This is Part 2 in our 3-part series on the 2011 DC Investment Forum. For more coverage, read Part 1: Coping with uncertainty and Part 3: Are we there yet?
In September, more than 100 senior DC plan decision-makers, recordkeepers, academics and money managers gathered at Benefits Canada’s 2011 DC Investment Forum in Toronto to discuss the future of DC investing and how to help plan sponsors address these challenges and opportunities. Following are highlights of the sessions.
After the global financial crisis: The five key risks to retirement income
“The Canadian population is happy and optimistic about their own retirement,” remarked Peter Drake, vice-president, retirement and economic research, with Pyramis Global Advisors. While it’s positive that Canadians are looking forward to their post-work years, Drake said there are five factors that put DC plan members and their retirement funds at risk, particularly in the wake of the 2008 financial crisis.
1. Longevity risk
Canadians are living longer than ever before and are retiring earlier, noted Drake. “However, I think that might change. We are much more likely to see people working in retirement than we have seen before.” He believes the financial crisis left people more conservative when it comes to their retirement, so their plans for supporting themselves have changed.
2. Inflation
“Even if the Bank of Canada can keep a stable 2% annual inflation rate, if you take the average yearly household spending of about $54,000 for a couple and project it over a 25-year retirement, the purchasing power is reduced to about $33,000,” Drake explained. And if inflation is greater, it goes down even more.
3. Asset allocation
“Interest rates need to be considered when talking about this,” said Drake. “If you are going into a period of rising rates, what about returns and volatility? People need to think about the trade-off of potential volatility and returns. The more bonds you add to a portfolio, the lower rate of return you will get in a low interest rate environment.” And, of course, lower returns mean less money for retirement.
4. Inflation-adjusted annual withdrawal rates
“It is important to keep these rates low, especially during the early years of retirement,” Drake explained. “Our suggested target is 4%, but we know people can’t always stick to that.”
5. Out-of-pocket healthcare costs
“Healthcare spending generally goes up in the later stages of life, and there is also out-of-pocket spending to consider, such as nursing homes, dental care, prescription drugs,” he added.
“Managing these five key risks is very likely to improve employees’ retirement income,” Drake summarized. “The biggest challenge is education and advice for employees.”
Risk-based investing as an option for DC plans: How to be risk diverse, not risk averse
“Investment beliefs are driving the decisions,” noted Emmanuel Matte, vice-president with Standard Life Investments. “This is true for investment managers, and it is especially true for individual investors, or DC plan members, who often make decisions about their retirement savings based on short-term news.”
Matte believes this leads to three issues for plan sponsors. One, they should start to think differently about market exposure. “Market indices have been shown to have a lot of risk, and people in the industry are discussing moving away from them,” he said, adding that the traditional bond/equity mix offering is not necessarily the best option for reducing risk. “DC participants need to be looking at other asset classes or strategies to maintain their capital. This becomes even more important as a participant reaches retirement.”
The second issue is diversification. “What we have realized is that traditional diversification doesn’t work that well in times of financial crisis,” Matte explained. But how can investors build a portfolio that actually diversifies risk? “Diversify the sources of risk, not the asset classes. Focus needs to be on the downside risk.” One way that sponsors are doing this is by offering alternative investment options, such as real estate.
The final issue is the idea of absolute return. “The ultimate risk for DC participants is not having enough money at the time of retirement and outliving the money they have put aside,” said Matte, adding that participants need to build a portfolio in which no single risk exposure dominates returns so that if there is an event—such as a tsunami or a market correction—they will reduce their overall losses.
Matte believes that sponsors need to consider new solutions for DC plan members to address these issues and help participants to avoid losses. “A lot more DC plans will start moving toward absolute return-type solutions, especially within balanced funds. But remember, ‘absolute’ does not mean ‘guarantee.’”
Leigh Doyle is a freelance writer based in Toronto. leigh.doyle@gmail.com
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