Pensions World

Flexibility is the key when it comes to designing lifecycle investment strategies advises Nick Smith, Towers Watson

Lifecycle investment strategies were designed some years ago to ensure that defined contribution (DC) plan members, who do not make their own investment decisions, have a reasonably appropriate risk/return profile over their savings life. Today, lifecycle is a well established part of the DC landscape, but the world moves on and lifecycling needs to adapt and evolve to continue to meet the needs of a fast developing DC world.

While lifecycling is not perfect, we believe that the principle of lifecycle is still sound. However, it is time to enhance the traditional design – and this enhancement should begin with a better understanding of, and focus on, the needs and objectives of the DC plan’s membership.
The Investment Governance Group (IGG) principles and best practice guidance, published at the end of last year, addresses investment default design and, among other things, says: “… the design of an appropriate default strategy considers … the needs of the broad membership, including … members’ attitude to risk”.

Two clear points stand out  – “risk” and “needs of the membership”.

Variability and volatility

Investment risk is extremely important to a DC member and so any lifecycle strategy needs to be built around a solid understanding and measurement of risk, from the perspective of the individual member. To a member, risk is very simple. Risk is the chance that objectives will not be achieved, which, in turn, is a combination of the level of outcome, the variability of outcome and the volatility of the journey.

Now, in an ideal world, a member would have absolute certainty about their retirement outcome and have no volatility in the journey, but the reality is that most DC members need to take at least some risk to get the return required to achieve a satisfactory or adequate pension income. The challenge therefore is for a member to effectively create a “journey plan” that balances his or her expected ability to contribute with his or her risk tolerance at differing points along the journey. We need to recognise that these things will change quite substantially for most people over time.

Personalised savings plan

DC design must meet the needs of the membership. Fiduciaries should ask themselves: what are the investment needs of the membership? How much risk can the membership cope with and what level of return do they need to achieve an adequate retirement outcome? In what form do members want to take their DC benefit?

Understanding the needs and profile of a DC membership involves recognising that there are various types of member groups, who will have different attitudes towards, and ability to take, risk. An analysis of the membership can allow fiduciaries to assess whether their, maybe, traditional lifecycle approach might be oversimplistic in meeting the risk and return needs of members and whether it is time to consider a more sophisticated design with a view to more effectively meeting member needs.

A lifecycle strategy should be a flexible framework providing an appropriate investment structure to the majority of a plan’s membership.
A core default should be set and a flexible framework around this should allow members to adjust the default to take account of their own personal needs and preferences.

This flexibility is going to become even more important in the brave new world of flexible retirement. Does the member want to take benefits entirely, or partially, as cash? How much does the member want to annuities and in what form? And/or does the member actually want to transfer into drawdown, where cash and annuity protection funds may not be the best investment vehicle therefore?

Most DC plan members want simple, guided choice based on an assessment of their personal circumstances. So we are not talking about a range of complex investment choices and neither are we talking about a single “one-size-fits-all” lifecycle. Most DC plan members need a flexible lifecycle framework within which to personalise their savings plan.