’s speech attacked ESG as hamstringing capitalism, and in tandem with pension investments, from achieving their fullest potential by following political agendas and adding in superfluous ESG costs.
Some within the pensions industry may agree that the cost of ESG reporting on DC schemes has been disproportionately high, an issue exacerbated by introducing these requirements before the asset managers had implemented carbon reporting themselves. That said, UK regulation has only required schemes to ensure they have considered ESG factors when making their investment decisions, and have not required specific tilts towards green or social projects.
Maximising returns?
The speech did not consider the question as to whether a duty to ‘maximise risk-adjusted financial return’ extended to differences in the economy into which members of a scheme might retire into under different carbon emission scenarios.
Payet says: “Every delegate from member countries has the right to express their views at the OECD meetings. The OECD acknowledges that the main goal of pension funds is to manage the retirement assets of members in their best interest, as the OECD Core Principles in Private Pension Regulation state. This means to obtain the best risk-adjusted returns in their investment to provide pensions.”
Diversity concerns
Similarly, proponents of DEI might point out that the speech did not address the extent to which an understanding of the way diverse groups of people respond to different types of financial products and communications enables plan sponsors to achieve better retirement outcomes. The case of Muslim savers opting out of pensions because of poor communication about Shariah options is one example.
Danhof’s speech highlights the growing schism between Europe and the US over climate and other ‘culture war’ subjects, a rift that has seen some schemes in Europe dump American asset managers in favour of those based physically and culturally closer to home.
Mandating allocations
The UK’s Mansion House Accord and reserve mandation power in the impending Pension Schemes Bill, which can force schemes to allocate 10 per cent to private market assets, of which 5 per cent will be in the UK, is one obvious example of politics entering the field of investments that the OECD is warning against.
Payet says: “In our core principles of private pension regulation we have one that says in general countries are encouraged to avoid investment limits, whether they are maximums or minimums. Because we believe pension managers and asset managers should have the flexibility to invest where they see the best risk-adjusted returns.”
“For me the question the UK should ask itself is not to mandate a minimum investment in the UK, but ask why the pension funds in the UK are not investing in the UK. I am sure the pension funds would like to – you don’t have the exchange rate risk, you understand better the market. So if they don’t do it, it means something else is going on,” says Payet.
She says “The US stock market has been functioning like a charm for the last 20 years, and has attracted a lot of investment. So that explains high US allocations. But there must be something else that explains such a low proportion in the UK.
“This is eventually one of the projects we want to work on, but we have not started yet, which is to understand this relationship between pension fund investment and capital markets. It is like a chicken and egg question. Do you need pension funds to develop capital markets?
“Or do you need good capital markets to have good performance for pension funds? I think the UK should look in that direction to understand better what prevents their pension funds from investing locally, instead of doing the mandate threat.”
Pricey private markets?
The UK government is steering the industry towards private market allocations regardless of what the OECD says. So does Payet think they are suitable for DC pensions?
“As long as the pension provider has an understanding of the risk that is taken with that part of the portfolio and everything else is managed in a proper way, then yes definitely.
“We recognise the risk is higher because the information available is more limited. So the uncertainty is bigger. But as long as it’s within a comprehensive, strategic asset allocation and the risk is managed overall, this is in line with our principles.”
The UK’s experiment in driving DC assets towards domestic markets will serve as a practical testing ground for the OECD’s chicken-and-egg question. What the OECD will make of the results of this experiment remains to be seen, but whatever the case, understanding lessons from abroad will always remain best practice.
BOX: OECD PENSIONS OUTLOOK 2024 KEY FINDINGS
- Investing in equities is likely to provide a higher average performance, more assets accumulated at retirement and higher replacement rates than investing only in fixed income. Even during the payout phase, people taking regular drawdowns are likely to receive higher pension benefits when investing a significant part of their savings in equities
- While conservative investment strategies reduce volatility, they provide only moderate protection to members of DC pension plans and lead to sub-optimal outcomes during the payout phase when
taking regular drawdowns - Combining equity investment with regular drawdowns may bring higher total pension payments (benefits while alive plus bequests) than taking a lifelong annuity, but without full longevity protection
- Countries should avoid investment regulations that favour investment strategies that are too conservative, in particular for the default option