By AL CLARKE

THE growing trend in funding for pensions is for the onus to be placed on the individual through Defined Contribution (DC) rather then be borne by the individual's employer as with Defined Benefit (DB). This is a great result for companies as they can remove the pension liability albatross from around their neck. But is it a good development for the individual?

Let's start by looking at the benefits of DB. Regulation surrounding the investment of pension assets under DB has been strict and controlled. Debate may exist on past errors being made through changes to regulations, but the overarching principle still remains sound - to maximise the probability of providing adequate funds for an individual's retirement.

Companies are required to make a sensible assessment of the expected pension liabilities and then embark on constructing an asset mix that has the best chance of meeting these liabilities. Any shortfall between the value of the assets and the liabilities needs to be made whole by the company. This level of accountability pushes companies to be conscious of the level of risk they are taking relative to the liabilities as they are on the hook if the investments should go wrong.

The same level of accountability does not exist in the DC space. With the onus back on the individual, the standard procedure is to allow the level of investment risk to be decided simply by how long the individual has until retirement. There is little consideration given to what the profile of the pension liability may look like for the individual. The driving force tends to be 'the longer the individual has to retirement, the more equities in the investment'. This unfortunately can result in some very volatile outcomes for the individual investor.

Let's use an example of an individual who will retire in 2030 that is looking for a DC fund in which to invest their pension savings. The standard advice for that person would be to pursue an equity 'buy and hold' strategy as equities always outperform in the long run. A cursory glance at 2030 target date funds available in the market place shows the majority positioned at 100 per cent equity, reinforcing this point. There are two potential problems with this strategy: the ranges of return outcomes are very broad and they also have little to do with the pension liabilities of the investor. So why has this standard advice evolved this way?

The accompanying chart shows the performance of the Dow Jones Industrial Index (the longest dated US equity index) from 1920 to 2009. A logarithmic scale has been used so it can fit sensibly on a page.

It is evident looking at the chart that equity markets go through fairly distinct medium term secular trends with some being very good for equities and others being quite poor, especially when compared to inflation. It is also easy to see how the sensational bull market from the early 1980s to 2000 shaped a lot of the current thinking on the 'buy and hold' strategy recommended to our 2030 retiree. Equities went up more than 10-fold so any data including this period will suggest equities always outperform. But it is worth looking at the period preceding this remarkable run.

The 1960s and the 1970s marked a period of high volatility in equity markets with no long term reward. An individual with 20 years left to retirement who pursued a 100 per cent 'buy and hold' equity strategy at the start of this period would have received virtually no return for the investment and significantly underperformed cash. This highlights the problem that the range of outcomes with 100 per cent equity can be very broad and subsequently sometimes very disappointing.

The more concerning outcome for an investor in this period was the amount to which they underperformed inflation. Remember the pension liabilities for a retiree will typically be increasing by the rate of inflation. Rent, health costs ,transport, movie tickets all contribute to the measurement of inflation and are all costs that retirees require so they can live a normal life in retirement.

During the bear market of the 1960s and the 1970s, the cumulative rise in the cost of inflation was 216 per cent, outstripping the 100 per cent equity investment return by 215 per cent. This highlights the second problem that the pure equity strategy has very little to do with the nature of the pension liabilities it is supposed to be funding.

To give our 2030 retiree the advice to invest 100 per cent in equities fails to recognise that equity returns can underperform inflation for long periods of time. A more appropriate strategy may be to treat our individual in a similar way as a DB scheme would approach their liabilities. We need to come up with a sensible set of expected liability cash flows for the individual in retirement and then construct an asset mix that has the highest probability of meeting this liability.

This exercise could be as complex or as simple as deemed necessary depending on the ability to construct a set of meaningful future liability cash flows. But the key principle is to recognize that these liability cash flows form the basis of what the asset mix is trying to achieve. The risk taken in the asset mix should be compared to the expected performance of these liabilities, inflation included, to increase the chances of the individual having sufficient funds available for retirement.

When the advice for our 2030 retiree is framed this way, the 100 per cent 'buy and hold' equity strategy looks far from optimal. The more appropriate investment strategy would most likely be a mix of equities, bonds (some inflation linked) and real assets that together maximise the probability of meeting the expected liabilities. This strategy reduces the possibility of suffering a disastrous outcome similar to the 100 per cent equity investor in the 1960s and the 1970s.

Whilst providing significant heartache for the sponsoring company, DB at least guaranteed a stable income for employees in retirement. As the market trend moves to pass this heartache on to the employee, it is essential to ensure the individual is equipped with the appropriate toolkit to accept this new responsibility. The toolkit should include at the very least a clear understanding of their cash flow needs in retirement and the relevant investment strategies that have a good chance of delivering these cash flows.

As an industry, the responsibility lies with the practitioners to provide sound advice beyond simply recommending 100 per cent equity to anyone with more than 10 years to retirement. The advice needs to be relevant for all investment climates, not just a bull market, to ensure the investment strategy of the individual has the highest probability of meeting their objective - a sufficient and stable income for retirement.

The writer is Regional Head of Multi Asset, Schroder Investment Management

This article was first published in The Business Times.