Your Quarterly Health Chec - J.P. Morgan · 2017-06-16 · Your Quarterly Health Chec Summer Welcome to Pension Pulse, ... we take a closer look at the reasons behind the improvement

FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION

Pension Pulse Your Quarterly Health Check

Summer 2015

Welcome to Pension Pulse, the quarterly update from our Pension Solutions and Advisory Group, which is designed to provide UK pension funds with up-to-date information on market trends, funding levels and the latest industry and product developments.

Every edition of Pension Pulse includes an examination of recent changes in pension funding, an overview of the fixed income market environment and analysis of some of the most topical issues currently facing pension investors—including a dedicated Defined Contribution (DC) in Focus article.

In this edition, we take a closer look at the reasons behind the improvement in UK funding levels in the second quarter of 2015, ask whether alternatives can provide an answer to the funding conundrum, and look in detail at the Institutions for Occupational Retirement Provision (IORPs) II debate in Europe and the impact that this could have on UK trustees.

We end with a look at the defined contribution market, and the risks and opportunities faced by members when trying to accumulate an adequate pension pot for their retirement.

We hope you enjoy Pension Pulse!

I N T H I S I S S U E

The tail is wagging the dog: UK funding levelsPension funding levels improved in the second quarter but future funding status will continue to reflect the shortfall in asset duration relative to liabilities.

The tide turns: The fixed income market environmentThe German Bund market set the pace in the second quarter, leaving other markets in its wake.

A solution to the funding conundrum? Alternative investments With lower return expectations making it increasingly difficult for pension funds to improve their funded status, could alternatives provide a solution?

Let sleeping dogs lie? Solvency II for Pensions While the debate over IORP II may not be gaining wide coverage in the UK, the stakes could be high for UK pension schemes.

DC in focus: The multifaceted risks of DC investingInvestment managers and other service providers are continually looking for new and effective ways to help position participants for self-funded retirement success.

Rupert BrindleyManaging DirectorGlobal Pension Solutions and Advisory Group

Alexandre ChristieVice PresidentGlobal Pension Solutions and Advisory Group

Anthony S. GouldManaging Director Global Pension Solutions and Advisory Group

2 PENSION PULSE – SUMMER 2015

In this article we hope to unpack the mysteries that surround pension funding fluctuations and highlight the implications for investment strategy. We show the central role that under-hedged interest rate exposure has had over the past decade, and suggest that the evolution of aggregate funding levels will continue to reflect the shortfall in asset duration relative to liabilities.

Explaining the drivers of long-term pension well-being First the good news! Over the second quarter of 2015, long-dated Gilt yields rose by 40 basis points (bps), long-dated real yields rose by 16bps and credit spreads rose by 11bps. This three-fold win caused funding levels to improve by 3.4% according to the Pension Protection Fund, and by 4.3% on our preferred measure, to stand at an estimated 92.7%.

Now for the explanation. We start by charting the aggregate UK defined benefit pension data published by the UK’s Pension Protection Fund (“PPF”) for those schemes that are eligible for its safety net (EXHIBIT 1). The liability values are known as “Section 179” reserves, and they reflect the cost of buying out with an insurance company the level of compensation that the PPF offers to pension members whose sponsor goes bust.

EXHIBIT 1: PENSION FUNDING TRENDS SINCE 2003

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15

Valu

e, £

bn

Assets

Liabilities

Source: J.P. Morgan Asset Management. For illustration purposes only.

EXHIBIT 1 shows that since the start of the PPF’s data collection in March 2003, both pension assets and liabilities have shown strong growth in real terms. This growth has arisen from several sources—from asset market movements, from deficit contributions and from new pension accrual exceeding pension benefits in payment.

The value of pension assets has increased by a multiple of 2.3x (corresponding to 7.0% per annum compound growth), while the value of liabilities has increased by an even larger multiple of 2.8x (or 8.7% per annum compound growth).

However, the most noteworthy aspect of EXHIBIT 1 is that the volatility of the liabilities, driven by dramatic Gilt market fluctuations, has swamped that of the assets. According to the PPF’s data, asset volatility has averaged 5.1% per annum, while liabilities have been three times as volatile, at 15.5% per annum. The basic message is clear—the liability “tail” has certainly wagged the pensions “dog”.

