The crisis in gilt markets made national headlines following the government’s mini budget in the final days of September. This left members of defined benefit (DB) schemes worried, rightly or wrongly, that their pension might be at risk. Yet one aspect that has received little attention is the impact that the plunge in gilt markets is having on members of defined contribution (DC) schemes, especially those who are due to retire.
With the burden of disappointing investment returns being shifted onto members, few seem to care that those returns can vary considerably and workers planning to retire imminently might be left with less money to fund their twilight years than previously anticipated. How are DC members navigating volatility in bond markets to prepare for an uncertain future?
Lifecycle
Decumulation, the cornerstone of most pension investment strategies tends to be based on adjusting the investment strategy to the lifecycle of the scheme member.
The default funds for younger members tend to be invested in growth assets, such as equities, but as they approach retirement their portfolios are gradually converted to more liquid, and presumably more secure, fixed income assets.
The irony in this case is that the assets many investors deemed to be the most secure – UK government bonds – have been far from stable. While equity markets have been rocky. The FTSE100 is down -2.6% when compared to the same period a year earlier.
In contrast, yields on 10-year UK government bonds have risen by more than 250%. That is good news if one plans to hold these bonds for a longer period of time, but not for those wishing to cash in on their retirement savings. “The sell-off in gilts has meant that older pension savers invested in defined contribution pre-retirement funds might have noticed a dip in fund values, which will have an impact on individuals if they intend to retire imminently,” says Jon Cunliffe, managing director of investments at B&CE, the provider of The People’s Pension.
A closer look under the bonnet of different retirement stage strategies reveals that the outcomes can vary significantly, depending on the investment strategy the DC provider pursues, but also on the amount of support that has been put in place for members approaching retirement.
Under the bonnet
When comparing DC retirement-date funds, even within the master trust landscape, it is worth noting that it will inevitably result in comparing apples with pears because every provider approaches the retirement stage differently.
Nest, for example, has funds for each year of retirement. Its 2022 fund is for members due to retire this year, whereas Now Pensions only has two main investment strategies – the growth-oriented Diversified Growth fund for younger members and the Retirement Countdown fund for older members.
Nevertheless, it is striking that the asset allocation and subsequent investment performance can vary significantly from provider to provider.
Nest’s Guided Retirement fund, for example, is aimed at members aged between 60 and 70. It still has significant exposure to growth assets, but members allocate only a proportion of their savings into the fund, the rest is kept aside for emergencies.
The Guided Retirement fund still has a quarter of its assets exposed to global equities and 19%, its second largest holding, in global high-yield bonds. It also has a 13% allocation to hybrid property funds, but no investments in gilts. The fund is down -6% this year.
In contrast, TPT Retirement Solutions 2020-2022 Target Date fund has about half its portfolio invested in gilts, roughly a quarter of those are inflation linked. It still has a 17% exposure to global developed equities. Since last year, the value of the fund has dropped by -2.8%.
The People’s Pension’s closest comparator is the Pre-Retirement Fund, which, however, is aimed at members just before the retirement stage. Members start transitioning into the fund from 15-years prior to retirement and will be 100% invested by the time they reach retirement. After that, they can
either switch to cash or an annuity.
Its biggest holdings are money market funds at 20%, US treasuries at 18.6%, followed by US equities at 9.7% and 9.5% each in gilts and UK corporate bonds. Since last year, the fund is down -9.6%.
Meanwhile, LGIM’s Pre Retirement fund, which is also aimed at members approaching retirement, invests in a combination of gilts at 34.6%, utilities at 10%, UK financials corporate debt at 8.5% and consumer services corporate debt. As of June 2022, its value had fallen by -19.5% when compared to the previous year.
