The implications of retiring later for DC investors

By 4 minute read

Life expectancy in older age has been increasing throughout much of the world over the last 70 years and this has had several knock-on effects on pension provision. Firstly, it has been one of the factors, alongside lower interest rates, which has led to the transition from defined benefit (DB) to defined contribution (DC) pension arrangements by employers; and secondly, it has led to governments increasing pension ages to reduce costs. This article investigates the implications for DC pensions of retiring later and whether it represents an opportunity to reduce investment strategy risk in order to offer more certainty to members.

Taking a simple lifecycle structure and seeing how it performs at a variety of retirement ages, we investigate the effect of later retirement on the size of pension in real terms. As an example, our analysis under a given deterministic scenario indicates that a 5-year increase in retirement age can see the pension amount available to the member increase by around 45%. This increase can be split between various components, as shown in the graphic below.

Figure 1: Factors influencing increases in real pension for a 70 year old retiree versus a 65 year old retiree. Source: Aegon Asset Management

DC investors as a whole will receive a wide variety of pension outcomes depending on how markets perform. The question we wanted to analyze was whether some of the additional expected pension can be forgone for more certainty over the pension amount. In a stochastic scenario we find that this is the case – by investing more prudently we can lower the expected pension (whilst still offering an expected pension that is as high or higher than for the original retirement age) but improve the pension outcomes in the worst cases. This therefore shows potential for pension schemes to adjust the level of risk in the lifecycles offered if pension ages increase.

However, we also wanted to investigate how such a strategy would have performed historically. Using over a century of returns from the US markets, we carried out a similar analysis which suggests that de-risking for a member who invests throughout the whole lifecycle actually leads to worse outcomes in general (both expected outcomes and in the worst case scenarios).

This difference in conclusion can be explained by the current economic outlook and the level of interest rates which are built into the stochastic projections. Looking back over 100 years we can see that, historically, equities performed significantly better over medium and long-term periods than bonds in all but a few periods. It is therefore not surprising that, even in the worst case scenarios, using less risky lifecycles would not have been optimal for young members. Over shorter periods, for example considering a 55 year old who will retire in 10 to 15 years, the picture would look more conventional, with lower equity allocations corresponding to improved downside scenarios.

As part of this historical analysis we also investigated which retirement periods would have been advantageous for DC investors to retire in. Based upon US data, the sixties and seventies stand out as the period of higher real income for investors converting their investments to an annuity. They would have benefitted from the rise in asset values during the post-war period as well as high interest rates for converting their investments to income. The low interest rate environment following the financial crisis means DC investors are currently experiencing worse than average market conditions in which to retire and explains why the options to continue investing after retirement are proving popular in countries where they have been made available.

Figure 2: Projected real pension by retirement year. Source: Aegon Asset Management on basis of Shiller data

We conclude that whilst using less risky lifecycles may appeal to pension schemes in a DC world where market risk lies with the member (rather than the employer), it is not necessarily the case that lower risk asset allocations would have led to better outcomes in the worst cases historically. Reducing lifecycle risk as pension age increases may therefore not be the optimal thing to do, even if it intuitively seems like it may protect pension scheme members.

Oliver Warren

About Oliver Warren

Investment Solutions Consultant