Outside of the public sector, most Irish workers in an occupational pension plan are saving into a defined contribution arrangement. Such members will see the value of their accumulated funds rise and fall according to the underlying markets in which they invest.
Technology now allows for many members to be able to access details of their pension pots on a daily basis, reflecting the day to day fluctuations of markets. This additional daily information carries with it the danger that members react to short term movements. This article by John Grant of Fitzgerald Actuarial Limited looks at how members have responded to market events of 2020 and what lessons may be learnt.
Trustees of defined contribution pension plans have the responsibility for members’ investments and for providing individual members the key tools needed in order to be able to take appropriate decisions, including:
- A suitable range of funds (reflecting the different risks that an individual will face, along with each member having their own personal risk tolerances)
- A default strategy for members who do not select an option
- Sufficient and appropriate communication
Particular attention is drawn to the 10 Years preceding retirement, the implications being that as a member draws closer to retirement it is no longer appropriate to simply take a long-term investment view and investment risk should be reduced. In 2008 the Irish Association for Pension Funds (IAPF) introduced ‘Investment Guidelines’ for Trustees which emphasised these points, as well as an investment guide for defined contribution pension plan members.
Subject to meeting specific criteria, defined contribution plan members have since been given further choice through the use of Approved Retirement Funds (ARFs) upon retirement. This additional option allows ongoing investment past a member’s retirement date, thereby extending the time horizon of the investment portfolio. This reinforces the need for communication, education and expert financial advice.
Over the years the choice of core multi-asset funds has improved, offering funds of differing risk levels and better diversification, while multiple lifestyle strategies allow for individual risk tolerances, different options at retirement and changing risk priorities as a member nears retirement. This may address the first two points of the above, but what of ‘communication’?
In 2020 markets continue to be volatile, as is demonstrated in the chart on the left showing the performance of the global equity market over the last 12 months. Over the course of February and March global equity markets fell by more than 30% from previous highs, surpassing the definition of a “bear market” (which requires a fall of at least 20%).
At the September 2020 IAPF Defined Contribution conference, Irish Life reported a five-fold increase in the number of member queries relative to the same period in the previous year and saw a large increase in members switching to cash. Likewise, Zurich reported a notable increase in switches in mid-March. This is highlighted by the graph1 below showing the number of weekly switches being made, the peak numbers being made in the two middle weeks of March, accounting for c.25% of all switches made up to 3rd July 2020.
It was noted by both Irish Life and Zurich that very few of the switches came from members following the default strategy. 70% of those members switching to cash remained in the cash fund option as of September 20202, giving rise to concern at the appropriateness of this behaviour, given the immature nature of defined contribution plans; a cash fund is primarily designed to allow members to reduce exposure to investment risk as they approach retirement. However, a cash fund can also be used by members for short term tactical moves and provides protection against further market falls. Short term tactical asset allocation decisions by members are not encouraged as it brings additional risk for long term investors.
The Impact of Switching – 2020
In the table below the impact of making switches is highlighted by the returns that would have been achieved over the first nine months of 2020 by:
- being invested in a Cash Fund for the entire period
- being invested in a Core Growth Fund for the entire period
- starting off in a Core Growth Fund and undertaking a single switch to a Cash Fund with this switch taking place on:
- Friday 13th March
- Friday 20th March
- Monday 23rd March (reflecting the low point to date for 2020)
|Investment Policy||9 month return to|
end September 2020
|Cash Fund for entire period||-0.7%|
|Core Growth Fund for entire period||-5.6%|
|Start in Core Growth, single switch into Cash on:|
a. 13th March 2020
b. 20th March 2020
c. 23rd March 2020
The flight to cash in response to market falls may be seen as an instinctive move. However, such a move may have negative impact for members investing for the long term as they are now faced with the decision of when to return to the market. Most members will not have significant investment expertise to undertake this.
As we progress through the fourth quarter of 2020, markets are likely to continue to be volatile given the US presidential election, the lead up to Brexit and the continuing fight against Covid-19. However, the numbers for the first nine months of 2020 in the table above indicate that those members that have fared best are those that have simply stayed invested in the same fund, be it a cash fund or a multi-asset core growth fund. Members that switched from a core growth fund to a cash fund in mid March may be worse off by in excess of 10% when compared to members that simply stayed invested in the core growth fund over this timespan.
Communication & Education
The IAPF guidelines for trustees highlighted the importance of communication to successful member outcomes. Unfortunately, in this technology driven world, investors are often subject to information overload.
If members are reacting in ways that are less than optimal, the best way to address this is through education and targeted communication. At this point it is worth considering two quotes from the Pensions Authority, “The better that people understand risk, the more likely they are to be comfortable with it”, and “In general, over the longer term, the lower the risk, the lower the investment return that can be expected.”
Communication for members will often concentrate on the impact that a small difference in return will make due to the impact of compounding, the positive element of taking a long-term view. Maybe it is time for equal, or higher, emphasis to be placed on educating members on risk, arguably the driving force behind members’ actions in 2020.
The Pensions Authority emphasises that with the introduction of the Institutions for Occupational Retirement Provision (IORP) II legislation, trustees are required to take a forward looking, risk-based approach with a successful audit not being based on a lack of breaches but based on having the right processes in place and being actively followed through. It would be logical to apply this same approach for members of defined contribution members, they are ultimately the ones selecting their investment options, by default or active selection, from those options provided by the trustees. Placing more focus on risk education for members may allow for a better acceptance of risk where required and an understanding of when to seek to reduce certain risks.
Taking this year’s market movements and setting it into context with a slightly longer timescale, we use the same equity market movements as above, but over 5 years. This helps to underline the sharp recovery in markets since the February / March bear market and the difficulty of ‘timing’ major switches.
Since 1900 there have been over 30 bear markets in US equities, so in saving for a pension over a long term of 30 to 50 years, each member will inevitably experience several bear markets. In my own working lifetime I’ve seen:
- Black Monday in October 1987 (when I was one month into my first full time job)
- The bursting of the dot com bubble in March 2000
- Planes fly into the Twin Towers as I set off for a trustee meeting in 2001
- The unravelling of markets in 2008 as a result of the global financial crisis
- The effect of economic slowdown and a global pandemic in 2020
We should not be shocked at bear markets, they are part of investing over the longer term when seeking to provide higher returns. Interestingly it seems that under investment defaults, members are less likely to take action themselves and are more prepared to leave it to ‘the experts’, though, this may simply be due to inertia.
For trustees and sponsors of defined contribution and additional voluntary contribution pension plans, there are key lessons to be learnt from 2020:
- The default strategy is the backbone of most defined contribution schemes and should be reviewed regularly to ensure that it is fit for purpose;
- Education, with an emphasis on risk, is a key part of the communication process in assisting members to reach better outcomes;
- A scheme is as good as its weakest link, be it investment, communication (including education) or administration
- Members need professional financial advice
Notes & Sources:
1 Data courtesy of Zurich
2 As provided by Irish Life
3 The Core Growth Fund and Cash Fund used for the analysis is taken from a single provider for illustration purposes only
4 The FTSE All World Index (in US$ terms ) has been used in the line graphs to illustrate the volatility of equity markets in 2020
5 All quotes attributed to the Pensions Authority are taken from its 2016 publication ‘Investment Guidelines for Trustees of Defined Contribution Schemes’