Staying in the frame: the art of pre-retirement de-risking

A picture may say a thousand words, but how it’s framed has a big impact on what people see. This is as true of political slogans as it is of art. For example, the UK government’s COVID-19 slogan, “Stay home. Protect the NHS. Save lives” was designed to maximise public compliance by positioning it clearly as a life-or-death choice.

Why is framing so powerful? Psychologists Amos Tversky and Daniel Kahnemann suggest it’s a result of several mental shortcuts (called heuristics) and biases. We tend to rely on easily recalled information (the availability heuristic), to over-emphasise things that cause an emotional response (the affect heuristic) and put greater weight on avoiding losses than making gains (loss aversion).

Some areas seem more susceptible to these biases than others. One area where we’ve noticed unhelpful framing is in how people assess investment strategies for savers in the run-up to retirement.

Every picture tells a story

Most people intuitively see the benefit of reducing future retirees’ investment risk as they approach retirement. Their thinking tends to focus on a short-time horizon, like the last year before retirement, because it’s easier to imagine an ageing saver over just one year, rather than 10 complex years.

It’s common to hear views like “it’d be terrible if they lost a lot in the last year”, because imagining the person losing their savings evokes an emotional response. Our data also shows that people look at their pension pots more when closer to retirement. Finally, all the focus is on the risk of losing money, not about the full range of better outcomes: “Why take the risk for one year of extra potential return? It can’t be a good idea.”

Seen in this light, the solution seems obvious – we should derisk people’s investments. The graph below compares the potential central, downside and upside outcomes from holding either cash or a diversified multi-asset fund for one year.

But here, as in art, it’s all about perspective. Focusing on only the final year before retirement may not be a helpful way to think about outcomes.

Why? Because an individual doesn’t just magically appear with one year to retirement, and with a given amount of savings. The end outcome is also impacted by previous years. If they have been gradually de-risking into cash over the 10 years before retirement, they have been sacrificing potential returns for a decade.

Taking the long view

To properly assess de-risking options, we need to go further back than just the de-risking period. If an investor experiences a few years of poor investment returns, just before derisking, and then switches into cash several years from retirement, they crystalise that position and no longer have exposure to any potential market rebound. So they are exposed to a disappointing outcome from being invested, followed by a lower potential return from cash.

So, let’s take a 15-year period, where the saver gradually de-risks over 10 years from a diversified multi-asset portfolio into cash.

Now, the impact of de-risking to cash or remaining in a multi-asset fund look very different. It is much bigger in the central case, the downside outcomes look more similar, and the upside outcomes look more different.

In short, if you’re going to achieve similar downside outcomes with de-risking, but better average or upside outcomes with staying invested, what is the benefit of aggressive de-risking?

In the very worst outcomes, such as the bottom 1%, there will be some marginal benefit to derisking to cash, but it involves expecting lower returns in almost all other scenarios.

The risk of too little risk

Of course, de-risking into cash is a relatively extreme approach (albeit not without precedent), and we are not saying that de-risking is inherently wrong. However, we do believe that caution is needed to avoid jumping to the ‘obvious’ answer, and that one of the biggest risks to outcomes is not taking enough risk when people approach retirement.

In this example, we’ve made assumptions that we know when the saver will retire and that they want to take all their savings as cash at retirement. It turns out that neither of these are generally true, and correcting for them may encourage even less de-risking.

But those are topics for another day – coming soon to this blog!