Cracking the complicated code of pension default fund terms can seem daunting. This glossary explains the most common.
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- Terminology relating to pensions default investment can be complex and not always simple to understand.
- Key terms include lifestyling, tactical asset allocation, white labelling and decumulation phase.
- Understanding industry jargon can help benefits managers to explain key concepts to their workforce.
This is an investment system used by many pension funds in recent years that progressively switches each member’s investments out of riskier assets, such as equities, and into more stable assets, such as bonds, as they approach retirement.
The aim is to ensure that members do not suffer severe falls in the value of their pension pots just before retirement.
The system was widely adopted at a time when most people were forced to buy an annuity at retirement, which crystallised their pension pots on a specific day.
The switching process normally begins 10 years before members are expected to retire and this long lead time makes the system inappropriate for staff who plan to go into income drawdown instead of buying an annuity as they will be denied potential investment growth over that decade.
Lifestyle funds have done well over the past decade, when bond markets have been strong, but falling bond markets could diminish lifestyle pots just as members are about to retire.
These are actively and tactically managed across a range of assets that include alternatives such as commodities.
The idea is that if one asset class falls, another will rise to compensate.
These funds fall into a range of Investment Management Association classifications, such as ‘multi-asset funds’, and some, such as the Standard Life Gars (Global Absolute Return Strategies) fund, are ‘absolute return’ funds that use derivatives to try to gain additional returns.
These hold a variety of asset classes according to an investor’s planned retirement year, so, like lifestyling, the portfolio automatically dials down its equity exposure and becomes more heavily weighted in bonds as retirement nears.
However, the system is less formulaic than lifestyling and allows the underlying investments to be more actively managed even during the de-risking phase.
Tactical asset allocation
Experts believe that at least 80% of the potential returns from an investment portfolio are driven by the choice of asset classes used, rather than by more granular decisions, such as which stocks are selected.
To harness this, some fund managers running multi-asset portfolios such as diversified growth funds try to switch tactically between assets to catch an asset class as it rises and exit another when it is about to fall.
Pension funds can choose to present their provider’s investment funds in their own livery and styling.
This reinforces the perception of the pension as an employer-sponsored benefit. White labelling can also be used to guide members into a more appropriate fund for their needs by labelling the funds according to their risk profile, such as ’adventurous’ or ’cautious’.
Some pension funds categorise members by asking them to complete questionnaires on their attitudes to money and on their personal circumstances, such as marital status and dependants, to guide them into the most appropriate default fund.
This is likely to result in a better outcome for members because risk is a hard concept for most employees to understand. There is also a real risk of lost opportunity if the member is too cautious at a younger age and chooses non-growth assets, such as cash.
Many pension providers offer ‘open architecture platforms’ to enable members of their workplace and private schemes to select and switch between underlying investment funds.
Most workplace schemes will not offer members full access to all the funds on a platform because the choice of hundreds of funds bewilders most employees; six to 10 funds is generally considered optimal.
This is the term given to the period when a pension holder switches out of their pension pot and into an income-producing plan, normally but not always when they retire.
Currently, this means buying an annuity or entering into an income drawdown plan, but from April members will also have the opportunity to take as much of the fund as they like in cash, subject to income tax at their highest rate for any excess over the 25% tax-free cash entitlement.
This an increasingly common phrase that also refers to the period leading up to retirement.
Uncrystallised funds pension lump sum (UFPLS)
This is the term for the new option from April for pension holders to access as much of their fund as they wish, without having first to designate the funds as available for drawdown. Of each payment, 75% will be taxable as pension income at the individual’s marginal rate of tax and 25% will be tax free.