1. Why should we care about DC pensions? Professor Andrew Clare, 2012 Centre for Asset Management Research, Cass Business School, London.

2. Click to edit Master title style Copyright: Andrew Clare, 2012 Page 1 Overview The future is DC - globally The traditional lifestyling approach to asset allocation A simple asset allocation experiment Summary Further research Visit the CAMR website at: www.cass.city.ac.uk/research-and-faculty/centres/camr

3. Click to edit Master title style Copyright: Andrew Clare, 2012 Page 2 DB death throes We know that DB is on its last legs: today 60% of UK pension assets are in DB schemes in 2000 this figure was approx 95% !!! Because the costs are higher than previously assumed: performance of equity markets since 2000 focus on marked to market accounting longevity

4. Click to edit Master title style Copyright: Andrew Clare, 2012 Page 3 DC around the world DC schemes now account for 44% of $26.5m invested in pensions globally, up from 35% in 2000 (Towers Watson) Global DC assets have grown at around 7.5%pa since 2000 DC pension assets account for: 81% of total pension assets in Australia 60% of total pension assets in Switzerland 57% of total pension assets in the US of A

5. Click to edit Master title style Copyright: Andrew Clare, 2012 Page 4 DC in the UK Around £400bn – £500bn of UK pension assets are currently in DC arrangements Today, 3.6 million people in the UK are building benefits in workplace DC pensions, trust and contract-based (NAPF) But it’s still in its infancy in the UK: only 34% of DC plans have been around for more than ten years And here comes Super DC...

6. Click to edit Master title style Copyright: Andrew Clare, 2012 Page 5 National Employment Savings Trust (NEST) Workers will be auto enrolled into NEST Contributions will come from employers (3%), employees (4%) and the tax man (1%) Eligibility: not in a qualifying scheme already age between 22 and SPA gross income in excess of 7,475 Government estimate that 7 million, mainly low paid workers will eventually enroll in this “voluntary scheme” It will soon become one of the biggest DC plans in the world

7. Click to edit Master title style Copyright: Andrew Clare, 2012 Page 6 Ticking the box The burden of DC is on the individual, including the investment choice – that is the asset allocation decision We know that the majority of DC participants “tick the default box” in the US Choi et al (2002) reported that between 42% and 82% of participants in DC plans that they examined chose the default option in 2002 HBW reported that about 80% of DC participants chose the default option in the UK (see Byrne et al (2007)) Employers and fund providers can therefore have an enormous influence on eventual pension income

8. Click to edit Master title style Copyright: Andrew Clare, 2012 Page 7 Traditional asset allocation for DC Traditionally the asset allocation “advice” that has come from the industry has been: invest in equities until X years from your chosen retirement date gradually de-risk from equities to gilts (in a straight line) for the last X years Known as life styling So how has lifestyling performed? We published a paper* late last year that looked at this issue … *Outcome-orientated Investment for retirement, Cass Business School, London

9. Click to edit Master title style Copyright: Andrew Clare, 2012 The representative DC member Representative member is a 55 year old male with ten full year’s to retirement Employer and employee combined, contribute 12% of member’s gross annual salary Member starts with a DC pot equivalent to twice their gross annual salary Member earns the average wage At the end of the ten years the member has to purchase annuity as given by the following: Page 8

10. Click to edit Master title style Copyright: Andrew Clare, 2012 Annuity rates I think the recent decline has less to do with QE than some would claim Page 9

11. Click to edit Master title style Copyright: Andrew Clare, 2012 Results of traditional lifestyling The combination of falling annuity rates and an equity bear market have taken their toll on the traditional approach Page 10 0.0% 20% 40% 60% 80% Pension as a proportion of final salary Year lifestyling begins Pension/Final salary (Level)Pension/Final salary (RPI)

12. Click to edit Master title style Copyright: Andrew Clare, 2012 What might improve the outcome? Improving the outcome: greater contributions, begun earlier greater focus on needs of individual cost – which leads many to the view that passive funds are to be preferred to active ones diversification asset allocation – but dynamic asset allocation by a professional will cost How far can we get without active fund management? Page 11

