In collaboration with Peter Warken, CFA , Angelina Kostyrina, CFA , Sebastian Kring and Pauline Tsambika Staubert from DWS.
Life Cycle Models combine risk-return optimized multi-asset fund solutions with age-dependent allocation glide paths, thus providing an easy-to-customize and resilient investment solution for pension schemes.
The last few decades have been so tumultuous for global capital markets. In particular, the 2000s witnessed stock markets plummeting by over 50% during the dot-com bubble and global financial crisis, followed by a gradual recovery. From 2012 to 2022, bond markets saw interest rates sharply decline to negative yields, only to face a sudden ‘interest rate turnaround’ alongside rising inflation in subsequent years. Looking forward, the trajectory of capital markets remains uncertain, driven by rapid technological advancements and persistent geopolitical tensions. Navigating this volatility demands strategic foresight and robust investment solutions.
Companies offering pension investment solutions, typically in the form of Defined Contribution (DC) Plans, are therefore looking for resilient and simultaneously return-seeking investment solutions. DC-Plans, with a Lifecycle Model as the underlying investment concept, can accomplish this demand if designed properly. Within these plans, each employee is assigned to an account which employers and/or employees contribute to. The employees’ claim is then directly linked to the capital market-driven value of their account. This puts the appropriate Life Cycle concept not only into focus for the company, but also for the employee.
Designing an Advanced Life Cycle Model for DC-Plans: Optimizing Risk and Returns
A Life Cycle Model for a DC-Plan should be designed based on two modules. The first module consists of at least two multi-asset fund solutions with at least two distinct risk-return profiles. The second module consists of age-dependent allocation glide paths, which steer the allocation of the individual employee accounts in these fund solutions over time and tailor the Life Cycle Model to the risk return-profile of the company and its employees.
First module: At least two multi-asset funds should be used in a Life Cycle Model ranging from a defensive risk-return profile to a dynamic one. It is important that these investment profiles are broadly diversified and, at the same time, risk-returned optimized with a state-of-the-art capital market model. Modern finance underlines that this is the best approach to achieve a long-term optimal risk-adjusted return in a dynamic capital market environment. That is why these funds should offer broad diversification across various asset classes, particularly stocks, bonds, and commodities. This diversification reduces risk while simultaneously exploiting return opportunities – an important contribution to the resilience of the pension solutions. Depending on the preferences of the plan sponsor, the individual asset classes within multi-asset funds, such as US stocks or European bonds, can be implemented cost-effectively through ETFs and/or actively managed funds. Furthermore, various ESG aspects can be analysed and considered when selecting investment instruments, both for ETFs and actively managed funds. For small to medium-sized DC-Plans, plan sponsors can rely on existing UCITS-funds with strong track record and cost-efficient share classes, while for larger DC-Plans an implementation via special funds specifically set up for the company’s DC-Plan can be carried out. In the latter case, the employer can actively participate in the design of the investment guidelines of the special fund.
Second module: Age-dependent allocation glide paths are customized to the risk-return profiles of the employees. Depending on the employees’ planned retirement age or the planned pay-out phase after retirement, their account assets are allocated into suitable multi-asset funds designed in the first module. Younger employees can take more risk due to the longer investment horizon and benefit from higher equity shares in their account. On the other hand, older employees might find a more conservative allocation with a higher bond share more appropriate. The key question is now how to ensure a smooth de-risk in the employee’s account portfolio as the employee approaches retirement. This de-risking process is implemented via the age-dependent glide path. Through forward-looking capital market simulations and the consideration of historical stress scenarios, age-dependent allocation glide paths can be analysed in terms of the risk-return profile. These analyses enable the company, as well as their employees, to make a well-informed choice of the appropriate allocation glide paths and thus determine the Life Cycle model and the de-risking process.
In a time when capital markets continue to be so dynamic, a resilient and risk-return optimized DC-Plan is crucial. A pension solution, designed on the principles outlined above, adds to the attractiveness of the employer for new employees, as well as to the retention of existing ones, and makes an important contribution to the financial security of employees after their retirement.
*This promotional communication is intended for professional clients only. Refer to https://www.dws.com/insights/cio-view/cio-view-quarterly/q2-2024/letter-202406/ for the important notes.