Why Do We All Fall Down?

Why do we all fall down? Recently, one of us was asked this question by a four-year-old child after the umpteenth performance of ‘Ring a ring a rosies’. Children have an ability to ask excellent questions that we often brush off or simply dismiss. Sometimes we become so accustomed to something that we fail to question why, or have forgotten why, we actually do it.

Defined Contribution Investment Strategies

To a large extent, this is the case with the typical investment strategies utilised in defined contribution (DC) schemes. We are constantly presented with ‘evolutions’ to strategies that have been around for many years, but do we ever take a step back to question their overall appropriateness? The cornerstone of most DC strategies is a focus on how we can maximise accumulated savings (or reduce their variability).

Sometimes we need to be reminded that the primary concern of the DC fund members is (and always has been) whether they will have sufficient income in retirement to live comfortably.

A good retirement is measured by the standard of living you want in retirement; a standard of living is not defined by a pot of money, but a stream of income. The savings needed when you retire is the amount needed to sustain the standard of living which you have become used to enjoying in the latter part of your working life. That is an income goal; it’s not a wealth goal.

While National Treasury discussion papers, and consulting approaches, may make references to concepts like a replacement-ratio objective (a measure that expresses income in retirement as a proportion of a member’s salary), the actual investment strategies conceived do not in fact focus on them (other than the initial mention).

Investment statements that members receive focus on return and volatility. These in turn drive investor behaviour. They are not measured in terms of the members’ investment goals or the likelihood of meeting them. Members should not be focusing on how many rands they have in their account, but how many ‘income units’ they have.

Investment statements that members receive focus on return and volatility. These in turn drive investor behaviour. They are not measured in terms of the members’ investment goals or the likelihood of meeting them. Members should not be focusing on how many rands they have in their account, but how many ‘income units’ they have.

Life-Stage Investing

The most popular investment strategy is a life-stage approach to investing. Simply put, younger members are invested in more aggressive portfolios targeting higher returns (i.e. portfolios with more equity) and are phased down to more conservative portfolios (i.e. portfolios with more cash and fixed income) as they approach retirement. At no point is the member’s personal circumstances catered for. The only member-specific information used is their expected time until they retire.

The entire framework is essentially predicated on an assumption that investors become more conservative as they approach retirement and wish to reduce the volatility of their fund credit.

When you consider behavioural motivations, it is not hard to understand why such an investment approach has found favour.

Goals-Based Investing

Our thinking should evolve to consider the obligations or goals of the individual member and design an appropriate investment approach that targets these. Rather than regarding the member’s fund credit as the liability, we should be measuring the liability as the cost of securing an appropriate inflationlinked income stream for the member at retirement. This is analogous to the traditional defined benefit plans where the member was guaranteed an income at retirement based on their salary and tenure with the retirement plan.

This change in formulation results in a significantly different investment strategy.

Consider the investment strategy that focuses on preserving a fund credit in the year before retirement. While history is not an indication of future performance, we consider how two different investment strategies would have fared for a member if the past five years of investment returns are used as a proxy.

The benefits of a more conservative cash-based strategy are apparent if your objective is to preserve the accumulated savings.

But if we consider the reality that the retirement savings are intended to be used to provide an ongoing inflationlinked income stream, the results are very different.

The graph reflects that inflation-linked bonds are now the optimal investment for an individual wishing to secure a given level of income in retirement. This is because annuity prices are driven by changes in interest rates. The cash investment is a very poor choice of investment.

Of course, investments are never simple and we need to consider whether the individual might need to actually increase their equity exposure to provide the maximum likelihood of affording a reasonable income benefit, or reflect the reality that a member may make use of the tax-free withdrawal of some of the savings at retirement. This can easily be incorporated into a framework reflecting meaningful goals.

So What Should Members Of A Defined Contribution Plan Be Invested In?

The investment strategy should optimally allocate the member’s assets to a mixture of risky assets (such as equities) and risk-free assets (which is not cash!). The allocation to each should change over time so as to maximise the likelihood of achieving the investment goal. The devil remains in the details, but the key differences to current frameworks are that risk is defined as the possibility of not achieving the required retirement income, and the risk-free asset is defined with reference to a deferred inflation-linked annuity.

Conclusion

It’s convenient and tempting to dismiss a four year old’s question about ‘ring a rosie’ by saying it’s just a silly nursery rhyme and we shouldn’t pay too much attention to the words. The reality, though, is that it describes the Black Plague in England centuries ago, with the final verse of “we all fall down” referring to the inevitable death due to the disease. Conversely, it is also tempting for a retirement fund member to assume that his/her default DC fund investment strategy is well thought out (when closer analysis in many instances suggests otherwise). By identifying meaningful goals and asking the right questions, we can help prevent our members from all falling down.