By Will Allport
With typically low contribution rates, market returns compressed by lingering economic woes and continued activist central bank policies and a pensionindustry- wide propensity to pursue passive investment strategies, today’s UK defined contribution (DC) savers face potentially disappointing outcomes and uncomfortable retirements.
With limited capacity to increase pension savings rates, we believe that many DC savers would greatly benefit from higher investment returns in addition to contributions and market returns. They need a crucial third lever: investment “alpha”.
In our view, a DC saver’s investment objective is best reflected by a future income “replacement ratio”: the proportion of a person’s final income that DC savings can provide as a retirement income. For average earners, expected replacement ratios of 50%+ might be considered successful, while those delivering 30% or less would likely require members to delay retirement or prepare for severe lifestyle adjustments. Alternatively, the investment objective could be considered as a nearerterm annual premium. For someone contributing 12% into a DC plan, an annual return of roughly 7% (approximately 4.5% adjusted for inflation) would likely be sufficient to achieve a 50% replacement ratio after 40 years.
Risks of pursuing a beta-focused approach
However, many UK DC default funds are passively managed, relying on index returns – “beta” – for growth. While historically, allocations to global equities or other “equity-like” assets, based on 10-year returns of major asset classes, were able to meet the 7% annualised return demands of a 50% replacement ratio, our expectations suggest such returns no longer exist. We therefore urge DC schemes to candidly assess the potential outcomes of their investment approach on the basis of our forward-looking viewpoint, rather than extrapolating history.
Pursuing alpha: The conundrum of cost versus affordability
Our research suggests that a typical UK DC portfolio may return just 4.5% annualized (approximately 2% adjusted for inflation) when passively managed, far short of the return required for a successful retirement outcome. Clearly, future outcomes can be greatly improved by increasing contributions; however, earnings growth has heavily lagged the costs of living increases since 2008. To suggest that shortfalls in retirement outcomes can be addressed through persuading savers to increase contributions could seem, at best, naïve!
With increased savings being largely unaffordable and sufficient market returns unlikely, disappointing outcomes are all but certain unless pension schemes incrementally increase returns for savers’ portfolios, seeking alpha on top of beta through the careful application of active management skills. True alpha, however, has an additional price above those of market returns. Yet, what is the true cost of a pension scheme? The total long-term expense ratio, the shortfall in outcomes against a desired ambition or the total contributions required achieving such an outcome ambition? We believe that cost should be considered as a function of all these variables, though the second will more likely define savers’ long-term view on the success or failure of their pension saving journey. Although alpha is a rare and valuable thing, we believe that managers with proven track records, robust investment processes and stable business models may deliver it.
With economies hampered by persistently high levels of debt and low earnings growth, we expect returns achieved by passively-managed DC plans to be unacceptably low, leading to severe lifestyle adjustments in retirement and questions over the suitability of current DC investment strategies. We recommend that DC schemes define expected future returns; focus on the concepts of “value for money” and “net-of-fee outcomes” in designing a successful DC investment strategy; and finally, embrace active management to increase returns and control risk. DC plan members can no longer afford to remain passive.
By Will Allport is PIMCO vice president and head of defined contribution (DC) practice in the UK and Ireland
Comments