Please note: AI generated transcript.
Text on screen: Solving the DC retirement problem. Andrew Stephens, Head of Distribution EMEA and Paul Richmond, Deputy Head of Solution Design
It's no exaggeration to say that retirement is one of the most significant trends in the world right now. And we probably don't need to spend too much time talking about the demographic challenge given the tour de force we've just had. But those changes in demographics are certainly having an impact on how we invest, how we work, how we save, how we retire.
In many countries, large swathes of people are increasingly reliant on their DC assets to fund their pensions. That's certainly true in Australia and in the US but it's increasingly true here in the UK. In fact, 60% of retirees in the UK today are reliant, at least in part on their DC arrangements. If we're not there already, we will be there soon with the first cohort of UK retirees in entirely reliant on their DC assets for their retirement.
For individuals who have already in their DC arrangement been exposed to investment risk throughout their working lives, reaching retirement creates a whole series of new questions to be answered. How shall I invest? How much can I spend? Will my money last? But the challenges go beyond the individual and into society at large. What happens to a society where large swathes of retirees aren't able to retire in comfort or indeed outlast their savings? Who foots the bill? How does society function? What are the impacts on a country's economy?
There is some good news at least, and at last there is some government action to do with addressing some of these challenges. In Australia, for example, superannuation schemes are expected to provide a retirement income strategy. And in the UK the upcoming pensions bill will mandate DC schemes to include at least one default decumulation strategy, again, with the focus on retirement income.
So what makes retirement different? I mean, the obvious answer is that for the first time workers are going to be without a regular salary, and that's going to create seemingly difficult answers to simple questions. Can I afford to retire? Will I run out of money? Can I improve my pension? What if my circumstances change?
And it's well understood probably across this room that the challenge of retirement investing, investing in accumulate in, in decumulation and the associated sequencing risk that comes with that is one of the thorniest problems in investing. As we all know, sequencing risk is the risk that you're forced to sell assets to fund your retirement income at the worst possible market time.
And that leaves today's retirees with an uncomfortable choice between two imperfect options. On the one hand, they can invest in an annuity, they have an income for life, but they have built in rigidity. The other option is that they could go into draw down. They have access to growth markets, personalisation and customization is possible, but you're potentially asking retirees to make the most difficult financial decision of their life with high degrees of complexity without the necessary tools to do so.
So over the last two years, we set ourselves the goal of trying to build an investment framework that would remove these compromises for retirees.
And we set these ambitions. Can we build an investment framework in which retirees never have to worry about running out of money, that they will have confidence in how much they have to spend in retirement, that they'll be able to retain flexibility throughout their retirement period so they can change if their circumstances change. And last, but importantly, given the investment horizon available to them at retirement, which seems to be getting ever longer, enable them to access growth markets so that their pension outcome could be improved.
We bring you good news. We have developed a solution which we believe fulfills all of the ambitions that Andrew just set out. We're in the process of testing this with the market and we're going to run you through our proposition today. We're going to start with the retirement framework and then look at the investment implications.
So How do we think about solving the problem of giving someone an income for life? There's an existing product in the market which does this. It's called an annuity.
An annuity gives you reliable income until you don't need it anymore, but it has some flaws. And those flaws are you give up all flexibility if your circumstances change, you have ill health. If you want to take money out to give it to your kids, you've got a big bill to pay and it takes away the upside potential. You can't get a better pension income than the one you've secured when you purchased the annuity.
But this is a powerful tool. Can it help us solve the problem anyway? We think it can. But we think instead of annuitising at the point of retirement annuitize later in life, this takes away the uncertainty of how long any individual will live. And it creates a window before that, a window between retirement and the point of late stage annuitisation, which gives us the flexibility that we're looking for.
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. For us as investors it gives us something very powerful. It gives us a defined investment horizon and a defined investment objective.
We need to invest to deliver sustainable distributions to a member, a salary replacement during the flex period. And we need to have enough capital left at the end to secure the late stage annuity. And we want the income from that annuity. It's a bit at the same level that the members experienced in the flex window. We don't want a big drop off at that point in time.
We've also thought about the needs of the providers of DC benefits trustees, GPPs, master trusts IG-Cs. Obviously they want to give their members excellent outcomes, but they also need to think about the practicalities. Hundreds of thousands, millions of members, all with differing circumstances when they come to retirement. How can we deliver customization without operational burden?
So we want to keep our solution very simple on the outside, and we're going to show you just two strategies today.
These strategies have some features in common. They're both highly liquid. They're both operate in the same retirement framework. They're both trying to produce a sustainable level of salary replacement during the flex period and leave enough capital to fix with the late-stage annuity.
But they have some differences. The first one we're going to show you is there to maximize stability. The second one is there to maximize the level of income, the amount of pension you can get in retirement, but still with an eye on stability, by using risk management techniques that take away some of the pain that would otherwise be experienced with decumulation and the use of growth assets.
So how do we actually invest in these strategies? Let's start with the stability-focused strategy on screen, right now. At its heart, this strategy is just holding a basket of high quality bonds.
Where the magic happens, however, is in borrowing some of the techniques already widely in use in the DB space using cashflow driven investment. If we can build a profile of bonds that allows us to mature into the cashflows we need to fund retirement, we immediately remove that sequencing risk that we were so concerned about at the beginning of this presentation.
We can also use a basket of gilts to hedge annuity rates. So we don't have that variability to worry about at the fix period that Paul was talking about.
In fact, by maturing into the cashflows, we don't need to sell at all. Sequencing risk is completely removed while still being able to provide predictable pension payments to our retirees.
