A default fund is where a defined contribution (DC) pension scheme member will have their contributions, and those of their employer, invested if they do not actively select an alternative investment option.
There are many different types and designs of default fund, resulting from more than a decade of market developments, but they can be broadly categorised as old style, lifestyle and alternative style.
Old-style default funds are often single funds, and the old-style approach has been used for over 20 years, according to Spence Johnson DC market Intelligence 2013, published in December 2012.
There is no statistical evidence for this, but anecdotally we understand that most of these are passive and active equity funds, and with-profits funds.
There is seldom a de-risking phase in these defaults. According to the Spence Johnson research, 65% of very small schemes, with fewer than 1,000 members, are still using this old-style approach for default fund design. Larger schemes, with more than 1,000 members, are much more likely to use lifestyle default structures, as described below.
The second broad type of default fund is lifestyle, or ‘lifecycle’, which has been introduced in the last 10 years. This approach is used by about 90% of larger schemes that have a default fund, and is the type of fund recommended most frequently by investment consultants, according to the Spence Johnson research.
The third broad type of default fund could be called the alternative style, which is a new alternative to lifestyle funds.
Alternative funds have emerged in recent years, and encompass a range of innovations in default fund design, the most common being target date funds, which manage members’ retirement outcomes in the context of a target retirement date.
Other alternative style developments include outcome-oriented default funds, which aim to offer members an acceptable retirement income to replace their previous income when working; risk-based funds, which aim to match members’ risk profiles; and structures that offer liability-driven investment for DC, which enable members to remain in riskier assets for longer.
Most members use the default option. Across all DC workplace pension schemes, about 72% of members invest via the default fund, according to the Spence Johnson research. However, this varies by scheme type. Smaller schemes average 65%, while larger schemes tend to be 80%.
The research also shows that among National Association of Pension Funds (NAPF) members, the ratio of members reported by schemes to be saving into the default is 83%. And among the case studies created by the Defined Contribution Investment Forum (DCIF) and the NAPF for the NAPF report, Default fund design and governance in DC pensions, published in September 2013, the proportion ranged from 40% to 85%.
The differences in the popularity of large and small scheme defaults may be because most smaller schemes are much older than larger ones, and in many cases were established before default funds existed and became mainstream. There are currently many more smaller schemes than larger ones in the UK pensions landscape.
Another trend sees default funds accounting for a growing proportion of DC assets. Default fund assets are believed to represent 70% of DC workplace pension scheme assets today, according to the Spence Johnson research, but the report also states that they will account for 83% of all DC assets in 10 years. This puts more pressure on scheme fiduciaries to ensure default funds will deliver excellent member outcomes.
The pool of assets within DC workplace pension schemes is growing fast. The Spence Johnson research predicts that the total DC assets in default funds today will grow in size by 3.5 times over the next 10 years, equivalent to an annual growth rate of 13.5%. One case study told the research consultancy that its DC default fund assets are currently growing at 40% a year, albeit from a small base. This strengthens the argument for attention to be given to default fund design.
Simon Chinnery is head of UK defined contribution (DC) at JP Morgan and chairman of the DCIF
Read the digital version of The future of default funds 2014 supplement, in full.