The biggest risk, is not taking risk

It may sound counterintuitive, but in long-term savings and pensions the biggest risk is not taking sufficient investment risk. To increase the confusion, we tend to measure risk as short-term variability around a projected trend. The irony is that short-term volatility doesn’t matter for long-term savers, the real risk is that the realised outcomes deviates from the projected trend.

The de-risking folly

The industry standard among DC schemes is to have a default investment approach in which the savings are de-risked as members approach their retirement age. In practice, what happens is that short-term volatility is reduced for someone who typically has a long remaining investment horizon. We know that for someone at age 65 the average remaining life expectancy is approximately 20 years. ?

An average investment horizon of 20 years, doesn’t warrant a de-risking of the short-term risk. So, the conundrum is to understand why most default lifecycles are aggressively de-risked towards retirement? A plausible answer is that the de-risking that takes place is primarily for reducing the business risk of the provider.

From the provider perspective, the member communication is targeted on de-risking towards the member’s first day of retirement instead of the last pension payment. The reason for this is that when members retire, they are likely to take their money and go somewhere else. From the provider’s perspective the customer journey may end at retirement, so de-risking short-term variability towards the end of the relationship with the member/customer is understandable from a commercial perspective. But does it make sense for the savers who have a remaining average investment horizon of more than 20 years?

The multi-pot madness at retirement

The multi-pot approach that has recently gained popularity targets members who are retiring. The framing behind the multi-pot narrative is to mentally compartmentalise the savings in retirement based on different purposes. It is a variation on the typical household budget with jam jars that our grandparents had. Typical pots in this narrative are; money to be spent in the near future, a growth pot for money to be used later, a rainy day pot as well as a pot for buying an annuity in later life.

From a marketing perspective, this sounds great as it will help the member to think about how they want to spend their money during their retirement. Taking a closer look, the multi-pot approach is actually a disservice to the members since the investment risk is framed as short-term volatility. The pot to be spent in the near future needs to be safe so it is invested in cash. The growth pot is invested in a balanced portfolio consisting of equity and bonds. The rainy day pot needs to be safe and it is invested in cash and the pot set aside for buying an annuity later in life is invested in bonds with a long duration to minimise the short-term volatility.

On a standalone basis, each pot makes sense, but doing the math based on examples given by providers reveals a shocking truth for the overall savings. At the day of retirement, the average allocation of savings is around 30% in equities and 70% in a combination of cash and bonds. For someone targeting a lifelong income, with a 20 years’ average remaining investment horizon, this is a highly defensive portfolio allocation. ?

Perception of risk depends on context

Our perception of risk and our risk appetite depends on the framing. For example, do we analyse workplace pensions in isolation or do we analyse the overall disposable income, including state pensions and other means tested benefits? Depending on the framing, our perception of risk for an investment strategy will be quite different.

Another challenge is that risk cannot be directly observed, so it has to be quantified indirectly. It is straight forward to measure the short-term variability around a projected trend, while it is near impossible to measure the long-term risk in the projected trend. Therefore, it should not come as a surprise that most DC providers end up using short-term variability as the measure for long-term investment risk. This is referred to as ‘availability bias’ by behavioural experts. ?

The final and perhaps the most important driver for the framing of risks are agency issues. Everyone says that they manage the risk in the best interests of their members, but as illustrated in this blog that is not always the case. We should always ask ourselves this question: Which are the risks that are being managed, and, for whom?

What gets measured gets managed

Most experts would agree that for a long-term investor, risk should not defined by short-term volatility around the trend. The real risk for a long-term investor is getting the trend wrong. But the available bias leads to using short-term risk measures such as volatility. This could have been a harmless academic debate, but as the Management guru, Peter Drucker, pointed out “what gets measured gets managed”.

Looking out for members best interests, we should not be afraid of challenging industry practice and redefining risk. It is time to retire short-term counterproductive measures of risk, such as value-at-risk and tracking-error. This is easier said than done. The seductive power of short-term risk measures that allows us to build complicated models that deliver beautiful charts and tables is very strong since it acts as catnip for most decision makers.

A constructive way forward is to use scenario thinking as the foundation of strategic decision making. This helps to identify and quantify the potential impact of the longer-term risks on member outcomes. This could include analysis on how the savings would be impacted if certain economic regimes would take hold for a longer time-period. This could be complemented by an analysis of how the investment strategy would weather historical periods covering a decade or two. ??

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PS Years ago, I spoke with a pension fund risk manager who had prepared a new risk report. I challenged him by saying “if you want to see a grown man cry, then show me risk measures such as value-at-risk and tracking-error”. He looked a bit awkward, then showed me value-at-risk numbers and I ended up crying on the inside.