What’s creating that liability volatility?We use a regression analysis over the past four years to identify that the liabilities have behaved very similarly to long duration bonds. Their observed duration is estimated to be 24 years (+/-1 year), with an inflation sensitivity of 7 years (+/-2 years). The regression fit is very good, with an R squared measure in excess of 95%. We note that this compares with the regulator’s slightly lower estimates, as at March 2014, of roughly 20 years for Gilt yield sensitivity and 7 years for inflation, as stated in the 2014 Purple Book.

This analysis shows that only about one-third of the PPF benefits are inflation-linked, whereas full benefits are more inflation sensitive. The majority of PPF compensation payments relate to benefits accrued before 1997 (which are not eligible for indexation), while other compensation payments have inflation-indexation capped at a below-market rate of 2.5% per annum.

THE TAIL IS WAGGING THE DOG: UK funding levels

Rupert Brindley, Managing Director, Global Pension Solutions and Advisory Group

J .P. MORGAN ASSET MANAGEMENT 3

P E N S I O N P U L S E – S U M M E R 2 0 1 5

What about other funding measures?We now look in greater detail at the accounting measure of funding strength for UK-quoted companies (EXHIBIT 3).

We estimate corporate funding levels on a bottom-up basis using data extracted from the corporate accounts. Our calculations are based on historical audited data, but we need to roll-forward these values to present market conditions. Our measure excludes funds if they lack a UK-quoted sponsor and will include data on any non-UK group plans for which a UK-quoted sponsor has responsibility.

The accounting basis uses a discount rate that contains an estimated AA credit spread. Hence, as market spreads for corporate bonds widen, the value of the liabilities declines.

EXHIBIT 3: FUNDING RATIO ON ACCOUNTING BASIS

92.7%

75%

80%

85%

90%

95%

100%

Dec 14 Jan 15 Feb 15 Mar 15 Apr 15 May 15 Jun 15

Estim

ated

IAS

fund

ing

leve

l

Accounting Average PPF Universe


EXHIBIT 3 shows an encouraging trend during 2015, with the accounting measure improving slightly faster than the pan-UK PPF average.

So what does all this mean?This improving funding trend during 2015 suggests that schemes may be about to dust off their investment de-risking plans and try to capture some of the benefits of improved corporate bond levels by adding bond-like holdings in a liability-aware manner.

Do the assets offer an adequate hedge? A good liability hedge may be provided by either swaps or bonds. A long-dated portfolio that blends index-linked bonds and conventional Gilts could provide rate duration in excess of 20 years, with an additional seven years of inflation exposure.

However, we see a stark contrast when we analyse the actual asset sensitivities. This reveals a nominal duration contribution of about 2 years (+/-1 year) plus a real duration contribution of about 2.5 years (+/-2 years). Hence, there is a huge gap between the asset and liability sensitivities, which explains why the reported funding ratio volatility has been so high.

This may not be the full story because we need to recognise the existence of Liability Driven Investment (LDI) derivatives. The 2015 KPMG Liability Driven Investment Survey estimates that the total volume of LDI hedging that has been implemented corresponds to a notional hedge amount of about £657 billion. While it is difficult to quantify the extent of the double-counting of these hedges with bonds captured in the PPF asset database, we estimate that UK pension assets have accessed an additional 7.25 years of nominal duration and 5 years of inflation via these off balance sheet hedges (EXHIBIT 2).

EXHIBIT 2: ESTIMATING THE TOP-DOWN SENSITIVITY TO NOMINAL AND REAL RATE CHANGES

Rate Duration (Years)

Inflation Duration (Years)

Asset sensitivities 4.5 2.5

Liability-driven hedges 7.25 5.0

Combined asset sensitivities 11.75 7.5

PPF Liability Sensitivities – Regression fit (& regulator

estimate)

24 (20) 7 (7)

Asset sensitivities scaled to Liabilities(£1281bn assets v. £1522bn liabilities)

9.9 6.3

PPF Net Liability Mismatch 14.1 (10.1) 0.7 (0.7)


Even allowing for derivative hedging, the liability mismatch shown in EXHIBIT 2 explains why we expect the aggregate PPF funding level to remain volatile, and to be exposed to further declines in conventional Gilt yields.

