DC pension default investments explained

Default funds are a critical component of DC pension schemes and there are key factors employers must consider in their strategy

IF YOU READ NOTHING ELSE, READ THIS…

  • There is no single definition of a default fund.
  • Investment strategy is as, if not more, important than asset allocation.
  • Nest is expected to become a benchmark pension scheme, particularly on charges.

 

A default investment option is the fund or funds into which employers automatically put employees who do not make an active choice about where to invest their money in a defined contribution (DC) pension scheme.

There is no such thing as a typical default option because fund types vary widely between employers. It was this realisation that prompted the National Association of Pension Funds (NAPF) to review how its 2012 Annual survey allowed participants to describe their scheme’s default investment option.

Mel Duffield, head of research at the NAPF, says: “In last year’s survey, 83% of members described their default fund as a lifestyle fund while 8% said they were using balanced or managed approaches, with 3% using target date funds. [This year] we tried to be more specific about what default funds are.”

The survey lists five fund types: passive tracker, which typically tracks a particular index, such as the UK FTSE All-Share; multi-asset fund (excluding diversified growth funds), which can invest in a range of assets including commercial property and commodities; diversified growth fund, which tends to invest in various asset classes and sometimes uses a range of fund managers; absolute return, which seeks to deliver positive returns to investors above those they may have received from their bank account irrespective of market conditions; and bespoke solution.

However, Duffield says the terms are not used in a mutually exclusive way.

STRATEGY

Traditionally, default funds have been invested primarily in equities during the accumulation stage of the investment cycle, when members are building their retirement savings. Funds are then switched to less-risky assets, such as bonds, during the decumulation stage, typically five or 10 years before an employee’s retirement, to protect against any adverse risks to their savings, such as equity market volatility.

This is known as life styling, although some employers use the term interchangeably to describe their fund type. It is also dismissed by many pension advisers as too crude an instrument to reflect the economic climate.

Target date funds are increasingly popular as default options because they target a specific investment end date, usually an employee’s retirement date.

CHARGES

In December, industry trade bodies, including the NAPF and the Association of British Insurers, revealed a code of conduct they want employers to follow that requires the disclosure of workplace pension charges.

Professor Debbie Harrison, senior visiting fellow at Cass Business School, says: “There are annual management charges (AMCs) of between 1.5% and 3.4%, and that is bad.”

New types of scheme designed to comply with auto-enrolment tend to have lower charges. For example, the national employment savings trust (Nest) has an AMC of 0.3%, and The People’s Pension from B&CE has a flat-rate AMC of 0.5%. Harrison adds: “Whatever the charges, transparency is key.”

GOVERNANCE

The Department for Work and Pensions (DWP) requires a three-yearly review of default funds, looking at the design, performance and continued suitability of the default option.

Harrison says employers must ensure any governance boards they use are fit for purpose. “A big corporate may have a big trustee board, but not a lot [of trustees] know a lot about DC, so it’s important to embed governance.”

THE FUTURE

Many pension advisers expect Nest to become a benchmark for future schemes, particularly on charges. But Henry Tapper, director at First Actuarial, says: “The Nest approach takes all the risk out that it can, which to us is wrong.”

Nest starts new investors on a foundation phase of about five years, during which it seeks returns only to match inflation.

Chris Wagstaff, client director, executive education at Cass Business School, says: “People will probably be a little more conservative than in the past. They don’t want to be accused of taking money off people who haven’t necessarily given them consent.”