Planning for the third age

The pension reforms of 2014 represent a dramatic change in how and when many defined contribution members will access their pots in retirement. With 85 per cent to 90 per cent of plan members relying on a default strategy to get them to a point at which they can retire, there is a clear opportunity for advisers to anticipate their clients’ needs far into the future, particularly if they have a strong understanding of the default funds and levels of savings.

Default fund design has evolved significantly over the years in the UK and it is clear that further evolution will be needed, specifically in relation to flexibility of design to accommodate changing member requirements.

Currently the most common form of default fund for pension schemes is lifecycle, which mechanistically changes asset allocations over time based on age. When first introduced there was a prevailing expectation for equity investments to deliver an impressive 8 per cent to 10 per cent or more a year, with little attention paid to downside exposure. But times have changed – and savers approaching retirement need to consider what the objective of their default fund is. Is it to maximise their pension pot or to maintain their lifestyle?

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We can also learn a lot from our friends across the pond, where target date funds are well established and hold more than US$650bn of US pension assets. TDFs employ not only dynamic asset allocation that changes gradually over time, but also active asset allocation to take advantage of shorter term market movements. Compared with lifecycle structures, they may also be more focused on member outcomes, rather than simply on beating a benchmark. Their single fund structure means they can adapt quickly and efficiently to change, for example, in regulation or member behaviour. TDFs are easy to communicate – the name of the fund being the year closest to when a member expects to retire – keeping member experience simple and allowing plan sponsors to focus on encouraging better saving behaviours.

If one is to look at different types of lifecycle defaults and compare them with target date funds, analysis shows a range of 10,000 possible portfolio outcomes (incorporating variables such as member contribution rates and changes to rates over time, frequency of salary growth, event and size of post-retirement withdrawals). The four lifecycle defaults are as follows:

1) Adventurous: This structure most closely reflects the asset classes and allocations found in most DC defaults today. It has the highest equity allocation during the pre-retirement period – 100 per cent equity with 10-year derisking into 50 per cent cash and 50 per cent bonds.

2) Balanced: This lifecycle structure maintains a more moderate equity allocation, starting with 85 per cent equity and 15 per cent fixed income, with 10-year derisking into 50 per cent cash and 50 per cent bonds

3) Cautious:. This structure, which as the lowest equity allocation starts with roughly 62 per cent equity and 38 per cent fixed income, with 10-year derisking into 100 per cent cash.

4) New generation: This structure is based on the adventurous structure, but replaces 50 per cent of the equity allocation with a median-performing dynamic growth fund and derisks into 75 per cent bonds and 25 per cent cash.

When compared to the projected outcome of a target date fund solution (in the case of this analysis I used the structure of TDF solution SmartRetirement), TDFs were found to best fulfil their outlined objective of maintaining a savers’ lifestyle at retirement. They offer the highest percentage of member outcomes above the minimum income replacement target, and the best lowest possible outcomes (see chart).