Offering a choice of default funds to pension scheme members rather defeats their purpose. Defaults are for those who do not want to make any choice about investment, do not feel capable of doing it or think that someone is doing it for them. One of the painful facts about default is that although the funds perform poorly, savers tend to believe they are actively managed and designed to optimise their retirement incomes. Only when they reach the end of their working lives do they shake the pot and wonder why there is so little money in it.
Pension providers take some trouble to encourage savers to make active fund choices, but few claim success.
Members are right in thinking the choice is beyond them; even sophisticated investors must sometimes wonder if holding a pin over a list of 200 funds might be more successful that trying to pick winners over a 40-year stretch. We should stop trying to turn retirement savers into chief investment officers. It makes sense to know our limitations and scheme members do: about 90% of them are in default funds.
From next year, millions more will join them as they are automatically enrolled into workplace defined contribution (DC) schemes. We can expect that very few of the conscripts are going to become informed and active investors. All qualifying schemes for auto-enrolment will be required to have a default fund.
The question employers should be asking is not how to get more employees to choose funds, but how to make a better choice for them. This is not a comfortable place to be. Taking investment decisions for other people is regarded as risky and scheme sponsors and trustees tend to run scared of the responsibility. But liability comes in many forms and one is contributing to a scheme that ultimately will not satisfy employees’ retirement needs.
Auto-enrolment gives employers the opportunity to be a true ‘financial friend’ to workers by offering a range of default options to fit basic employee profiles. Offer a choice of funds for those who want to take responsibility for their own investment decisions, but bring in the professionals to design a default structure for the rest.
Passive equity trackers have been the traditional choice for default funds, but they are not up to the job. Cost is an important consideration when choosing a default option, but it should not be the only one. The aim should be to bring more flexibility into default vehicles to move away from the one-size-fits-all fund to a structure that provides some semi-fitted options for different cohorts of members. Simple questionnaires can be used to group members of similar age, risk appetites, career and income expectations and retirement age targets. A balance has to be struck between the degree of segmentation, the complexity of fund management, and cost.
Diversified growth funds have gained in popularity for default funds because of their wide spread of asset classes, but they now have a challenger. Target date funds are increasingly the choice of pension providers in the US looking for a happy union of automation and tailoring. ‘Set and forget’ funds are designed and managed to meet the retirement income needs of staff who have chosen similar ages at which to retire. Assets are reallocated within the fund to maximise growth or protection as investors approach their retirement date. The funds are low maintenance but retain an element of off-the-peg.
In the UK, the government-sponsored National Employment Savings Trust (Nest) has adopted this structure for its low- to medium-income members to provide a reasonable return on investment at a reasonable cost. Nest’s decision was informed by research showing that young people in particular would be highly sensitive to losses in the first few years of pension saving and some form of guarantee would be needed to persuade new savers to stick with a pension.
Employers and trustees can do a couple more things to change the reputation of default funds and make them a much safer place to be: establish good governance and regular auditing. Stop worrying that 90% of members are in default funds because they are a positive feature of DC schemes; they just need some attention.
Susan Jones is executive director at TOR Financial Consulting
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