Rethinking DC default design
Andy Dickson of Standard Life Investments considers the shift towards passive investing, and recommends factoring in the growing uncertainty involved with equity investment over time.
Long-term investors, such as those saving for retirement in a defined contribution (DC) pension plan, often rely on the performance of equity markets to reach their goals, trusting that the booms and busts over several economic cycles will balance out in the long run. Indeed, the trend recently has been towards passive or index investment approaches specifically aiming to align the investor with equity market returns. Among the reasons for this shift towards passive investing are:
• Index funds appear cheap and comparing the costs of different investment strategies is easy;
• The bewildering array of actively managed portfolios means it is incredibly difficult to make an informed choice.
What is often missed is that the uncertainty associated with equity investment actually compounds through time. This means the final outcome could lie in a very wide range (see chart below).
Clearly, to have some reasonable degree of confidence of attaining a particular savings goal, then we must budget for this uncertainty. We could seek to achieve this in two ways.
1. By switching to low-risk assets like bonds, we can reduce the range of investment outcomes. However, the potential for returns will also be lower. This means that, to reach the same goal, much more must be saved along the way.
2. We could retain higher-risk, higher-return equity assets while building up a risk buffer by saving more so that, if we are not fortunate in our investments, there should still be enough to meet our goal.
In both cases, there is a need to increase the amount saved to be reasonably confident of reaching a particular goal. The increase represents consumption forgone today for greater certainty tomorrow. It can be thought of as a ‘lifestyle cost' - that extra amount saved could have been spent on ensuring a better standard of living today rather than being tied up in long-term investments to help protect against the chance of high risk/ low investment returns in future.
We think it is important to consider this cost when making an informed choice about different investment options, as not all are equal. In particular, some investments may appear relatively expensive in terms of fees but in fact measure up well because the manager is delivering worthwhile and genuine risk diversification. This can reduce the ‘budget for uncertainty', leaving the saver with greater confidence of achieving their investment goal, as well as more to spend today.
Our new paper, 'Rethinking DC default design: budgeting for risk' describes this issue in greater detail and calculates the value generated for long-term investors.
To find out more, visit www.standardlifeinvestments.com/dc
