How to select the right default fund approach for an organisation

June Pensions Piece

Need to know:

  • Deciding on a default fund strategy depends on the quality of the investment strategy, the suitability for employees, and ongoing governance.
  • Active funds are targeted at growth and are diversified across a range of asset classes, while passive funds track a market and are considered a cheaper option.
  • Employees’ expected choices at retirement can help determine which fund route will be most appropriate.

Structuring an appropriate default investment fund for a workplace pension scheme has three main components: the quality of the investment strategy, the suitability of the solution for the scheme’s membership profile, and ongoing governance.

The big trend in recent years has been increased use of diversified growth funds (DGFs), which might be defined as active multi-asset funds that are quite tactical. Theoretically, these should be an attractive option for all types of employee because, while they are targeted at growth, they are diversified across a range of asset classes, and in the event of a crash, if one asset falls then another should rise. For example, at its simplest, when equities fall, bonds typically rise.

The main alternative is passive funds that simply track a market, whether up or down, usually the MSCI World index, and possibly with a currency hedge. Large employers can negotiate fees for passive solutions of as little as 30 basis points, including administration, which makes them far cheaper than DGFs, which may have expense ratios of 65 to 85 basis points, before administration, which may be another 20 basis points.

David Hutchins, lead portfolio manager, multi-asset solutions Europe, Middle East and Africa (EMEA) at Alliance Bernstein, says: “In practice, the vast majority of default arrangements are passive funds. The value-for-money debate is not happening so employers are just buying the cheapest. One of the things we’ve been trying to push is for people to examine the investment content of the fee they are paying. Passive funds are poor value for money. Where there are proper competitive forces at work, [one] would expect half of what you spend to go on the product itself. This is the case with active funds, but with passive funds only 15-20% is spent on the product manufacture itself; the rest goes on marketing and distribution.”

Active management returns

The argument against active investment management is that study after study has shown that active managers on the whole fail to outperform the benchmark. However, defined benefit (DB) pension funds are stuffed with active managers and there is an inconsistency where one set of trustees run both types of scheme. Arguably, it is the trustee’s fiduciary duty to provide active management if they think that active management can achieve better returns.

Rona Train, partner and senior investment consultant at Hymans Robertson, explains: “An important question is, what level of volatility the [employer] wants to see. We might use a DGF with an absolute return focus to protect against the downside. We often blend a DGF with a passive fund to bring down costs. It might be 50/50, or 60/40 in favour of passive.”

Retirement choices

Normally a projected pot analysis will reveal which of the three new routes available at retirement most employees will take: cash, annuity purchase or drawdown. Typically, three different lifestyle funds are used to target each of these routes, and at this juncture in defined contribution (DC) pension provision where pots are still small, normally the default fund will be targeted at cash, so it would be based on a lower level of volatility, to avoid big losses just before retirement.

White labelling funds allows the employer to switch underlying managers with minimum fuss if needs be. Jon Sweeney, investment specialist at Prudential Portfolio Management Group, also points to a combination of passive and active with a strong asset allocation and governance framework under that. As DC scheme members take on all the investment risk themselves, then arguably they will not want to take on much.

“DGFs are a way to smooth the journey,” he adds. “Experience shows that people, especially younger members, are more likely to give up paying into their pension if they have seen a big drop.”

However, very young workforces may be better suited to passive funds or solutions heavily weighted to equities, to capitalise on as much growth and compounding over the years as possible. “We would advocate that having around 70-80% in equities during the accumulation period produces the best result,” says Sweeney.