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?
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).
While it is still unclear exactly what investors will do in retirement after April, the need for advice will undoubtedly be greater than ever. Annuities may still be right for those wanting certainty. Drawdown is likely to become more popular and cash will be king for others.
For instance, in a survey of UK savers, more than half (62 per cent) claimed to be seeking some income yet only 44 per cent of them were able to correctly explain the meaning of the term ‘income investing’ – and 79 per cent had never been approached by their adviser to discuss income-generating products.
Ensuring members understand their options in the run up to retirement and onwards will be a challenge, but also an opportunity.
It is worth noting that corporate advisers in the US have been dominating the DC space for some time, stepping into the workplace to ensure staff are appropriately positioned for retirement and supporting a corporate’s default investment strategy. In light of the pension changes in the UK, we would expect to see a more US-like model for financial advisers develop here.
If the accumulation default is properly structured to manage the changing landscape – and good advice for the corporate is vital here – then a flexible, appropriately risk-managed and diversified portfolio (such as a target date fund) should offer a great springboard into the third age.
Now is the perfect time to help clients look beyond the short-term implications of the pension reforms to their longer-term objectives in retirement. The US model of close collaboration between advisers, the corporate and the members has led to an integrated model that our fragmented market would do well to emulate.
Simon Chinnery is head of UK DC at JP Morgan Asset Management
Key points
The most common form of default fund for pension schemes is lifecycle, which mechanistically changes asset allocations
TDFs were found to best fulfil their outlined objective of maintaining a savers’ lifestyle at retirement
A flexible, appropriately risk-managed and diversified portfolio should offer a great springboard into retirement
