How to ensure default investment strategies result in good member outcomes

Jenny Holt

With the majority of defined contribution (DC) pension scheme members using their scheme’s default investment solution, ensuring this is fit for purpose is vital for employers. There are several key issues that they must address to ensure their scheme’s default investment strategy results in good member outcomes.

  1. How have April 2015’s pension reforms driven changes to default investment strategy?

The new pension freedoms are driving a lot of employers to look again at what they, in some instances, have only recently put in place to ensure these continue to be suitable given how members are now behaving, which is quite different to before.

Most employers have implemented either a lifestyle profile or a target date fund, which allow for de-risking as the employee approaches retirement. They tend to have a growth phase asset mix and then a glide path asset mix. The pension freedoms do not necessitate a change in the growth phase because, while members are still paying in and are not in the years approaching retirement, the aim is to maximise returns for a given level of risk. So most of the focus has been on the glide path stage.

We are now in a situation where we anticipate far fewer people will buy an annuity and they have got a much wider range of options. For employers to try to guess what the majority of their employees will do is difficult given we are less than a year in, and it also carries some risk.

The glide path is really important and, in most instances, probably does need to change for the majority of schemes.

2. Why is future proofing a default investment strategy so important?

Having a default with a structure that allows ongoing changes to be made is really important. Those changes can be driven in economic conditions, in customer behaviour or further legislative change. That is a real advantage from an employer’s point of view because it means that as things change it is not constantly having to think about changing or reviewing its default if it knows, for example, that its provider will be taking on that responsibility.

You then avoid the situation we have got at the moment where, for many schemes, they have got members going into modern flexible future proofed solutions, but they have got some existing members who are stuck in older-style solutions, which do not have that flexibility built in.

3. How can employers work with their provider to ensure the best member outcome?

There are questions employers can be asking about the default solution they are putting in place for new members:

What does the glide path shape look like?; What ongoing governance is provided?; What level of flexibility and future proofing is in there?; What options are there beyond the default?; Does the provider have other options that target different outcomes, so people who do still want to buy an annuity or those who are focused on drawdown can do so?; What can providers do to support communications and engagement strategies with employees?

The other aspect is around what services can providers offer employers to help them manage different populations of employees who may be in different legacy default solutions. That is the key challenge for the industry at the moment.

4. How can employers increase staff understanding of, and engagement with, default investments?

It would be good to see employers doing more or playing their part in employee engagement because with the best will in the world, there is probably still a lot of distrust of financial services organisations among employees. They either trust messages coming directly from their employer or with the support or blessing of their employer, so they can add a massive benefit there by lending weight to that messaging.

If employers have got a really good default solution in place, for many people that’s a good place to be. Employers should not necessarily encourage a lot of people to go down the self-select route. It is probably unrealistic to expect a lot of people to want to engage to that level and there are probably only a small number that have got the knowledge and skillset to do that to a level of success.

It is about getting the balance between giving people enough choice to allow them to fine tune but in a way that they feel comfortable with and that does not overwhelm them with them having to make really quite detailed investment decisions unless they want to.

5. Should employers select an active or passive approach?

A lot of it will come down to personal preference and choice. What drives the majority of the return from any investment solution is asset allocation. That is something employers should focus on when selecting a default: how actively managed is that strategic asset allocation? If that is the main driver of the return, then who is looking after that? How is it being constructed? And what is it trying to do?

Beyond the top-level asset allocation, the two other things that can potentially drive outcomes are tactical asset allocation, which you can still have even if using passively managed underlying funds. The other thing is the underlying stock selection, which you only get if using active managers.

Making sure you have got an actively managed top-level asset allocation is important, followed by passive asset allocation, followed by stock selection.

With all these things, the proof of the pudding is in the eating, so whether performance is being delivered for the level of risk that is being taken.

Jenny Holt is head of investment solutions at Standard Life