So far so good. But what if our retirees want access, to a improved pension? We have exactly the same investment challenges we had before and we can use the same framework fixing the annuity later in life. We have the same investment period to solve for, but what we're trying to do here is to create higher sustainable monthly distributions in the flex period and then have a larger pool of capital at the end of that flex period. So we can buy an even larger annuity.
Now, the obvious place to start when thinking about improving pensions and access to growth markets is to access the public highly liquid equity markets.
But it's worth at this point, borrowing from the James Bond film that will never be made - you only retire once - and market conditions into which you retire truly do matter.
So the 14 blobs that you're looking at on this screen represent 15 year equity market returns. So one of the blobs is the 15 year equity market return starting on the 1 January, 1997. Another one of these blobs is the 15-year equity return starting on the 1 January, 1998 and so on.
I'm sure that every everyone in this room is aware that this period will cover two significant periods of equity market draw down and the crises that fermented them. We've got the dot-com bubble bursting in here, and we have the GFC.
We need to ensure that any framework that we build works for retirees irrespective of the environment in which they retire into. And so we've chosen two periods to retire into: 1997 and 2007. Thank you.
So we're going to take you through the member experience. Someone retiring in these two challenging periods.
Someone retiring at the start of 1997, what are they thinking about? Maybe they're excited because the Spice Girls just got their first Christmas number one. Maybe they've just recovered from the drama of Euro 96. Maybe they're excited about the forthcoming election of Tony Blair as prime minister.
But from our perspective, what we're going to look at, a couple of benchmarks for our solution, the first benchmark is what could I have got if I'd annuitized at age 65? And that's what the red line on this chart shows at a 100%. This shows the income that it could have got had they retired, had they annuitized at age 65. In 1997 gilt yields were 7.8%. This is a high hurdle in today's prices.
The second benchmark we're going to set ourselves is what would I have got if I'd just had a portfolio of global equities and had been decumulating to take this salary replacement from it and then annuitising at 80 with whatever money is left. And that is what the bars show. The light blue bars show it from the flex period. The dark blue bars obviously show it for the annuity.
You can see there's a lot of white space here, big gap between the bars and the red line. And that's what we want to solve for in our solution.
What's happened exactly as Andrew said, the dot-com bubble bursting and the GFC have twice materially impaired the value of the member's pot and consequently, it's hard for them to sustain the same level of income and spending in retirement.
So let's see what we can do about that. Let's add some downside protection to the equity portfolio to take away some of the pain of large market drawdowns and see what happens. You can see the picture now looks much better.
The members now got 97% of an annuity. Pretty similar kind of territory to the annuity they could have secured on day one through this approach, but we've forgotten to do something else really important, we've forgotten to hedge the annuity price.
There's a massive drop in yields between 1997 and 2012. And consequently, the cost of buying that annuity at age 80 has gone up a lot compared to what we could have got at outset.
So let's hedge that. Let's add some guilts into the portfolio to hedge the changes in the principal thing that drives annuity pricing, but without compromising too much on the amount of equity exposure we can maintain in the flex period.
You can see now the picture is a lot better. This has been a really challenging environment into which to retire and to maintain equity exposure. But still at the end of it, we've achieved an outcome which is better than annuity.
I'll fire up the DeLorean and skip forward 10 years to 2007 and repeat the process.
2007, investing right at the start of the GFC. Again, this produces challenges. Here we're showing investment in equities, drawing down to build, to take a salary in retirement. Outcome here is much better, right? As Andrew showed, the equity returns a 10% per annum instead of 5% per annum, and therefore the member gets a better experience relative to annuity overall. But with a degree of variability and some years the income they're able to take is materially below that of annuity.
So again, let's add in the two protections of our approach. We'll add in downside protection through the systematic use of equity options and we'll hedge the annuity.
The outcome is far better. This member's total income is double that they could have secured from an annuity, had the annuitized at age 65 and it's nearly 50% better than what they would've got if they just invested in equities.
Now we're not promising financial alchemy here. What we're trying to do is improve the potential for member outcomes using risk management techniques. We've identified the potential sources of failure and then we've applied techniques that we're applying in DB space and defined benefit schemes that are mature and decumulating. They've been using the same techniques to their benefit.
So we've discussed the two underlying strategies, the stability focused strategy, focusing predominantly on the stability of those cashflows through time and then the growth focused strategy, which still delivers those cashflows through time, but gives members exposure to growth markets.
Each of these strategies can of course be then entered into on a standalone basis, but in combination we're able to satisfy almost any default design risk/return preference, cohorting of underlying members, as well as being able to deal with different levels of guided self-select, and so on.
So in summary then going back to the ambition that we set for ourselves, removing the compromise for retirees and against these four ambitions that we set out here to not run out of money, to make sure that retirees have confidence to spend in their retirement, to retain the flexibility by avoiding segmentation and to give access to growth so that the time horizon is allowed to deliver.
And we've done that by deploying a number of tools. The first two tools are there to specifically deal with sequencing risk. We've described how by maturing into the cashflows, we don't need to worry about forced selling at all. And we've also shown the importance when accessing equity markets or assets more broadly. That downside protection has an outsized benefit, particularly in a decumulation context.
We haven't forgotten to hedge the annuity rates hopefully to deal with the variability of annuity purchase later in life.
And importantly, and especially given Professor Harper's comments from earlier, we've allowed retirees to retain growth exposure for longer, thereby we hope delivering improved pension outcomes.