Examining unrewarded risk
When it comes to investments, risk isn’t a bad word. A certain amount is necessary for any reward to be gained. Upside risk is the measure of the potential for an investment to gain in value. Measures of downside risk estimate how much the investment could decline in value if market conditions changed. Some measures reveal the worst-case scenario that shows an investor exactly how much they stand to lose.
Although the majority of pension savers are by no means financial experts, knowing that their pension schemes seek to minimise the downside is an important factor in building trust in the industry. After all, the dot.com bubble, the 2008 global financial crash and the coronavirus outbreak have demonstrated to the public that their life savings – not to mention the prospect of a comfortable retirement – are at risk. It’s a provider’s responsibility to try to effectively manage this risk to protect their members’ funds.
As Mark Fawcett, Nest’s Chief Investment Officer explains, ‘Too often the pensions industry talks about investment performance without considering the risk taken. And yet we know from our research that many pension savers want steady, smooth returns instead of high volatility… All pension schemes can help build confidence in savers by focusing on achieving the best risk-adjusted returns for members, and moving away from often misleading short-term, headline returns.’.
Why is it so important to identify a scheme’s unrewarded risk?
Firstly, schemes that do better on a risk-adjusted basis are likely to produce a smoother experience in challenging markets. That’s important for members because we know from our research that the DC generation are very loss averse and value steady returns over high octane growth.
Secondly, taking less risk or reducing volatility means there’ll be a smaller spread of returns between members retiring at a similar time and members of different ages, so all members are more likely to have a fairer experience. With higher risk funds, some people may get really high returns and others may get the opposite. We don’t think that’s fair or right for our members, which is one of the reasons we’ve designed our strategy the way we have.
So how can you identify which funds have taken on too much risk?
That’s where Sortino ratios come in. They represent a portfolio’s risk adjusted return, but only considering how much downside was experienced to get there.
Independent experts Defaqto include Sortino ratios as one of the measures in their annual guide How to analyse workplace pension default funds. It shows the best and worst performing providers, and ranks Nest as one of the UK’s top performers over the last five years based on downside risk-adjusted returns.
Sortino ratios for the default funds are shown in the table below. A higher number indicates better downside risk-adjusted performance.
|Provider||3 years||5 years|
|B&CE (The People’s Pension)||1.92||1.85|
|Legal & General||2.14||2.11|
|Lewis & Co||1.23||1.50|
|Willis Towers Watson||1.28||–|
|Workers Pension Trust||1.34||1.55|
|XPS Pensions Group||1.35||1.39|
To see how Nest ranks among the UK’s pension providers get the full guide.
You can receive credit for structured continuing professional development (CPD) when you read Defaqto’s guide.