Now Pensions Retirement Countdown fund is aimed at members before retirement. Once they retire, they will be expected to convert their savings into cash, which makes risk reductionall the more important, as Emma Matthews, head of investment at Now Pensions explains. “The Retirement Countdown fund is focussed on minimising the risk of capital loss (risk objective) and to deliver a return equal to the Sterling Overnight Interest Average (SONIA) rate, consistent with the preservation of capital return objective. As a result, the fund will typically invest in the money markets, cash deposits and shortdated bonds.”
At the time of writing, its entire portfolio has been invested with Blackrock’s Liquid Environmentally Aware fund, which is a money market fund. As of July, the Now Pensions’ Retirement Countdown fund performed 0%, year-on-year. But it should be added that prior to retirement, members will be invested in a combination of the Diversified Growth andRetirement Countdown funds with the former down -8.6% since last year.
The examples show that DC members could get different outcomes, depending on what their funds invest in. While it is difficult to generalise, it appears that diversification, and particularly not just being invested in fixed income, seems to pay off.
Annuity headache
Another challenge for the pre-retirement stage is that in most cases, members will convert their savings either into cash or annuities and with gilt prices falling they could be in for a bad surprise, warns retirement consultant Lane Clark & Peacock (LCP).
The volatility in bond markets has wiped out more than a third of annuity values since December 2021, this could be disastrous for people looking to cash in right now so holding onto the annuity might be the better option.
This could be a problem, not so much for master trusts but for members in legacy schemes following an annuity-targeted strategy, says Lydia Fearn, a principal at LCP. “It depends on what strategy members are invested in. We still have a lot of members who want to take out cash.
“What we are finding is that there are some legacy arrangements which mean that members are still on an annuity-targeted strategy which invests in long-dated gilts to try and match annuity pricing in the market. If annuity prices go up, they go up, if they go down, they go down. It is doing what it is designed to do but if you have members who are in the later stage of an annuity-targeted strategy but have no intention of buying an annuity, they will see their assets drop considerably. This goes back to good communication and ensure members are in the right place,” she adds.
The challenge here is to distinguish between investment losses in retirement stage default funds and a lack of guidance, particularly given the fact that DC providers are not meant to provide advice, but members might not make the most informed decisions.
This is also a problem that has been on the agenda of the PLSA, which in 2020 published a set of recommendations for DC decumulation to navigate this balance. Among others, it recommended that schemes could be doing more to provide the right products for withdrawing cash and keeping members informed about the different options available.
Investment tweaks
At the same time, DC investors have a role to play and it would be a remiss to suggest that they are not responding to a rapidly changing market environment.
Just like in DB land, interest and inflation risks are on the agenda of DC investors, as Cunliffe explains. “Earlier in the year, The People’s Pension acted pro-actively to reduce the interest rate sensitivity and credit risk of our bond allocation by reducing our allocation to gilts and sterling corporate bonds in favour of US treasuries. With market valuations much more attractive we feel that the outlook for investment returns over the long term is markedly better than at the start of the year and we expect markets to begin their recovery phase once the peak of the inflation and interest rate cycles are in sight.”
Now Pensions’ Emma Matthews says that there is still value in the traditional transition from risk assets to fixed income, but that guidance matters. “For us at Now Pensions, it comes back to how we believe we can best support our members – taking risks to grow assets (over the long term) in excess of inflation in the early years, focussing on balancing the risks that drive different asset returns. Then gradually de-risking to be majority invested in the Retirement Countdown fund at the point a member reaches retirement.”
But she also acknowledges that there is room for change. “We review our approach regularly, with a deep dive every three years. We are looking at how to solve the post-retirement problem – we are mindful that member needs may change and we want to be on the front foot to deliver a great post-retirement solution for them,” she adds.
For Nest, diversification is an important element of the puzzle, even at the decumulation stage. “We developed the Guided Retirement fund to support our members who are over 60 and who want to start taking their money out of Nest while still benefiting from potential investment returns. “Because our aim is to provide these members with sustainable withdrawals until age 85, they can continue to benefit from the returns from illiquid investment,” a spokesperson for Nest said.
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