In an age of increasing individual responsibility for retirement provision, volatility of investment returns across all asset classes has never been more relevant to consumers. Here we look briefly at some of the challenges.
By Russell Ward, FIA, Principal, Milliman.
With governments such as in the UK and Australia encouraging people to take more control over their savings, especially with new freedoms over retirement savings and annuities, consumers are right to be nervous—risks previously borne by their employers or insurers are now being transferred to them. Key amongst these risks are:
• Longevity risk: Outliving retirement savings.
• Inflation risk: Reduction in buying power of a fixed level retirement income over time as the prices of goods and services purchased increase.
• Volatility risk: The impact on the value of retirement savings from varying investment returns and the decisions that can drive.
Here we will concentrate on volatility risk.
Unfortunately, the choices many consumers make in the face of market volatility frequently destroy value. Consumers can quickly retreat to cash when faced with volatility they don’t understand. However, the idea of cash as a safe haven can be illusory, as whilst returns are stable they are also close to zero, meaning that retirement savings can be quickly exhausted—a smooth ride but a ride to the wrong destination.
The graph below shows returns based on three possible responses to the catastrophic market crash of 2008, showing the return profile for an investment made in the FTSE 100 on New Year’s Day 2008.
Investor A held his or her nerve and remained invested and eight years later that person would have been up 43%. On the other hand, Investor B switched to cash at the low point in 2008 and remained there. The crystallised loss would be almost unchanged eight years on.
Investor C may have felt he or she had struck a careful balance between overreaction and inertia, moving into cash at the bottom but back to equities a year later. Eight years on, however, that person has still enjoyed only a zero return.
The variation in outcomes between our three investors is extreme here but the example serves to illustrate how reactions to market volatility can drive materially different returns for consumers.
Indeed, the situation can be made worse if consumers compound their problems by stopping contributions at times of market volatility, as they see total funds invested reduce despite having made additional contributions over the preceding year.
Volatility can be a particular problem for those trying to achieve a stable and sustainable level of retirement income. Here, negative returns in the early years of retirement result in assets being sold at depressed prices to provide income. When returns improve, the depleted fund has much less scope to benefit. This effect, known as the “sequence of returns” problem, can result in a retirement savings pot being exhausted years earlier than might have been expected.
So today’s consumers face a real dilemma—they need investment growth to build up a healthy pension savings pot and they need to make that pot last throughout retirement. However, the opportunity for growth often brings with it volatility of returns which, as we have seen, can be real headache.
The message here is that there is scope for insurers to offer investment approaches, which provide the potential for growth but mitigate volatility and help consumers avoid the consequences of their instinctively overcautious responses.
This doesn’t necessarily mean insurers embracing guaranteed returns, as they impose severe strains on solvency and in today’s market conditions are expensive to deliver.
Instead, insurers should be looking to create products that take the rough edges off volatility sufficiently to keep cautious and often frightened consumers on board. A well-structured and cautious but active investment strategy will clearly be part of this and that will require insurers and regulators to embrace greater diversification.
Furthermore, we expect approaches which go further, explicitly limiting volatility and providing consumers with some protection from market downturns, to gain in popularity.
Moving beyond investment strategy, insurers and annuity providers must play to their traditional strengths as being providers of longer-term savings and protection products. They must also look at their cost bases, charges and transparency. There is a danger in many countries that if this doesn’t happen asset managers will move in on this opportunity.