DC retirement: creating confidence to spend | Insight Investment

So it's fair to say that retirement is one of the most significant trends in the world right now.

In many countries, large proportions of population are increasingly reliant on their DC assets to sustain their retirement. But the challenges extend beyond the individual and into society at large.

So in the UK, for example, we estimate that 60% of UK retirees are already reliant, at least in part, on their DC savings to fund their retirement. And if we're not there already, then we will be soon where the first cohort of retirees will be entirely reliant on their DC assets.

Now, at an individual level, savers have been exposed to investment risk throughout their working lives. But retirement creates a whole series of new questions to be answered. How shall I invest? How much can I spend? Will my savings last?

Now, if you apply those questions at a society level, what happens to a country where vast numbers of retirees are unable to retire in comfort, or worse, outlast their savings? What are the impact on a country's economy? And governments have started to recognize the risk of inaction and have begun seeking to address these challenges. For example, DC providers will be mandated to include at least one default decumulation strategy with a focus on retirement income.

So what makes retirement different?

Well, working life provides a familiar financial experience, a regular and reliable salary. And at retirement, that certainty abruptly disappears. Members receive a pension pot and are expected to determine what that means for their future standard of living.

And to complement that, throughout their working lives, DC communications have predominantly expressed retirement wealth as an account balance or pot size. But two identical pension pots can sustain very different levels of income depending on the prevailing level of interest rates, future investment returns, the order in which those returns occur, and indeed how long a member lives.

And that leaves retirees with an uncomfortable choice between two imperfect options. On the one hand, they can invest in an annuity. It delivers income for life, but has built-in rigidity. On the other, they can go into drawdown. But here, you're effectively asking retirees to become professional investment managers, addressing all of the challenges that I've laid out above.

So what can be done?

Well, over the last few years, we set out to develop an investment framework that addresses these compromises for retirees. We asked ourselves, can we build a solution where retirees never have to worry about running out of money, where they can be confident in their capacity to spend, where they retain flexibility so that they can change as their circumstances change? And lastly, given the investment horizon available to them at the point of retirement, can we preserve access to growth markets so that their pension outcome can be improved over the course of their retirement?

And importantly, can we do all of this while warehousing the technical detail so that retirees simply retain a salary-like experience?

Now, the first step in the process is to ensure that we can deliver income for life.

And there's an existing product in the market that can do exactly that. It's called an annuity. It gives you reliable income each year until you no longer need it.

However, you trade certainty for a total lack of flexibility. If your circumstances change, the annuity does not flex with you and you forego all future upside. But certainty does have value.

So why not pose a different question? Rather than should I annuitize or pursue drawdown, we pose the question, how does the relationship between certainty and flexibility change through an individual's retirement?

And that question drives a key difference in the delivery of retirement income. Rather than annuitizing at the point of retirement, annuitize later in life when the need and desire for certainty exceed the benefits of flexibility. And this creates a window between retirement and late-stage annuitization that affords members the flexibility while it remains valuable.

And this model of flex and then fix is one that many in the market are converging on because of the attractive balance of features that it offers. Under this model, we seek to not only deliver a pension for life, but the right form of pension for each stage of life.

So to bring this to life, we wanted to show you two solutions today.

Now, these strategies have some features in common. They're both liquid. They both operate within the same investment framework, but they have some differences. The first is designed to maximize stability. And the second is designed to maximize the pension income available to members while mitigating some of the risks associated with the use of growth assets.

So starting with the stability-focused strategy, this strategy is simply holding a portfolio of high-quality bonds. Yet the magic happens through the design of those bonds, which rely on the tried and tested techniques that have been commonplace within the DB community for decades.

We build a portfolio of bonds whose income and maturity proceeds deliver the cash flows that members need, a concept that many of you will know as CDI. And by delivering income needs with maturing assets, we immediately remove sequencing risk.

Then, leaning on the concept of liability hedging or LDI, we also buy a basket of gilts to hedge the cost of the late stage annuity, so members don't have to worry about changes in income as they move into the fixed period.

So far so good.

But what if our retirees want access to an improved pension?

Now, what we're trying to do here is create higher sustainable income distributions in the flex period and a larger capital base from which to purchase late stage annuity.

And an obvious place to start when thinking about delivering long-term growth is access to public market equities.

So I'm gonna take you through an experience of what it would have been like for a member retiring in nineteen ninety-seven.

And it's important to say that unlike DB, DC members will inevitably have two benchmarks. It's an asset manager's nightmare, but nevertheless the practical reality that we face when engaging with a DC audience.

And when the market goes up, members will expect their income to grow. Yet when the market falls, they don't want to see their income fall.

So with that in mind, we set the level of annuity income, which is depicted here in the red dotted line, as a baseline or floor for which the strategy should be measured against.

Now, the light blue line shows the income delivered in the flex period, and the dark blue shows the income during the fixed period. And I've chosen this period because it captures two significant market events: the dotcom crash of the early two thousands and the GFC of two thousand and eight, two thousand and nine.

And the impact of these drawdowns is amplified by sequencing risk as the member was forced to sell despite the market crash in order to generate income. As a result, the level of income purchased in the fixed period, and indeed the total lifetime income, were materially lower than the level that could have been secured at outset, hence the large amount of white space here.

So what if we add downside protection?

Well, let's reduce the participation in those major market crashes, and you can see that while the income did suffer in those years, it was far less pronounced than without protection. But the late stage annuity still provided a lower level of income than was available at outset, and that's because gilt yields fell over the period. Left unhedged, that materially increased the cost of annuities.

So to address that, this final example adds annuity hedging on top of downside equity protection, and you can see that the resulting income distribution is far more stable and, crucially, higher than the level that could have been secured at outset, fourteen percent higher.

Now, you could say that we've cherry-picked a period of history that demonstrates the value of downside protection and hedging, and you'd be right.

So to what extent can this investment process and the outcome that it delivers be generalized?

Let's turn to the next slide.

So what are we looking at here?

Now, the analysis in the previous slide showed that a member retiring on one January ninety-seven would have experienced an uplift of fourteen percent versus an annuity. And here we repeat that analysis, assuming that the very same member retired at the end of each month from thirty-one January ninety-six through to thirty April twenty twenty-five.

And in each case, you can see that the light green line, which represents the total income delivered over the member's retirement, is comfortably above the red dotted line, the annuity benchmark. And in most cases, it outperforms the dark green line, which is naked equities, the two benchmarks that I referred to earlier.

In fact, on average, across all of these different cohorts, this strategy would have delivered a sixty-three percent uplift relative to annuities and a fifty-three percent uplift versus equities. And even in its worst period, September ninety-six, the strategy delivered more income than a member could have secured via an annuity at age sixty-five.

So we've discussed the two strategies.

The stability-focused approach delivers reliable and stable cash flows through time, much like an annuity but with higher flexibility.

And the growth-focused strategy, where the goal is to deliver higher income than could have been available through an annuity.

Each of these strategies can be entered into on a standalone basis, but in combination, we're able to satisfy a very broad range of default designs and risk return preferences.

So in summary, returning to the ambition that we set ourselves, removing the compromises for retirees, i.e., never running out of money, delivering confidence to spend, retaining flexibility, and allowing a member's time horizon to be used in their favor, we believe we can achieve this through the tried and tested techniques that have successfully delivered members outcomes in the DB world for decades.

In doing so, it's our view that retirement doesn't mark the end of a payslip, it simply transitions individuals to the start of a new one