When saving for retirement, members of defined contribution (DC) pension funds should start with a realistic look at how much income they’ll need when they retire, and what sort of capital will be required to fund that income. They then need to continually keep an eye on their funding level. This is a conceptual departure for many members, who are currently focusing solely on how much capital they’re building up and whether that capital is increasing or decreasing.
“It’s astonishing how few people saving up for retirement actually know if they’re heading in the right direction,” says Petri Greeff, head of liability driven investing services at RisCura, a global financial analytics provider and investment consultant. “This is like saving up for a holiday with no idea what that holiday will cost.”
Knowing your funding level means knowing at any point in time whether you have enough money to provide you with the income you’ll need once you retire. If your funding level is 100%, for example, you’re doing well. If however, your funding level is only 50%, you’ll know you need to put more effort into your savings, adjust your investment strategy, or both Greeff says. “Simply saving up for a pool of money, without understanding what income that will translate into is a dangerous approach.”
Greeff says that RisCura finds that trustees of DC funds are also focusing on the pool of capital they’re building up for their members, and not the income those members will need when they retire.
“Because of this thinking, trustees and members are focusing on capital protection, whereas they also need to focus on income protection,” says Greeff. Focusing on income protection means focusing on three main risks to members’ income and its purchasing power; namely interest rates, inflation and longevity.
With the advent of DC funds, trustees no longer think about these risks. Instead, they focus on helping members accumulate, and protect, a pool of capital. This thinking has come about through the fact that DC funds have no further obligation to members once they retire.
But is that really the case? DC fund members have expectations about the level of income they’ll be able to enjoy when they retire. And they have an expectation that if their retirement savings are not going to be sufficient, trustees should have been pointing this out. How are trustees managing these expectations?
“There is a reputation risk to DC funds that trustees need to acknowledge and work towards mitigating,” says Greeff.
While there are many subtleties involved in structuring an investment portfolio for income protection, RisCura says one of the key tools is the use of inflation linked bonds, as opposed to nominal bonds or cash, which are the norm when capital protection is the focus.
“In a capital protection world, members are typically advised as they near retirement to switch out of risky assets such as equities and into relatively riskless assets such as cash and nominal bonds.” Yet neither cash nor nominal bonds address inflation.
Instead, as they near retirement, members should ensure their portfolio acknowledges the importance of income protection and includes a portion of inflation-linked bonds.
“Capital protection thinks up to retirement and income protection thinks through retirement up to death. Looking at retirement saving this way helps trustees and members better manage inflation, interest rate and longevity risks and provide for a better, more secure retirement,” Greeff concludes.