THE TAIL IS WAGGING THE DOG: UK funding levels


All major bond markets are somewhat correlated because of shared global inflation and liquidity influences. However, in the second quarter of 2015, it was the German government bond market that set the pace, and the other markets were caught in its wake.

Where’s the greater fool?The quarter started with bond investors absorbed by fears of eurozone deflation, and elated at the prospect of the European Central Bank buying €60 billion of bonds each month. The impact of this official buying was seen inasmuch as the yield on two-year German bonds stayed pinned at around minus 20 basis points (bps).

These levels are unprecedented, but even more remarkable movements were seen in the German 10-year bond, which rallied to yield as little as 7bps. These levels only appear rational if investors believe a zero rate policy will persist for at least a further decade, or if there is high confidence that a “greater fool” buyer—namely the ECB—will be willing to purchase these bonds at an even lower yield level.

Towards the end of April, as signs of European recovery became stronger, the pricing of the German 10-year bond corrected rapidly to reflect a more orthodox economic outlook. Only towards the end of the quarter did the recurrence of concerns about the Greek debt crisis prompt a partial recovery of demand for Bunds as a safe haven holding.

As we can see from EXHIBIT 1, this sharp correction also spilled over to the Gilt market, albeit in a more measured manner.

EXHIBIT 1: BOND YIELD REBOUND

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

31-3-15 30-4-15 30-5-15 29-6-15

Gove

rnm

ent B

ond

Yiel

ds, %

per

ann

um

10-Year UK 10-Year Germany 2-Year Germany

Source: Bloomberg. As at 30 June 2015.

View from across the pondTen-year US Treasuries also traded in a wide 70bps yield range, reflecting European and Chinese slowdown concerns, and the ebb and flow of expectations for a Federal Reserve (Fed) rate rise before year end.

US economic data released in the second quarter improved following a slow first quarter. After a 0.2% decline in GDP during the first quarter, data released for April and May suggested a GDP growth rate of about 3% in the second quarter.

Energy prices dominated market sentiment in late 2014 and early 2015, but stabilised during the second quarter. West Texas Intermediate (WTI) crude oil plateaued in April, and then traded in a tight $5/barrel range for much of May and June. This served to stabilise US inflation expectations.

Labour market improvements were broad-based, with the gains in the service sector and healthcare jobs more than offsetting losses in mining. Non-farm payroll figures reported during the quarter (for the months of March, April and May) showed an average monthly increase of 221,000. This brought headline unemployment down to 5.3% for May.

Insights from Fed watchingThe Federal Open Market Committee (FOMC) met twice in the second quarter. In April, the committee expressed some concern about the growth slowdown following the weak first quarter, though members communicated that they believed much of the weakness was transitory. In June, the committee adopted a more optimistic tone, noting the moderate expansion in the economy and a pick-up in job growth against the backdrop of somewhat diminished slack in labour markets.

The quarterly assessment update showed 15 of 17 FOMC members favoured a first rate hike in 2015, though there was a decrease in the number of participants calling for two hikes this year. Forward rate projections were revised somewhat lower, implying a slower eventual path once tightening begins. Timing remains a fluid debate, and FOMC statements continue to highlight the importance of data, together with “international developments” (presumably including US dollar strength and stability in Europe and China), to the committee’s decision process.

THE TIDE TURNS: The fixed income market environment

Rupert Brindley, Managing Director, Global Pension Solutions and Advisory Group



However, the backdrop of a healthy labour market and average hourly earnings, has led many market participants to expect a Fed rate rise in either September or December of this year. Hence, it appears reasonable to imagine that we may have seen the lows for bond yields for this cycle.

Don’t forget sterling, please!The sterling market is caught in the cross-currents of eurozone quantitative easing and Fed rate rise speculation. However, we do note that the UK rate cycle is more likely to resemble that of the US, since Bank of England governor Mark Carney is preparing investors and the public for a first rate rise in early 2016.

Finally, we note that issuance in sterling corporates is down 30% year on year compared to 2014, at a mere £18.5 billion. There is a risk that this trend might become self-reinforcing if major global borrowers increasingly seek out pools of liquidity and tight pricing. We will continue to monitor these developments for future issues of Pension Pulse.

THE TIDE TURNS: The fixed income market environment


Lower forward-looking return expectations are making it increasingly difficult for pension funds to improve their funded status. In order for pensions to meet their future funding obligations through the management of their investment portfolios, they will either have to wait for interest rates to rise and/or increase their allocation to risk assets. We believe that boosting allocations to risk assets, and in particular to alternative assets, may provide the most suitable solution to this widely-faced conundrum.

