Pensions World

Risk profiling in the DC market may be having a negative impact on retirement planning and adequate pension funding explains Stephen Watson, Alexander Forbes

In January 2011, the Financial Services Authority (FSA) issued a guidance consultation paper which raised concerns over the application of risk profilers and how, if inappropriate or inappropriately used, they can have a negative impact on retirement planning. This paper was issued at a time when the industry seemed to be going through its own “IT boom” and every major player was developing or already launched its own IT platform, platforms which were highly geared to “self service” rather than face to face advice – not surprising with the Retail Distribution Review.

Since its publication, I have seen, in the various industry and non-industry press, responses to the FSA paper by industry professionals, most of which I agree with. However, all the responses thus far seem still to focus on the risk profiler itself without any wider context – ostensibly suggestions include improvements to questions and scoring and confirming the need to test the quantitative results.

All very sensible suggestions which if adopted will no doubt lead to greater improvements; this can only be a good thing. However, on this particular issue, I keep wondering if as an industry we are still missing the main point; the old adage “can’t see the wood for the trees” keeps coming to mind.

There is one sentence in the FSA’s paper which for me provides the key and I quote “...some customers may be willing to take a lower risk with their short term savings needs and a higher risk with their longer term pension arrangements”.

On the face of it, I read this as the FSA, quite rightly, pointing out that we are dealing with human beings who, unfortunately for us in the industry, do not share a universal definition of risk that can be applied to all things at all times! But maybe this is where we need more lateral thinking. Could it be that there is a definition of risk that we can all relate to?

I put to you the obvious: could it be that, as a consumer, any downturn in my readily available cash resource is viewed as capital loss where as any downturn in my pension value (which I cannot yet access) is simply viewed as volatility?

Obvious it may be, but sharing as I do the FSA’s concerns I have not seen many, if any, risk profilers that make any differential between accessible and non-accessible assets. Most of the questions are heavily weighted towards the former.

Ups and downs

For instance, I completed an online third party risk profiler recently and it determined that I was a low to medium risk investor. Certainly for my “emergency fund” this would be true, but as I have between 20 and 25 years still to go until retirement, nothing could be further from the truth. If I had been a non-industry employee, I do not think I would have questioned the result and would have ended up with an asset allocation that was not suitable; you do not argue with professionals who know more than you.

A visit to the doctor is a good analogy. You have a medical issue, but are not a medical professional; the doctor advises you on lifestyle issues and prescribes medication. You do not question their opinion, but are not too happy when in a few weeks’ time the problem is not resolved and you are left with a number of side effects! The risks of the medication were not explained, but more importantly the risk of the medication not solving the problem was not put forward as a possibility. You might accept the potential side effects if there is a good chance that your illness is cured.

I would argue that consciously or unconsciously, the British public understands the difference between accessible and non-accessible cash – the problem is that we do not use plain language.

We are a nation of homeowners, a culture which transcends all divides regardless of income level, education and occupation. We own homes and understand that the value goes up and down; there are well publicised indexes that keep us informed and, if that is not enough, there is plenty of media coverage. But guess what? There is no panic selling when house prices move down! Why? I would argue that the average person is not particularly concerned unless they are ready to sell (negative equity issues aside). We understand that the value of any asset can go up as well as down. But I do not want it to be down when I come to realise the asset, ie during my working life I can accept volatility in my pension, but I cannot accept the risk of my value being less than expected at retirement!

In March this year, we launched the National Pension Index which is helping to demystify pensions (Figure). It aims to make understanding retirement income prospects easier by showing how much individuals need to save to achieve their target income in retirement. The “need” in this means people start to understand the trade off between low risk and high contributions versus higher risk and the potential for lower contributions, within a backdrop of flexible investing and the need to monitor their pension targeting investments.

Necessary risk

So if we assume that my assertion is correct then the focus for pension investments needs to change. It goes without saying that my tolerance to volatility needs to be assessed and explained, but the focus of risk needs to move away from just the accumulation phase and focus more on the “end game” so to speak, ie what is the risk of me not achieving my retirement goals? But in a DC environment, how do you balance a person’s appetite for volatility with their financial expectations in retirement? We believe that the answer is targeting.

In business, we understand the power of targets and how these can effectively change “human behaviour” and push productivity levels in the right direction. Is it not logical, therefore, that the same should hold true for retirement planning?

Rather than spending investment capital on a “new shiny risk profiler”, I would suggest that we deal with the proximate cause; the pure focus on investment risk is not appropriate. There needs to be a greater focus on developing communication pieces and tools that enable employees to effectively determine their income needs in retirement in a way that is understandable and, perhaps more importantly, engaging.

I wonder how many investors actually understand the potential consequences of a low risk investment strategy over the longer term? I would suggest that we have done well to educate clients about the dangers of high risk strategies, but not vice versa.

Could this be why so many people feel that pensions have let them down and so are not worth doing? If the asset allocation has been about protection rather than growth over the longer term, how can they be anything but disappointed? – a question not an assertion.

Rather than shy away from the realities of funding, it is important that we make sure that employees understand that there are two main fundamental parts to achieving their retirement goals: contributions and investment returns. The cold fact is that lower investment returns equal more required contributions – and more contributions may not be affordable!

If an employee really understood this, would they reach the conclusion that investment risk is necessary? I believe so and therefore, understanding that there are different levels of financial literacy, we will need to provide tools that make it easy for employees to understand this fact.

Shift of emphasis

Risk profiling still has a place, but should be used as a tool to enable somebody to understand their own tolerance to risk and then to understand and appreciate how this compares with any recommended investment strategy that is based on targeting.

As an industry, I think that we have focused too much on investment risk and not enough on the risk of poverty in retirement. The quicker we all recognise this, the quicker we can shift this emphasis and help the nation fully prepare for retirement.