How to choose the best default fund

All pension providers offer a lifestyle investment strategy as the central plank in their default funds for workplace pension schemes because the lifestyle concept is the best general solution for most members.

If you read nothing else, read this:

  • Tailoring default funds to the scheme membership is not just about offering ethical and shariah options.
  • Default funds should be designed with the specific nature of the workforce in mind, because employees of different ages and salaries will have very different needs.
  • Almost all new pension plans include lifestyle strategies, which move members out of  growth assets and into low risk assets in the run up to retirement.

But beneath that broad lifestyle heading, the underlying investments in these funds vary considerably, and they and any additional default funds should be chosen to match the profile of the scheme’s potential members.

Rona Train, senior investment consultant at Hymans Robertson, says: “Where you have two schemes and in one the average salary is £22,000 and in the other it is £80,000, the default structures for the two schemes must be different because the needs of the members are different.

“The starting point is: what level of replacement income do these employees need in retirement? For those on £22,000, the replacement income needs to be about 80% of their salary during their working lives, or they won’t be able to pay their bills. This group should go for a more cautious approach to investment, because for them, losing money is the worst scenario and could mean retirement on the breadline.”

Higher-paid staff may feel able to take a higher-risk approach because the impact of an investment performing poorly will not be as critical for their lifestyle in retirement, and they may well have other savings elsewhere.

In today’s market, where bonds are poor value and equity markets are volatile, both groups are well served by diversified funds, which invest in an array of assets that rise and fall at different points in the economic cycle, creating a smoothing effect.

For wealthier employees, there are medium risk diversified growth funds with perhaps an increased allocation to riskier assets, such as global equities. These allow the investment manager to access a greater range of investment opportunities, including derivatives, so the fund can be leveraged and ‘short’ positions can be taken if desired, making money when the price of an asset falls.

Multi-asset portfolios

However, charges can be an issue with diversified growth and absolute return funds, and multi-asset portfolios can be constructed specifically for the membership profile from a mix of passive funds at about half the cost.

Age profile and investment experience also play a part. When the National Employment Savings Trust (Nest) was developing its investment strategy, it conducted research which revealed that young people starting out in their career with little experience of investment are highly risk averse and are likely to stop contributing to a pension if they lose money in the first five years. Nest, therefore, devised a foundation phase to cover the early years of a member’s career where the default fund has the simple aim of maintaining the capital amount and matching inflation.

Another argument for using funds with little or no risk, and little or no return, in the early years is that at this stage, the biggest impact on the size of an employee’s pension pot is the contributions. Later on, as the pot grows, the biggest impact on its size will be the success of the investments. Low-risk funds are also cheaper, and if a member is making a small contribution, fees will make a proportionally bigger difference to the outcome.

Martyn James, principal at Mercer, says: “While the foundation phase is not right for many schemes, it can be right for some with a certain member profile. One of the hard things is how to invest the foundation phase given the current pricing of bonds. Diversified growth funds can provide a reasonable solution.”

For inexperienced investors, target date funds, which focus on a specific year or period when a member wants to retire, can work well because complexities are hidden from view. Paul Black, investment partner at actuarial consultancy LCP, says: “Target date funds help people to focus on things that are more meaningful, such as when they want to retire, rather than on the nature of asset classes such as equities and bonds. They keep complexity under the surface while members still have confidence that it is an appropriate fund.”

Advisers say many pension schemes are revamping their default funds to get rid of outdated managed funds and equity trackers, which were popular in the 1990s when markets were rising. A new way of dealing with the changing investment world is to ensure the underlying investment philosophy and asset allocations are flexible.


CASE STUDY: Addaction

Addaction is one of the UK’s largest specialist drug and alcohol treatment charities, managing more than 120 services in 80 locations in England and Scotland. It has an annual income of more than £41 million.

In 2007, the charity arranged a flexible retirement plan through The Pensions Trust, which now has 1,200 members.

Then, in March 2013, it moved onto The Pensions Trust’s new SmarterPensions platform for qualifying workplace pension schemes in the auto-enrolment market. This uses AllianceBernstein’s target date funds as the default in an attempt to ensure a more flexible proactive investment approach for members, enabling them to adapt to the changing economic climate.

The funds carry an annual management charge of 0.45% across most of the fund range. Ethical fund options, including ethical target date funds, are offered using the FTSE4GoodFunds index range and gilts to create the required investment mix.

Guy Pink, HR director at Addaction, says: “For six years, we have used The Pensions Trust to run our defined contribution (DC) pension scheme. The regular contact we have gives us the confidence that this is well-managed and run with sound financial and legal governance.”

The charity was one of the first organisations to be rolled into the new flexible target date fund DC scheme.

Claire Curtin

Viewpoint: Claire Curtin

Employers should ensure all their funds are being managed responsibly, as a minimum. Many schemes also offer an ethical fund option for members. With the shift from defined benefit (DB) to defined contribution (DC) schemes, staff should be allowed to ensure their investments are managed in a socially and environmentally responsible way.

Responsible investment overall does not have to be just through an ethical option. There are many misconceptions and assumptions that responsible investing only entails exclusions of ‘sins’, such as tobacco companies, from investments. But the concept is broader than just exclusions, recognising the need to consider wider management of risks that are not always immediately financial in nature but have longer-term implications.

The financial implications of environmental, social and governance (ESG) risks, such as climate change, resource scarcity, labour standards and good governance, are becoming increasingly apparent and are of particular relevance to long-term investors, such as pension funds.

Considering ESG issues in terms of potential risks and protecting shareholder value is very relevant to pension funds. Apart from case studies such as BP’s Deepwater Horizon disaster in 2010, there are many other potential risks that can affect financial returns, for example clothing retailers with supply chains in high-risk countries can carry a high level of reputational risk related to labour standards, as was seen with the Bangladeshi building collapse in April.

Pension funds are one of the largest and most influential asset-owning groups. By taking a lead and implementing good stewardship of beneficiaries’ assets, they can exert pressure on investment institutions to encourage more sustainable behaviour and drive better awareness of ESG risks and issues, such as fair employment, good governance and environmental sustainability.

Claire Curtin is Client Relationship Manager at Ethical Investment Research Services (EIRIS)