This year is a crucial one for defined contribution pension provision in the UK. The growing army of DC pension savers is about to be increased by millions more as employees begin to be auto-enrolled in workplace schemes. The question is: are the strategies that have historically been used as pension defaults are still able to cope with the circumstances that many of these new savers find themselves facing today?
The default approach of choice in DC continues to be a lifestyle strategy, where the investment risk is automatically reduced a few years ahead of retirement by moving to a mostly gilts portfolio. Change is long overdue.
Many of the six to eight million workers who will ultimately be auto enrolled are “natural defaulters”. Yet if defaults don’t match their usually unspoken expectations they may be turned off pensions for good. We would argue that the least they would expect from their pension default fund is that it would ensure that someone was actively managing the money, tasked with looking out for their best interests. That also seems to be increasingly the view of regulators.
The DWP has set out its stall clearly in its guidance for offering a default option for defined contribution automatic enrolment pension schemes, published last year. The theme that runs right through this paper is the importance of keeping in mind the needs, risks and objectives of the scheme’s members. We would agree with the emphasis, but would question whether many existing defaults currently match the aspirations, or indeed have the practical capability to do so.
The problem from our perspective is that a predetermined lifestyle default strategy is too rigid to cope with the fluidity of retirement today. Given that it is a series of components, utilised to a pre-determined formula, it is unable to cope with fast-changing investment environments and evolving investment ideas. Changing strategy or components takes time, effort and cost, while confusing members. Much better to have a framework that allows changes to be made seamlessly, with a professional manager on the hook for implementing those changes.
Changing strategy or components takes time, effort and cost, while confusing members. Much better to have a framework that allows changes to be made seamlessly, with a professional manager on the hook for implementing those changes
This is pertinent criticism after a year when UK long-dated gilts – often a major component of lifestyle portfolios approaching retirement- rose by more than 20 per cent. However welcome that might have been, it could have been disastrous had gilt returns gone in the other direction.
Furthermore, we believe lifestyle formulas rely too much on a fixed retirement date, a single point in time that may be wrong many more times than it may be right. The temptation to be overly precise in a DC world ignores the fact that we are dealing with individual benefit outcomes. Much better to aim at a retirement window and be open to the different ways in which people will access their money.
Both our research and our experience tells us that professionally-managed flexible target date funds (TDFs) can meet these objectives, offering simplicity for the member, employer and trustee, while delivering investment sophistication and accountability “under the bonnet”. The aim is to offer apparently effortless performance, while smoothing out any bumps on the journey without troubling the owner with any onerous engagement with the savings vehicle.
A TDF approach works by directing the saver towards a fund whose objectives are aligned with their age group. Each fund links savers of a similar age, allowing its investments and management to be much more closely aligned with their needs and risks. Crucially, the asset allocation can be monitored on a day-to-day basis, which means short-term volatility can be dealt with much more effectively than in lifestyle, whose management inevitably has to be based on a backward-looking view. As to those assets, it is agnostic, allowing any fund type, manager or asset class to be slotted into the structure without disrupting the membership.
Moreover, we believe similar age-based funds can be used as a “bridge” between stopping work and buying an annuity. This would smooth the transition into retirement by giving people more choice, flexibility and growth potential at a more affordable price than an immediate annuity.
We don’t think it’s a coincidence that Nest, the state-backed workplace has scheme, has adopted TDFs for its default approach. Indeed, we believe they will become the benchmark for the industry, leaving “lifestyle” as a term used only for fitness clubs. In our view, flexible target date funds offer a far better way to meet the expectations of the new generation of DC savers.
