In the aftermath of “The Great Gilt Crisis of 2022” the most frequent question we heard was “What could we have done better?”.
Some of the blame was laid at the door of Lifestyling methodologies, in particular their rebalancing polices and whether more could have been done to protect members. After all, this standard methodology had remained largely unchallenged for decades and was an area ripe for innovation and disruption.
Lifestyling
As an evidence led house Dean Wetton Advisory (DWA) first considered the available alternatives, but beyond adjusting the frequency of rebalancing the only noticeably different approach we found was Target Date Funds. The advantage of Target Date Funds is that members are bucketed together into similar cohorts that can allow for a degree of active asset allocation without adjusting the overall glidepath for all members. This additional responsiveness to market conditions can in theory help manage risk and prevent compounding of losses. However Target Date Funds usually require a manager to make these active asset allocation decisions, DWA therefore sought to replicate some of these benefits mechanically.
DWA quantitively modelled two new alternate strategies to the industry’s standard rebalancing method. Rebalancing is the process by which a member’s assets are realigned to the designated Lifestyle glidepath. Rebalancing is required either when returns have caused underlying weightings to drift from the target allocations, or to accommodate a change in the member’s risk tolerance which often naturally occurs as members approach retirement age. Rebalancing helps ensure that the risk being carried by a member remains appropriate over time.
In general, higher volatility assets should provide higher expected returns over the long term. Asset classes are therefore often classed by their relative levels of risk and glidepaths are designed such that this risk is appropriate to a member’s needs. Problems can occur with the standard rebalancing methodology when assets fall in value, if a high volatility asset falls in value the standard rebalancing method will purchase more of this asset to reattain the desired weightings. If this asset continues to fall in value then this effectively increases a member’s exposure and therefore the scale of their losses.
Ratchet and Freeze
DWA considered two alternative methods that aimed to avoid throwing good money after bad. A “Freeze” methodology which pauses rebalancing in the aftermath of increased market volatility and only resumes after the market has normalised, and a “Ratchet” methodology that forbids the selling of traditionally lower volatility assets, such as bonds, to purchase higher volatility assets such as equities. This essentially means the strategy can never re-risk. The modelling of these strategies examined rolling 5 or 10 year period iteratively from 1998 until 2022.
We used the longest dataset we could that remained meaningful. To interpret the data, we considered a number of measures of central tendency of the outputs from our model and graphed the output to identify patterns. Each output replicates what would have been experienced by a member if they were using our experimental rebalancing strategy. Important interactions were explored such as how different rebalancing strategy differed in each financial crisis given the same starting position, which helped give insight into how a member’s pension portfolio is likely to be affected in a crisis.
The importance of glidepath design
We found some preliminary evidence that adjustments to rebalancing methodology could make a marginal difference to member outcomes, but what was by far the most apparent conclusion was that overwhelmingly, the most significant factor in member outcomes was the design of the glidepath and the target asset allocations. When the costs of implementing a more complex rebalancing strategy are considered it is likely that any marginal benefits will be lost, though this may become viable as pension administration abilities improve and costs fall. Until that point, scheme fiduciaries should be focused on ensuring their investment glidepath is appropriately designed. If they are in a Lifestyle, it is worth considering the additional benefits of active asset allocation offered by Target Date Funds and whether the additional costs are justified to their members.
DWA have extensive experience in both designing Lifestyles and recommending suitable investment products, including Target Date Funds, should you require assistance in making the best decisions for your members.
Please contact us for more information.