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How much investment risk should young DC savers take?

It’s a standard financial rule of thumb that younger investors should invest in equities and then de-risk later in life. But are arguments for taking more risk as clear-cut as they seem?

Auto-enrolment has brought millions of young savers into defined contribution (DC) pensions. Unlike older generations, they are very unlikely to have a defined benefit (DB)pension, homeownership rates are lower and they are likely to rely heavily on their DC pensions to finance their retirement.

So should 'Generation DC' have a high equity allocation or be more cautious with a diversified growth fund? The truth is it’s a complicated matter with many different factors to consider! We've outlined some of the key considerations for and against an aggressive equity strategy in the early years of DC pension saving.

For

Against

Human capital theory looks at personal wealth holistically and takes into account future contributions, as well as current savings. These future cashflows are traditionally viewed as a bond-like asset. 

Younger members have less current financial wealth and more future contributions. This reverses for older members. To maintain an optimal asset allocation between bonds and equities, therefore, younger members may wish to take more risk with their current pension pot and other savings.

With an increasingly 'gig-like' economy and less job security, pension contributions are not necessarily such reliable cashflows. They may look more like high yield bond cashflows or equity dividends.

So if their human capital is more equity-like, younger investors may have less capacity to also take equity risk in financial assets. In other words, they want to reduce the risk of a potential double-whammy of losing their job and seeing their pension pot fall in value at the same time.

Equities have the highest long-term return potential. It is often said that equities are actually the least risky asset in the long run, as they are much more likely to outperform other asset classes over long-term time horizons.

Although few disagree that equities have highest upside potential, a more detailed analysis relies on return and volatility assumptions. 

In reality, we don’t have reliable ways to forecast these (particularly expected returns) for different asset classes, and there is substantial uncertainty around these assumptions.

As a result, the chance of equities outperforming other asset classes may be lower than traditional approaches suggest.  We discuss this in more detail in a recent article.

Taking into account this assumption uncertainty can lead to less aggressive and more diversified solutions.

Young people have a greater capacity to deal with financial shocks, such as by increasing future contributions. This suggests therefore that they should take more risk, provided that risk can be expected to be rewarded.

Financial markets’ downturns are likely to coincide with other financial pressures. Job losses affect younger generations more. Opt-out rates can increase after a squeeze on disposable income or a loss of confidence in pensions after a significant fall in a pension pot value.

Therefore, younger members’ risk capacity might not be as different, and much higher risk might not be justified.

 

DC schemes should check whether the behavioural and economic assumptions fit their scheme’s demographics.

Traditional models can paint an overly confident picture of equities over the long term. Understanding this promotes more diversified solutions and potentially higher contribution rates. Our points on human capital theory and financial capacity, in contrast, are scheme and sector-specific. Still, there is no clear-cut answer to the question we posed in the title..

The good news is that there are other factors involved that are easier to control for a well-run scheme. The main factor in the early years of the DC member journey is simply the level of contributions. Indeed, contributions will typically represent about 65-75% of the expected fund value after 15 years.

Another important factor is financial education and wellbeing. DC members who have less financial worries and understand the value of workplace pension and employer contribution are also much less likely to opt out. 

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