Ceri Jones looks at the available choices for employers selecting a default fund for their defined contribution plans

Default investment funds for defined contribution (DC) pension schemes have evolved since the early days of stakeholder pensions when, quite often, any member who did not nominate a choice of fund was simply invested in a cash or gilts fund.

Current default structures are usually based around lifestyling, investing primarily in equities at the younger ages and switching members progressively into cash and bonds as they begin to approach retirement. The idea is to move out of volatile equity investments gradually, rather than risk a situation where members retire just at a time when markets are falling or at a low ebb.

However, lifestyling is an imperfect tool. A system that is not individually tailored will move a member into cash prematurely if they plan to continue working past retirement age, so losing the potential returns that could have been made from equities. Other members may choose to retire early, while some are caught unawares by ill-health or redundancy and, as a consequence, may still be heavily invested in equities at their date of retirement. Neither does the standardised switching of a typical lifestyle fund take account of individuals' risk tolerance, which will vary according to factors such as total wealth and personal circumstances.

Investment management firm Black Rock has run stochastic models on the possible outcomes from DC schemes over the past 40 years. Emma Douglas, director, defined contribution sales, says: "Lifestyling is a blunt instrument. Even so, we were surprised at the huge range of outcomes."

Some consultants, therefore, are looking at new ways to provide default funds where timing discrepancies will have less of an impact. One potential solution is diversified target or growth funds, which are based on a wider range of assets than just equities or bonds, including alternative investments such as hedge funds, private equity, property and commodities. These aim to provide the same potential high performance of an equity portfolio but with less risk, because these alternative assets are inversely correlated and should rise and fall at different parts of the economic cycle. The overall portfolio should therefore be less volatile.

Monitoring members

These funds, however, are relatively young and lack a long-term track record. The Black Rock Target Return Fund, for example, has only been available in the DC market for 18 months but it has been offered in the defined benefit (DB) market for four years. The fund produced an annualised return of 10% from 31 December 2003 to 31 December 2007, compared with 13.5% from the FTSE All Share index, which represents the performance of all eligible companies listed on the London Stock Exchange's main market, over the same period, but with reduced volatility of 4.1% compared with the All Share's 7.9%.

"A lot of members are very conservative and risk averse and this is a good option for them. It fits in well with what DC members want, but it limits the upside members can achieve," says Douglas.

Another advantage of these multi-asset funds is their target returns are expressed in ways most employees find easy to understand. In place of the equity benchmark, funds are generally targeted at cash plus a certain amount, perhaps 3.5%.

Chris McWilliam, senior consultant at Aon Consulting, says: "We view [diversified funds] as less aggressive, because they are adding additional investments to equities to help mitigate the potential risk. Their clear targets are also easy for members to monitor."

Structured, or capital guaranteed, products have also been suggested as a solution. Structured products are generally invested in one of the big equity indices, such as the FTSE All Share, but they lock in a percentage of the fund's value at regular intervals. The disadvantage is that members won't be able to take all the gain in the index in a rising market. While few consultants yet advise on guaranteed funds for occupational pensions, several are now contemplating this option, partly because the tools to engineer the products are becoming available.

Peter Cox, head of DC at HSBC Investments, says: "These funds address the risk of savings abandonment. If an investor finds the value of their fund is less than the amount [they] put in then they may give up on the whole idea of saving, but if their pot has a notionally increasing value, they may be more encouraged to save. The markers to the fund's progress are very clear and well understood because the concept of a guarantee is well established."

But the cost of these guarantees is high, at perhaps 0.5% of the fund value as a minimum. With all the recent publicity about sub-prime debt and bank write downs, the other issue is that these contracts are based on derivatives engineered with a single bank, with the risk that this involves.

Some providers are looking at profiling members to place them in appropriate funds, which should reduce the incidence of using the default fund. HSBC Investments, for example, is beginning to develop a multi-lifestyle concept based on a questionnaire which helps set the fund configuration.

Crispin Lace, senior investment consultant at Watson Wyatt, says: "Consultants can get overenthusiastic about what can be done in an ideal world. But it is the employer who needs to consider whether to facilitate all these options. Employers need to identify what their objectives are in offering a pension scheme. Do they want to help provide a basic level of retirement income, or do they want to facilitate the member to make holistic wealth decisions? Very few choose the latter. Most employers are coming at it from a position of having offered a DB scheme in the past and being reluctant to cut members off. An employer might think 40% of final salary should be the end-game, for example, and [it] can then set a strategy to target that, including a default option designed to deliver that target benefit."

Consultants are also moving into fund provision, usually as a form of Manager of Managers operation, where they set the mandates and targets. For example, Jardine Lloyd Thompson (JLT) is putting together its own fund range for clients where the insurance company acts only as administrator.

Craig Roger, consulting director at JLT, says: "Many consultants will just pick the best off-the-shelf model which may be decided by price rather than by investment performance. We wanted to be creative about achieving a better return and being invested in the appropriate asset allocation, rebalanced at least quarterly. The range could include structured or absolute return funds."

Investment choices will also be the subject of one of the Personal Accounts Delivery Authority's consultation papers. Its chair, Paul Myners, will be looking for improvements to what he sees as an trade-off between flexibility and price. So employers could find they soon have an increasing number of default structures to choose from.

Default Investments in brief

There are essentially two ways of approaching the default fund problem. One is the current popular model of switching progressively from equities into cash as retirement approaches. The other, which deals with the problems of timing, is to come up with an asset allocation that is appropriate throughout the member's lifetime. Consultants are beginning to suggest diversified growth funds, a mixed bag of equities and alternative assets, which are said to offer the potential returns of a pure equity portfolio but with a reduced risk profile. However, there is not yet much past performance data to go on.

Some consultancies are also launching their own Manager of Managers and Fund of Funds operations, where they select the managers or funds. Others are experimenting with staff questionnaires to model an appropriate fund.

Case study

Misys offers wide fund choice

Misys offers a range of 11 funds to members of its £120m pension scheme, available through Prudential's platform.

These include index funds and an ethical fund from Legal & General, a corporate bond and a cash fund from M&G, and a property fund run by Threadneedle. With advice from consultants Watson Wyatt, the IT firm's trustees also added Schroder's diversified growth fund, a mixed asset fund, to the panel last October.

Members who do not select a fund are invested 50/50 in the L&G UK equity index fund and the World ex-UK index funds. Around 50% of the scheme's 500 active members use the default fund, far below the typical default rate, which varies but is often 90% or more.

Andrew Brown, group pensions manager, attributes this to employees' financial knowledge. "Our average employee knows a lot about the financial world, partly because we make [financial] software," he says.

As employees approach retirement, they can choose to switch into the L&G Pre-Retirement fund over five, 10 or 15 years. If they don't select one of these options, the 10-year time frame model will act as the default, moving the accumulated pot into the pre-retirement fund progressively, at a rate of 2.5% every quarter.

"The reason for lifestyling is to prepare people for retirement and the trustees' viewpoint is that 10 years does that much more gradually than five years," says Brown. IT is also a young industry and employees may not factor into their plans the prospect of early retirement.

The firm runs regular workshops to communicate with staff across its five sites.