New trends for DC pension default funds

Most defined contribution pension members use schemes’ default funds, but investment trends are changing, says Matthew Craig

If you read nothing else, read this…

  • Some 82% of defined contribution members do not actively decide where to invest.
  • Their contributions go into a default fund, which generally aims for positive returns without excessive risk-taking. Lifestyle funds, target date funds, diversified growth funds and risk-graded funds are all options.
  • More sophisticated designs may be needed, possibly with protection against market falls.
  • The default fund design for personal accounts in 2012 could become the benchmark for other pension schemes.

Default funds are for defined contribution (DC) pension plan members who do not, or cannot, actively decide where they want to invest.

According to the National Association of Pension Funds’ 2008 Annual survey 82% of active and deferred DC members use default funds. Tom McPhail, head of pensions research at Hargreaves Lansdown, says: “All you can do is recognise [member inertia], acknowledge it and work with it.”

Finding a risk-reward balance

The usual aim of a default fund is to find a balance between risk and reward, so members see their DC pot steadily increase over time, but without wild swings in value, especially near retirement. Lifestyle investing is one of the most widely used types of default fund. Here, younger members’ contributions are invested mainly in equities for long-term growth potential. As employees approach retirement, assets are removed away from the volatility of equities and into more stable fixed income or cash funds.

But DC experts feel lifestyle investing may be replaced by more sophisticated solutions. Ashish Kapur, European head of solutions at SEI, says: “Na‘ve lifestyling worked when the amount of money going in was fairly small. Most people benefited from pound-cost averaging and had reasonable pots of money at the end of the day. But going forward, when accumulated benefits are higher, some sort of downside protection [which provides a cushion against potential losses stemming from falling prices] will be important.”

Lifestyle investing criticised

Another criticism of lifestyling is that it can be mechanistic, switching assets according to pre-set rules, regardless of market conditions. It may also struggle to cope with unexpected events, such as forced early retirement. And after equity falls of up to 40% in 2008, younger employees may not be happy to see a big drop in the value of their DC assets because of their exposure to equities.

Default fund options Other options for default funds include target date funds, diversified growth funds and risk-graded funds. A default fund could also be a ‘plain vanilla’ investment fund. Before the equity market crash, this might have been an index-tracking equity fund. It would have avoided manager risk, but not market risk. Index-linked gilts could be a failsafe default option, says McPhail. “You can pretty much guarantee you will not lose money,” he adds.

A diversified growth fund invests in a wide range of assets, either within set limits for different asset classes, or by giving a fund manager freedom to seek out returns where they see the best opportunities. While an equity-based fund will inevitably follow the equity market, a diversified growth fund can aim for real, or absolute, returns.

Multi-asset funds do relatively well

BNY Mellon Asset Management International’s head of pooled funds and DC, Ian Harvey, says employers with multi-asset funds have fared relatively well. “They have seen single-figure declines in the past year,” he adds. “In some cases, they are looking to replace a straightforward multi-asset fund with a fund targeting a cash-plus benchmark with some downside protection.”

Target date funds have been widely used as DC default funds in the US and are seen as more advanced lifestyle funds. Members select a fund with a date near their planned retirement. The fund manager then invests with this date in mind. The investment is likely to be in a range of assets, with the manager deciding where to invest according to market conditions and the remaining life of the fund.

Asset allocation decisions vital

One concern with both diversified growth and target date funds is that asset allocation decisions become vital, which may be a weakness for some fund managers. Another idea is to offer members a choice of risk-graded funds, with staff given risk-profiling tools to help them make their choice. The risk-graded funds are then invested in a suitable mix of assets for their risk profile, to ensure members do not receive any unpleasant surprises.

When personal accounts are introduced in 2012, its default fund is likely to exert a strong influence on employees’ and trustees’ choice of other default funds. SEI’s Kapur says: “The personal accounts consultation paper seems to be in favour of something like target date funds, which are easy to communicate.”