How can alternatives make a difference?Illiquidity, leverage and active management are the portfolio characteristics most closely associated with the alternative investments spectrum. Each of these three characteristics serves to make the case for considering an allocation away from the more traditional asset classes.

IlliquidityInvestors who are willing to tie up their money for several years should reasonably expect to receive an illiquidity premium and given the nature of many alternative investments, they are often well placed to generate the associated heightened expected returns. This is because pension schemes typically have the capacity to allocate a portion of their portfolios to assets with a longer time horizon, indicating they have the potential to capture increased returns in a return-starved environment.

The private credit market provides one such example. Since 2008, a portfolio of multi-year mezzanine loans that sits as part of J.P. Morgan’s private credit offering has delivered a yield premium of 850 basis points per year compared with its public high yield benchmark1. This is a formidable premium, albeit one earned against the backdrop of a fairly benign credit environment following the financial crisis.

LeverageWhile any decision around leverage used by a pension fund must be taken on a case by case basis and viewed as part of a complete portfolio, an alternatives allocation to hedge funds, private equity and real estate investments that have built-in leverage might serve to offer enhanced returns.

Hedge Funds typically use leverage in many ways. For example, long-short equity hedge funds, the most prevalent, use a combination of long and short positions, often with gross exposures in excess of 100%, to achieve their returns.

Private equity firms use leverage in structuring a majority of the deals for buyout funds, arguably one of the most fundamental categories of private equity investing. Since 2008, the amount of leverage embedded in leverage buyouts, which constitute about 60% of all private equity transactions, has been 2.25 times the amount of leverage in S&P 500 companies2. Furthermore, real estate funds typically use leverage at an asset-by-asset level to increase returns.

Active managementPassive investment vehicles, such as exchange-traded funds, have experienced significant inflows over the past few years. This may lead to opportunities for active managers in public markets, as there is relatively less money chasing under-researched opportunities. However, at present, many large investors are considering the role of semi-passive “smart beta” strategies to capture their preferred risk premia within a low-fee budget.

In contrast, alternative asset classes are characterised by the prevalence of active managers, whether an investor is looking in the event-driven hedge fund space or for an Asian real estate manager. Therefore, the key driver of returns in alternative asset classes is active management.

Beware manager dispersionWhile these three portfolio characteristics provide compelling reasons for pension funds to consider investing in alternatives, the third characteristic (active management) presents specific challenges to investors looking to build an alternatives allocation. This is because the skill requirement inherent in the management of alternative asset classes manifests itself in broad differences across outcomes from different managers.

A SOLUTION TO THE FUNDING CONUNDRUM? Alternative investments

Declan Canavan, Managing Director, Head of Alternative Investment Strategies, EMEA

1 Yield to call of mezzanine loans is an average of those experienced by actual portfolios within a representative J.P. Morgan private credit offering from 2008 to 31 December 2014. Public high yield returns are represented by the weighted average yield of the JPM Single B High Yield Index over the same period.

2 Source: J.P. Morgan Asset Management, Bloomberg, S&P Capital IQ. Data as at 29 April 2015.



EXHIBIT 1 highlights the dispersion of returns among a range of hedge fund strategies compared to long-only equity strategies.

It is clear that the range of returns experienced by long-only equity managers is more closely clustered than those of long/short equity hedge funds.

EXHIBIT 2 illustrates the range of returns experienced across the alternatives spectrum. It shows that for private equity and real estate asset classes in particular, the difference in outcomes between the 25th and 75th percentiles is highly significant. Clearly, the divergence between the very best managers and the very worst managers can be quite extreme.

Identifying high-value opportunitiesAnother challenge is to find high value opportunities The sheer scale of the largest global players often means that in order to fulfil their desired allocations to certain alternative investment sectors, they will be required to meet high valuations for trophy assets.

Infrastructure has suffered from this trend, as medium-sized transactions with limited regulatory or political uncertainty now appear most likely to provide stable and attractive returns. Some infrastructure funds have been forced to lower their target returns as it becomes more challenging to identify opportunities with strong value potential.

