Speaking at last week’s Post-Retirement Conference, held by Conexus Financial in association with AIST, Scott Pappas said the defined benefit is “dying”. He argues that funds need to extract the benefits of such a plan in a sustainable model, namely defined ambition plans, which offer collective defined contribution (DC) schemes and money-back guarantees.

“Collective DC schemes share the risk among member cohorts. So rather than people close to retirement bearing all the risk, the collective model attempts to share that across all cohorts,” he said.

Defined benefit is costly and has an impact on the person funding the scheme, according to Pappas. “In comparison, defined ambition is much more sustainable, and there’s less or even no impact on the person funding it.”

In addition, Pappas thinks the DC model is complex for members, has an investment focus and is not designed to meet retirement goals. In contrast, defined ambition is simpler for members.

More effective risk sharing

“We’re moving away from a framework where we focus on investment risk. We’re moving away from the DC model to one where we’re achieving outcomes.

“The defined ambition model tries to maximise the probability of achieving these outcomes through more effective risk sharing.”

However, Pappas thinks defined ambition is only part of the solution.

“We need to actually have the portfolios that support this framework, that helps us achieve these retirement outcomes.”

With a defined benefit or defined contribution model, Pappas believes a single stakeholder bears all the risk – including investment, inflation and longevity risks.

Combining risk factors

However, with a defined ambition model, risk is shared among stakeholders, using a risk-factor allocation model.

“We’re tending to focus more on risk than focus on diversification,” said Pappas. “Rather than trying to maximise return by spreading risk across specific asset classes, we’re trying to do it in a more focused way, concentrating on diversification and managing tail risk.”

When focusing on risk factors, he thinks the fund should be allocating a certain amount of capital to a corporate bond, and to allocate exposure to interest rate risk and credit risk.

“These are the things that have the more stable correlations and offer better diversification.”

Risk factor allocation looks at underlying risks.

“Bonds have credit risk in some cases and interest rate risk. In equities… we want some of [the equity market premium] in our portfolio. But there’s also premiums for value stocks and size stocks. So, what we focus on when we build that portfolio is combining those different risk factors in the portfolio, rather than asset classes. And that’s how we achieve better diversification.”

Pappas thinks risk factor allocation uses simple portfolio design techniques, where a specific amount is allocated to each risk factor.

“It works for long-only investing, but it works particularly well if you’re able to go long and short.”

The model is creating a lot of interest in academia due to lower risk, better tail risk, and a much more attractive correlation in terms of holding it a portfolio.

Pappas said it’s also generating interest among international managers and has been used domestically by some super funds, including QSuper.

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