The debate about engaging members with their pension savings is a long running one.
Engagement is helpful, in that it leads some members to consider how much they need to save and helps them decide the kind of the retirement products they want.
But there is no evidence that engaging most members in choosing their own investments is desirable in terms of improving their returns. We can’t expect people to become financial experts overnight and investing means complex decisions need to be made, potentially quite frequently. This is where the importance of a well-governed default fund comes into play.
Largely due to the success of auto-enrolment and its more than 10 million new savers, billions of pounds are saved into individual UK workplace pension pots each year. The vast majority of this goes into well-managed and cost-effective default funds and invested in a wide range of types of assets and markets diversifying the risks for savers.
There are some who would argue that default funds are the place for member contributions to be invested if they fail to make an alternative investment choice. But our new report with State Street Global Advisors shows that staying invested in a default fund is by far the simplest path to take to achieving good returns.
There is empirical evidence that individual investors, fired on by behavioural biases, not to mention the complex nature of the decisions they face, make avoidable mistakes which can reduce returns.
DIY investors, those that take investment choices into their own hands, run the risk of missing out on up to £247,000 by switching from their workplace pension scheme’s default investment strategy and making their own fund choices instead.
The report finds the worst mistake for investors is not taking enough risk and investing in a cash fund over the long-term. By doing so they could miss out on nearly £247,000 over their working lives. Someone who switches too often buying into funds which have recently performed well and selling out when they fall could lose more than £173,000. Investors who fail to diversify their portfolios could miss out on just under £31,000, as could someone who fails to keep their portfolio under review, making choices once and never looking again.
What this report makes clear is that default funds are a crucial solution for many members, not just a back-up plan when members don’t engage with investment decisions. Defaults offer a well-designed and well-governed investment strategy that is suitable for most members and is a simple and effective option for achieving good returns over the long term. This avoids the need for individuals to make complex investment choices which requires expertise, judgement and most importantly: constant attention. Pension outcomes would improve if fewer people made choices.
The Australian Defined Contribution pensions system, the most similar system to the UK’s new DC system, offers compelling evidence in the case for a default strategy. The Productivity Commission recently examined the AUD $2.6 trillion Australian retirement savings system and found that “choice options” produced lower returns in aggregate than simple, single investment option default funds.
The millions of British workers, who last year alone saved the best part of £100 billion into their workplace pensions are perfectly capable of making important decisions. Many of them do daily. The issue is that people are already incredibly busy with their careers and their families and they simply don’t have the time and energy to immerse themselves in the fiendishly complex world of investment.
Defaults give people a short-cut to good retirement outcomes without either paying an expensive advisor to look after their assets or making them alter their schedules to pay attention to markets all the time. But the myth of the successful DIY investor is a powerful one, driving millions of investors to pay more in trading and platform charges than are strictly required; or losing out through their misunderstanding of their own investment time horizons.
That retail investors get worse outcomes than institutional investors isn’t news, but retail structures do not offer defaults so there is little option for their clients. What is important is to make sure the institutional benefits of a default in occupational DC schemes is seen by managers as the preferred product and highlighted to members time and again. Where low-cost, well-designed and well-governed investment options are available members are almost certainly better off in them. Engagement has its place, but it’s only in investment for a rare minority.