A SOLUTION TO THE FUNDING CONUNDRUM? Alternative investments

The real estate sector has also been affected as flagship properties in ultra-prime locations in global cities continue to draw the attention of the largest pension and sovereign wealth funds. As a result, real estate opportunities are likely to be better sourced among “A” properties in “B” locations, or vice versa.

Separating the wheat from the chaffAlternatives are too important to ignore in today’s investment environment. They span a broad range of opportunities, from aggressive growth-seeking in private markets through to more bond-like cash generation from real estate and infrastructure. A common denominator across these opportunities is the need for strong management skills to separate the wheat from the chaff.

As a result, many pension funds are now looking to form trusted partnerships with consultants and asset managers for practical input on portfolio design and investment origination.

EXHIBIT 1: RETURNS FROM HEDGE FUND STRATEGIES VS. LONG-ONLY EQUITY STRATEGIES

EXHIBIT 2: RETURNS ACROSS THE ALTERNATIVES SPACE

-20%

-10%

0%

10%

20%

Long/ShortEquities

Opportunistic/Macro

DistressedSecurities

RelativeValue

MergerArbitrage

Long OnlyEquity

Perf

orm

ance

Rel

ativ

e to

50t

h pe

rcen

tile

(%)

Top quartile Second quartile Third quartile Bottom quartile

-10%

-5%

5%

15%

25%

Retu

rn

0%

10%

20%

5.25% 6.00% 4.50% 4.75% 5.00%

7.75% 6.00%

25th %ile Median 75th %ile 2015 Equilibrium Assumption

Equity Hedged

Diversified Macro RelativeValue

PE/buyout

US Real Estate

EventDriven

Source: Hedge Fund Research, Morningstar. Managers selected with at least 60 months of performance from January 2004 ending in December 2013. Number of managers satisfying these criteria in the different sub-strategies: Long/Short Equities: 953; Opportunistic/Macro: 236; Distressed Securities: 47; Relative Value: 428; and Merger Arbitrage: 167. “Long Only Equity” represents US Large Blend Morningstar category over the same time period.

Source: J.P. Morgan Asset Management. HF manager returns are taken from Bloomberg as of September 17 2014. PE and Real Estate historical quartile returns are taken from Cambridge Associates data as of March 31 2014. Opinions, estimates, forecasts, projections and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. There can be no guarantee they will be met. Past performance is not indicative of comparable future returns.


While the debate over IORP II may not be gaining wide coverage in the UK, the stakes could be high for UK pension schemes. So what are the main points of the debate, how may the directive affect UK pension schemes, and how can UK pension trustees ensure that their opinions are heard?

Solvency requirements – not yet axed for good The purpose of the draft legislation that has been drawn up by the European Commission is to provide a framework to facilitate the transfer of pension schemes across the European Union. These proposals draw so heavily on the Solvency II rules for insurance companies that the whole directive has become better known as “Solvency II for Pensions”.

At the heart of the controversy is the European Commission’s belief that, since pension schemes and insurance companies perform roughly equivalent functions, they should be subject to similar regulatory requirements. This approach is described by the three pillar framework, summarised in EXHIBIT 1.

We believe this premise is flawed, since it does not take into account the fact that pension schemes and insurance companies have different objectives, time horizons and levels of recourse to additional capital.

Of these three pillars, the application of the first pillar to pensions causes the most concern in the UK, because there is a real risk that excessive solvency requirements could force higher levels of funding than should realistically be necessary.

We think that the Pillar I proposals are unlikely to receive a favourable vote in the European Council, and thereby become part of European law, in light of opposition from Germany, the UK, the Netherlands, Belgium and Ireland. However, another country is still required to achieve a blocking minority, and it is not certain that each country currently opposing the measures will continue to do so.

The current draft legislation also requires member states to allow pension schemes to invest in illiquid assets. This is welcome, since it promotes long-term investments in the economy, and allows occupational pension schemes to benefit from an illiquidity premium. In the present draft, however, no specific provisions are made to encourage occupational pensions to invest in illiquid assets. UK pension trustees could have an important role to play in persuading MEPs to propose a pragmatic approach, by allowing for an illiquidity premium in discount rates.

LET SLEEPING DOGS LIE? Solvency II for Pensions

Alexandre Christie, Vice President, Global Pension Solutions and Advisory Group

EXHIBIT 1: THE THREE PILLAR FRAMEWORK

P I L L A R I

Quantitative requirements

Pillar I focuses on valuation and the calculation of minimum capital requirements.

