Metzler: DC lifecycle models - avoiding a bond market bias

Lifecycle models within defined contribution (DC) pension schemes have typically been based around the idea of reducing investment risk as one gets older, by reducing exposure to equities and increasing exposures to bonds. This simplistic approach may have been appropriate during the 20 - 30 year period from the 1980s to the financial crisis, when bond yields were consistently heading downwards, but in the current environment of low bond yields when the most likely move may be upwards, it is not clear that the bond markets alone can be seen as a stable low risk haven for the majority of retirement assets. Supposedly low risk lifecycle DC investment strategies should move away from the doctrinaire mindset that bond portfolios will inevitably be safer portfolios when the underlying causes of the debt fuelled global financial crisis have not yet been resolved. Asset bubbles are appearing in many asset classes and investors are likely to see periods of tranquil markets in the coming years punctuated by periods of significant volatility across both debt and equity markets.

Whilst the debt markets alone, cannot be seen as safe havens, it is possible to structure portfolios that have high levels of downside protection assured with very high levels of confidence. These are typically based on harvesting equity and bond risk premia whilst adopting option like pay-off profiles to control downside risk. Constant proportion portfolio insurance (CPPI) is one tried and tested technique which relies on setting a defined floor at say 90% of a portfolio value and then splitting assets between essentially risk-free cash and risky assets. If portfolio increases in value, the proportion of risky assets is increased, whilst the proportion of risky assets is reduced if the portfolio value falls, and tends to zero as the portfolio value approaches its floor. The well known disadvantage of the CPPI approach is that once the portfolio hits its floor, it is “cash-locked” with a 100% cash position, giving no further opportunity for harvesting risk premiums.

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