Members of defined contribution (DC) pension schemes may be exposed to unintended investment risks by being in a default strategy, Aon has warned.
The problem is that most of these funds are still targeting annuity purchases at retirement age, which has been less of the norm since pension freedoms were introduced in 2015, the consultant said.
According to Chris Inman, head of defined contribution investment advisory at Aon, the change in preferences at retirement has introduced the need for pension schemes to re-think this approach.
He said: "Traditional investment strategies that utilise passively managed funds that invest solely in UK fixed income can now be exposing members to significant unintended risks."
Aon's research of capital loss of UK fixed income, relative to global equities and different types of diversified growth funds, "shows that these funds have not effectively protected members against capital losses, especially over recent periods where yields have risen," he added.
Fixed income funds used by defined contribution schemes tend to be restricted to the relatively concentrated UK fixed income market and, therefore, they may not offer the same diversification opportunities and liquidity as global markets, Aon stated.
According to a survey from the consultant, 85 per cent of savers are still using the default option, and 40 per cent of these default investment strategies target the purchase of an annuity at retirement.
Mr Inman said: "Regardless of whether members take their benefits as cash or draw them down as flexible income, how we think about risk should change.
"We should focus on the absolute variability of outcomes, as well as the magnitude and duration of the capital loss.
"For defined contribution members nearing retirement, investment strategies need to mitigate key risks including opportunity cost, longevity and inflation."
Aon is recommending that members find out from their schemes what sort of strategies their money is invested in as they get nearer to retirement.
They can then decide whether UK fixed income is an appropriate investment for them, based on their retirement intentions.
Alan Chan, director and chartered financial planner at London-based IFS Wealth & Pensions, disagrees with Aon’s view.
He said: "Typically, these [default strategies] are designed to suit 'medium' risk individuals and will have some in-built lifestyling to de-risk the portfolio gradually as they approach retirement, so that the fund value can be preserved and used to purchase an annuity.
"Clearly, this is not ideal for those who wish to go into flexi-access drawdown because this requires the pension fund to be invested throughout their lifetime or until they decide to secure an income via an annuity."
However, Mr Chan argued this does not mean that investors are exposed to undue risks, as the fund will be at their lowest risks as mentioned.
Savers "may miss out on some market growth but at least their pension is relatively secure," he said.
According to Mr Chan, there is no way of selecting a default pension fund to suit all retirement options, as there is no one-size fits all solution.
He said: "The best way is for savers to engage with their pension providers and make their preferences for retirement income known a few years before their retirement date, and a default fund can be selected or changed to suit an annuity or drawdown option.
“Undoubtedly, this is a big challenge that providers will need to overcome as most people simply are not engaged with their pensions.”
According to research from JLT Employee Benefits, savers who are invested in the defined contribution default funds with the worst performance could be missing out on more than £300,000 of additional savings by the time they are 55.
maria.espadinha@ft.com