P I L L A R I I

Governance

Pillar II provides guidance and rules on the design of internal control structures and aids supervisors in understanding the risk posed by the operation of the firm.

P I L L A R I I I

Disclosure

Pillar III describes the appropriate levels of transparency in engagement with various interested parties, including regulators and shareholders.

Source: EIOPA



The draft text lists a number of stringent disclosure requirements. The important point for UK trustees is that the European Parliament has proposed an amendment to introduce more flexibility, by requiring that information provided to scheme members be adequate for the needs of the user and written in a clear and user-friendly way. The text also requires the disclosure of information on the financial risk associated with the pension scheme.

Get involved in the debate before it’s too lateThe European Parliament has suggested many sensible revisions to the legislation but its recommendations are not final. The debate with the Council of Ministers is also not expected to start until the end of the year.

For UK pension trustees, now is the time to get involved. Influence can be projected by joining the European pension regulator’s stakeholders group (EIOPA), and speaking to MEPs involved in the relevant committees that are currently debating the draft legislation—the Committee on Employment and Social Affairs (or the EMPL Committee) and the Committee and the European and Economic Affairs Committee (known as the ECON Committee). Lobbying MPs in the UK parliament can also help, as they can have an impact on the position taken by the UK government in the Council of Ministers. Everything is still to play for.

Changes to governance requirementsThe second pillar is less contentious, particularly if the proposed requirement for cross-border pensions to be fully funded is deleted from the legislation, as recommended by the European Parliament.

Many of the requirements concerning governance have met with widespread approval, and no major changes are expected. For example, schemes would be required to have an effective risk management system, and to have internal audit and actuarial functions. These functions should already exist in UK pension schemes, either in house or outsourced, although there is a potential complication for any scheme that currently uses the internal audit functions of its sponsor.

A governance proposal of particular relevance to the UK is for decision-makers, such as pension trustees, to be sufficiently qualified, experienced and of good repute. While this proposal seems sensible, it is not obvious how to measure the experience and knowledge required nor how many current trustees could pass these new requirements.

UK trustees should support the European Parliament’s recommendation that qualifications, knowledge and experience should be collectively adequate for each pension fund rather than assessed for each individual.

The third pillar - changes to disclosure requirementsDisclosure requirements mostly relate to the Pension Benefit Statement, a new feature in the proposed directive. We do not think the third pillar is as relevant for pension schemes as it is for insurance companies and banks. This is because disclosure requirements for insurers and banks are intended to promote good risk management and help reduce a firm’s funding costs.

For a pension scheme, this argument does not hold true, because there is no such thing as a cost of capital for pensions, while investors in a pension scheme have very different motives to those who invest in insurance companies and banks. However, stronger requirements concerning disclosure can be desirable from a consumer perspective.

LET SLEEPING DOGS LIE? Solvency II for Pensions

Further reading

Paul Sweeting and Alexandre Christie. “IORP II Lite – The End of Solvency II for Pensions?” J.P. Morgan Asset Management (July 2013)


UK pensions have faced an avalanche of change over the past few years. As a result the defined contribution (DC) industry has experienced a great deal of innovation as plan sponsors, their advisers, regulators, investment managers and other service providers have continually looked for new and effective ways to help position participants for self-funded retirement success.

Accumulating an adequate pot Many of the proposed solutions have revolved around helping participants either avoid or better manage the potential pitfalls that could lower the odds they will be able to accumulate an “adequately-sized” pension pot.

The challenge of putting participants—many of whom are new to investing, or not engaged-on a safe retirement savings path is a complicated one, given the multifaceted risks of DC investment. Generally, these risks can be categorised under two headings: participant-controlled risks and participant-experienced risks.

Participant-controlled risks cover areas that hinge on member behaviour, including:

• accumulation risk, which basically means failing to save enough to retire; and

• participant-user risk, which involves misusing investment options with a resulting portfolio that is too conservative, aggressive or under-diversified.

These are usually the largest determinants of whether participants will secure safe retirement funding, since even the most innovative DC programmes still require members to save enough and invest appropriately.