13. Click to edit Master title style Copyright: Andrew Clare, 2012 So what should be the asset class mix? If there is one thing we know for certain it is that we don’t know which asset class will be the best performer over any given future period Optimisers seem sophisticated enough, but essentially they simply give us the answer that we put into them Plenty of evidence suggests that equally-weighted approaches to asset allocation outperform optimised portfolios – 1/N investing This applies both: within asset classes and across asset classes Page 12

14. Click to edit Master title style Copyright: Andrew Clare, 2012 Can we improve on a passive, 1/N approach? Being equally exposed, passively, will still mean that the investments will ‘track’ the market down We have been researching various forms of technical analysis, to see if we can improve on the main problem with passive investment – tracking the market down Trend following appears to be a cheap (almost costless) potential solution to the problem It works like this: invest 100% in the risk asset class in a positive trend invest 100% in a “riskless” asset class in a negative trend environment apply this rule to each asset class - independently Page 13

15. Click to edit Master title style Copyright: Andrew Clare, 2012 An example of a trend following rule We apply the rule at the end of each month, rather than daily, to each individual market Page 14 Trend

16. Click to edit Master title style Copyright: Andrew Clare, 2012 Preliminary research results For simplicity, we focus on the final ten years of the accumulation phase We look at the historic performance of a range of investment strategies on the outcome of the average DC member, including a trend following approach applied to: equally-weighted developed economy equity markets*,** equally-weighted basket of asset classes comprising Developed economy equity; Emerging market equity; Bonds (credit); Property; Commodities The “safe asset” is cash (in practice ILGs work better) *Price and momentum as robust tactical approaches to global equity investing – CAMR website **Breaking in to the black box: Trend following, stop losses, and the frequency of trading – CAMR website Page 15

17. Click to edit Master title style Copyright: Andrew Clare, 2012 Results: Alternative investment strategies There seems to be some value in TF, perhaps combined with MA and lifestyling Page 16 StrategyAverageRangeWorstSt-devReward to risk Level Equity only49%90%16%25%1.95 60-4045%65%20%19%2.35 Trad Lifestyle44%54%21%18%2.47 Eq TF43%54%23%16%2.72 MA TF44%37%29%12%3.82 Eq TF 60-4041%47%24%14%2.89 MA TF 60-4042%38%27%12%3.58 Eq TF Lifestyle41%44%25%14%2.84 MA TF Lifestyle40%33%27%11%3.58 The replacement ratio (Level)

18. Click to edit Master title style Copyright: Andrew Clare, 2012 Results: Alternative investment strategies Arguably it is the multi-asset TF that is the best performer Page 17 The replacement ratio (Real) StrategyAverageRangeWorstSt-devReward to risk Real Equity only32%47%11%15%2.11 60-4029%35%13%11%2.56 Trad Lifestyle29%35%12%11%2.65 Eq TF28%30%14%9%3.16 MA TF29%22%18%6%4.45 Eq TF 60-4027%28%15%8%3.30 MA TF 60-4027%23%17%7%4.07 Eq TF Lifestyle26%29%15%8%3.11 MA TF Lifestyle26%22%16%7%3.75

19. Click to edit Master title style Copyright: Andrew Clare, 2012 Summary The traditional Lifestyling rule has performed reasonably well over the past twenty years or so However, even: simple-minded diversification, coupled with mechanistic asset allocation rules seem to generate a narrower set of outcomes than the traditional lifestyling rule So arguably professional asset allocators should be able to improve the outcomes further? This is the DC challenge for professional asset allocators Page 18

20. Click to edit Master title style Copyright: Andrew Clare, 2012 Further research In the White Paper* that we published last year we showed why the investment strategy should be linked, dynamically to the replacement ratio goal – we plan to do this with these and other cheap, replicable investment strategies We also aim to investigate the incorporation of guarantees within this dynamic framework – again, in a cost effective manner Essentially what we want to do is identify an efficient, cost effective Liability Driven Investment solution for default funds *Outcome-orientated Investment for retirement, Cass Business School, London Page 19