The collapse in equity markets in 2008 has had a dramatic impact on the value of defined contribution investments, individuals' pension pots, and highlighted in stark terms how market volatility can impact on long term pension planning.

The average DC member will have experienced a drop of 35% in the value of their pension savings in the last year based on the returns from pension managed funds where most individuals are invested.

The example below illustrates how the level of investment returns can impact on an individual's final pension at retirement.

The figures are based on a male aged 30, with a salary of €30,000 and contributing 10% of salary with contributions increasing by 4% per annum, as a proxy for salary inflation. Salary at retirement age of 65 would be €118,000.

In this example, if we assume 4% annual investment return on the contributions the individual could purchase an annual pension of €23,000, 20% of salary. If we factor in an additional 4% per annum investment return, the estimated annual pension at 65 more than doubles to €49,000, or 41% of final salary. The pension purchase is based on current annuity rates for a male aged 65. As average life expectancy lengthens, as is forecast, the cost of annuity purchase will rise so one would expect the same accumulated pension pot will purchase a smaller pension in the future.

An investment returns matching salary growth ie 4% per annum should be relatively easy to achieve with a reasonable degree of confidence, index linked bonds could probably deliver this sort of return longer term. However, such a strategy will only deliver a pension of 20% of salary on retirement. So, either the member will have to significantly increase contributions, extend the savings period by pushing out the retirement age or target higher investment returns. Since the first 2 options are not very attractive the only realistic option maybe to target the higher investment return.

If the return on investment can be increased to say twice the level of salary growth, ie. 8% per annum, this would get an individual closer to a more reasonable target pension, at 40% final salary. The difficulty is that such an investment return cannot be achieved without accepting uncertainty in the form of downside risk and volatile returns. To achieve such an outcome the contributions need to be invested primarily in growth assets where returns can be extremely volatile. Recent experience has shown us that the volatility can be severe.

For those close to retirement the effect of volatile investment can be catastrophic if there is a sharp drop in the years close to retirement as most of the growth is achieved in the later stages of the savings period, when the accumulated pot is at its highest. This is illustrated above where the pension pot doubles in the five years pre retirement on a steady growth rate of 8% per annum.

So how can an individual capture the long term payoff from investing in high return seeking assets yet protect his pension pot against sharp market falls when it is at its highest and most vulnerable? The answer is Lifestyle.

Lifestyle is where there is an automatic switching mechanism to gradually move the member’s accumulated fund and future contributions from the central return seeking fund into more protection funds as they near retirement, typically bonds and cash.

Lifestyle Works!

Taking another example based on a similar savings pattern to that of the previous example and assuming the contributions are directed primarily to real return seeking assets (such as a managed fund) until 5 years from retirement. The term of the switch is typically 3-10years from retirement and depends typically on the level of risk in the return seeking fund. The higher the return the longer the switching phase. In this example, each year for the 5 years prior to retirement one fifth of the fund is switched out of the return fund towards bonds and cash ending up with a 75% bond, 25% cash portfolio at retirement. Based on a retirement date of end December 2008, the result illustrates the merit of the Lifestyle approach. In this case the lifestyle strategy results in a pension pot 35% larger than if no switching had taken place, protecting the member from downside risk as they approach retirement.

In setting appropriate investment strategy for a DC plan members should focus on a few key objectives:

• Achieving a long term investment return that will be significantly greater than the risk free rate with a reasonable degree of confidence; and
• Managing the volatility of return, particularly when nearing retirement age, as this is the period when the pension pot is biggest and most vulnerable to downside shocks.