While plan sponsors cannot completely control participant decisions around how much to contribute, how to invest those assets and when to make withdrawals, smart plan design can help facilitate constructive behaviours through strategies such as auto-enrolment and contribution matching.

In contrast, participant-experienced risks are caused by factors largely out of the participants’ control, including:

• longevity risk, or the risk of outliving retirement savings;

• market risk, which involves being exposed to a market drawdown as one approaches retirement;

• event risk, which is the risk of exposed to potential severe loss due to a single extreme market event

• inflation risk, which can result in a loss in the value of savings due to inflation; and

• interest rate risk, where value is lost in fixed income securities if interest rates rise.

Risks faced by participants over timeThese risks are usually best addressed through participants’ asset allocation choices. However, one issue currently being faced by the majority of UK DC pension schemes is their ability (or lack thereof) to quickly adapt their investment choices.

More than 85% of plan members are enrolled in a default strategy, the most common of which is lifecycle, which mechanistically changes asset allocations over time based on age. When first introduced there was a prevailing expectation for equity investments to deliver an impressive return of 8% to 10% or more per year, with little attention paid to downside exposure. But times have certainly changed.

We can learn a lot from our friends over the pond, where target date funds (TDFs) are well established and hold more than $650 billion of US pension assets. TDFs employ dynamic asset allocation that changes gradually over time. Compared with lifecycle structures, they may also be more focused on member outcomes, rather than simply on beating a benchmark.

DC IN FOCUS: The multifaceted risks of DC investing

Simon Chinnery, Managing Director, Head of UK Defined Contribution


P E N S I O N P U L S E – S U M M E R 2 0 1 5DC IN FOCUS: The multifaceted risks of DC investing

In addition to this, because of their single fund structure, TDFs are intuitive to use and easy to monitor, keeping member experience simple and allowing plan sponsors to focus on encouraging better saving behaviours. As a result, we believe TDFs will likely be the next phase in evolution of the default.

Furthermore, given DC pensions have typically glided members to an annuity purchase, unlike TDFs, a lifecycle structure is less readily capable of adapting its glide path in preparation for such a dramatic change in investor behaviour. Over the course of any individual participant’s working years, all of the risks described above may be experienced to some degree.

Clearly participants are retiring all the time and are highly likely to be exposed to one of these risks right as they most need their assets. This highlights the necessity to extract the most prudent risk-adjusted performance potential from a glide path long-term, but equally important is the consistency of returns to help stabilise outcome security over shorter time horizons.

Moreover, this emphasis on short-term risk becomes increasingly vital as retirement draws closer and participants prepare to access their investments.


J.P. Morgan’s Pension Solutions and Advisory group is a dedicated global team of actuarial, portfolio management and capital markets professionals focused on delivering product agnostic advisory services and implementable solutions though the pension lifecycle to clients.

We work with product teams across J.P. Morgan Asset Management to ensure that our best proprietary investment thinking is reflected in asset allocation and asset liability management investment recommendations.

We also provide thought leadership on issues facing institutional investors and the pension community.

RUPERT BRINDLEYManaging Director Global Pension Solutions and Advisory Group

[email protected] +44 207 7426040

ALEXANDRE CHRISTIEVice President Global Pension Solutions and Advisory Group

[email protected] +44 207 7425541

TONY S. GOULDManaging Director Global Pension Solutions and Advisory Group

[email protected] + 121 264 82777

PENSION SOLUTIONS AND ADVISORY GROUP

FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION

jpmorgan.com/institutional

NOT FOR RETAIL DISTRIBUTION: This communication has been prepared exclusively for institutional/wholesale/professional clients and qualified investors only as defined by local laws and regulations. This document has been produced for information purposes only and as such the views contained herein are not to be taken as an advice or recommendation to buy or sell any investment or interest thereto. Reliance upon information in this material is at the sole discretion of the reader. The material was prepared without regard to specific objectives, financial situation or needs of any particular receiver. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. The results of such research are being made available as additional information and do not necessarily reflect the views of J.P.Morgan Asset Management.

Any forecasts, figures, opinions, statements of financial market trends or investment techniques and strategies expressed are those of JPMorgan Asset Management, unless otherwise stated, as of the date of issuance. They are considered to be reliable at the time of writing, but no warranty as to the accuracy, and reliability or completeness in respect of any error or omission is accepted. They may be subject to change without reference or notification to you.

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