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OVER THE PAST few decades we've seen a profound shift in the way that companies provide retirement benefits for workers. The traditional defined benefit plan that our parents relied heavily on has now been largely replaced by defined contribution plans that allow workers to accumulate their own retirement savings.
Employees now assume the responsibility for making investment decisions and the inherent long-term planning risks. Analysis of data available in the United States, makes it clear that most individuals haven't made good decisions. And as people now live longer they should be worried those assets won't last long enough to fund a possible 30- or 40-year retirement.
Drawing from Alliance Bernstein's accumulated research and wisdom concerning investment planning, the following conclusions about sound asset-class selection and effective diversification have emerged.
Research shows that most retirement funds aren't providing the high quality investment planning and asset allocation that trustees - as fiduciaries - should require. The primary flaw is that members invest too conservatively. They hold too little equity and too much fixed income to generate the growth required to fund participants' spending over what may be several decades in retirement.
It takes a lot of equity to generate sufficient growth. Analysis of historical data shows that the conservative and moderate equity allocations were likely to generate enough growth to fund spending for only 15 or 20 years.
Cash is an ineffective and expensive risk-reduction tool, even for retirees. Although cash probably is the safest investment over very short investment periods we demonstrate that only very large cash allocations can significantly reduce the magnitude or frequency of capital losses. Furthermore, the opportunity cost of large cash allocations over long time horizons can be enormous.
To achieve a proper fund design we assess the likely investment circumstan-ces, objectives and risks of plan participants at different life stages.
Young savers enter the workforce with a valuable asset: their future labour income. Their initial plan contributions represent only a small fraction of their ultimate contributions - allowing them the freedom to take more risk - and they should simply seek high returns.
Midlife savers may have already accumulated significant savings, so strong returns can dramatically compound their savings. For a young saver with just R4 000, a 20% return is a gain of R800; for a midlife saver with R200 000, a 20% gain produces R40 000. Midlife savers can also accept significant market risk because they have very long investment horizons and can still replace lost capital through future labour income. They should thus seek high returns, gradually reducing risk as retirement approaches.
New retirees have depleted their labour income and must fund their spending needs through savings. They must deftly balance market risk, longevity risk and inflation risk. A new retiree's greatest risk is longevity; he must seek attractive returns to help fund a possibly protracted spending period.
Senior retirees have less opportunity to compound savings. A senior retiree should seek to limit the chance of a capital loss while generating sufficient returns to preserve purchasing power.
That framework leads us to redefine risk. While a classic measure of risk in investments is volatily measured by the standard deviation of returns, a myopic focus on that measure of risk is inappropriate in addressing retirement savings.
Broadly speaking, risk for these funds is the likelihood of failing to build enough savings to fund spending throughout retirement.
Different asset classes present different types of risk. Consideration of the relative importance of these risks at various life stages should be a central factor in asset allocation for retirement funds. (See table.)
The most important type of risk to consider will change over the participant's lifespan. In the working years, the main risk is a savings shortfall caused by not contributing enough or from investing too conservatively (or both). In the retirement years, it's longevity risk (risk of outliving your savings) and inflation risk (risk that your savings will lose buying power).
The risk of capital losses due to adverse market movements is relatively unimportant until well into retirement, when it may deplete savings beyond the point of recovery.
Equities can be effectively diversified to decrease market volatility without sacrificing returns by combining large-cap, small- and mid-cap equities, international equities and property.
The role of bonds is to offset equity volatility - but bonds should deliver a real return.
Higher equity allocations can lead to lower savings in bad market scenarios but massively higher savings in good market scenarios. Equity rich combinations can underperform more conservative funds on the downside but the higher median performance and significant upside is compelling. Insufficient equity exposure is risky. Clearly traditional performance benchmarks don't apply more effective employee communications are crucial in helping participants stay the course.
In conclusion, risk indeed needs to be considered more broadly than market risk and varies, dependent on the stage in the retirement cycle of the individual. Wider diversification and active management can be more effective at controlling market risk while benefiting from the growth potential of equities. Retirement fund investors should be wary about adopting low equity weightings to "control risk".
Equity growth is essential, as longevity is putting increasing demands on retirement capital.
