With auto-enrolment under way and defined contribution (DC) pensions continuing to replace final salary schemes, it is more important than ever for employers to review their default investment funds to ensure they are fit for purpose.
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- Default funds should be reviewed about once a year.
- Reviews should start by looking at the profile of the membership and the objectives of the fund.
- Employers should also examine the market to see what types of investment fund are available.
David Harris, managing director at TOR Financial Consulting, says: “Large numbers of employees are suddenly joining pension schemes and employers are realising that they are not making active selections. Only about 10-15% of people in DC plans are active investment selectors [while the rest are in the default fund].”
The Employee Benefits/Booz & Co Default funds survey, which polled 225 employers in January 2013, found that 67% of trust-based and 42% of contract-based pension schemes review their default funds at least once a year.
Tim Banks, director of DC sales and client relations at Alliance Bernstein, says: “For each governance meeting, a review of the default strategy should take place, with best practice being a formal annual review.”
Guidance from The Pensions Regulator states that default funds should be reviewed every three years. Mel Duffield, head of research at the National Association of Pension Funds, says: “That review should look at the investment objectives, the performance, suitability for the membership, and charges.”
The frequency of a default fund review depends on how the employer has structured the governance of its pension scheme. Banks says: “If you employ a traditional lifestyle strategy, it usually means there is nobody proactively managing that strategy on your members’ behalf, in which case there is a greater onus on the governance committee to keep that default fresh through time.”
Before making any fundamental decisions about the default fund, it is important to determine its objectives. “The way in which we define objectives is to look at the risk capacity for individuals against the targeted outcomes,” says Banks. “Once you have looked at those issues in depth, you can get a very good sense of the risk capacity for members, the tolerance for loss, what is added value, and then you can move to the next stage.”
After determining the objectives, employers should be looking at the profile of their membership, including earnings, appetite for risk and existing pension provision. This might involve employee focus groups to represent the workforce. Harris adds: “You want to have a cross-section, rather than more senior management or more employees from the factory floor.”
The next step is for employers to look at the types of fund available on the market. Duffield says: “There is a lot of interest in things like diversified growth funds at the moment, so it’s about a trade-off between the amount of investment sophistication and the charges your trustee board or employer has the appetite to pay.”
Harris adds: “Employers have to ask themselves what the ideal model is for them. This could come out of advice being generated from an adviser or a consultant, or from their own internal resources. Once they have decided on the type of fund, they need to think about the underlying investments and also running the process of selection.”
The final stage in a review process is to engage the members, particularly when a change is being made, because it could be a challenge to explain to members why a new fund is more appropriate than the previous one. Duffield says: “A lot of employers have said: ‘We’ve stripped out volatility, we’ve delivered it for the same charge or a lower charge, so we think we’ve delivered a better deal for you’.”
Employers should conduct a default fund review step by step, determining the core objective of the fund, their membership profile, what is on offer in the industry and the fund’s design.
Banks adds: “It’s really important to think about what you actually want to achieve up front, rather than jumping straight into design. It’s having that audit trail that gives you the ability to have the reviews as a continual dynamic.”