DC: Preparing your members for a comfortable retirement

THE NEED FOR ACTION

Anecdotal evidence and surveys show that most DC members have highly unrealistic expectations about the retirement income they can achieve with their current contribution levels. At the same time, they are also reluctant to take investment decisions, with the majority choosing the default option, regardless of its suitability. To mitigate risks for members in default solutions, the industry has until now relied on the Lifestyle concept, whereby the level of risk is linked to a member’s career path. In practice, this means members invest in an equity based fund until perhaps five or 10 years before their retirement. Then they are gradually switched into bonds and cash. Unfortunately, our research shows that the level of protection offered by Lifestyle is much lower than is generally assumed, even with an extended switching period. This is particularly worrying given the prevalence of Lifestyle as a default option. The danger is therefore that without action a sizeable proportion of members will face relative poverty in retirement.

TARGET DRIVEN INVESTING

In response, we have devised a new philosophy for DC, called Target Driven Investing (TDI), which aims to overcome members’ blind reliance on the default solution. The concept underlying TDI is that members can be empowered to take control of their pension planning by helping them to set an explicit and realistic target retirement income level based on their specific circumstances. Using the simple process outlined below, members can then devise investment strategies in line with their individual risk tolerance that help them meet that target.

A JOURNEY PLANNER

As a first step, members need to assess their income needs in retirement. Structuring members’ different needs in order of priority allows them to assess what is achievable given their contributions levels, time horizon and investment strategy. In essence, we believe we can distinguish three categories:

ESSENTIALS – Housing, all types of household and food bills, etc.

DESIRABLES – Hobbies, home improvements, running a car, etc; and

LUXURIES – Holidays, gifts, entertainment etc.

Each member will have a different view of the elements in each category, but we believe this provides a useful framework that allows them to:

(a) create an accurate picture of the level of income they can realistically achieve given their current saving amounts and what their priorities are;

(b) adjust their contribution level and desired retirement age to help close any deficit they may have now identified.

Practically speaking, we have helped this decision process further by providing members with a user-friendly modelling tool (Target Plan) that acts both as a journey planner for establishing the final destination and a monitoring tool.

TDI INVESTMENT STRATEGIES

What type of investment solutions should members adopt for each of these categories? From a TDI viewpoint, there is no one-size fits all answer as each member’s needs and risk tolerance are unique. In practice, though, most members will not be able to take many risks with that part of the portfolio that is to provide for their essentials in old age. Meeting desirables’ and ‘luxuries’ will require higher levels of risk, but again risk tolerance will vary according to the individual circumstances.

DEFAULT OPTIONS

Overcoming members’ inertia will inevitably be a long-term educational process and therefore we still need to provide default options for those schemes where Lifestyle is not a suitable option. In response, we have developed an alternative default solution called DC Target Return, which seeks to protect members’ capital over an entire investment cycle. This strategy proves particularly useful in turbulent market conditions as DC members value a greater certainty of outcome. Seeing a positive return also encourages members to keep saving and invest more. The Target Return strategy has an absolute return target (Cash + 3.5% p.a.), which is in line with the TDI philosophy of helping members focus on reaching their retirement target rather than beating a benchmark. Alternative default options include Target Date Funds, DC Banking and Advanced Deferred Annuities.

We believe DC Target Return represents an effective default solution within the TDI framework for those members unwilling or unable to set their own target and investment strategy; and a significant contribution towards increasing members’ chances of building up an adequate retirement income.

Emma Douglas is Director of Defined Contribution Pension Sales at Blackrock