What is the right default fund for my pension scheme?

  1. graphsncharts

All auto enrolment schemes must have a default fund; stakeholder pensions have required them since 2001.

There is no consensus about the “right” default fund for a pension scheme. The options generally available are:

  • Balanced Fund
  • Diversified Growth Fund
  • Lifestyle Strategy
  • Targeted Income Strategy
  • Target Date Fund

The two labelled “strategies” are usually a combination of funds and other investable entities managed to a formulated methodology but most people think of them as funds. Of course, within each of these fund types the component parts are themselves extremely variable and can make enormous difference to investor outcomes. However in the company pensions market, in principle, all the above can meet the DWP’s default fund best practice guidance (link). What’s critical is that the employer ensures good governance of his scheme’s specific fund.

Naturally advisors, marketeers and fund managers support the default fund they sell or administer. We also see the theme that if a default fund design doesn’t need much after-sales course correction, it tends not to receive much adviser support.

We’ve seen this with Target Dated funds which have taken about seven years to become widely acceptable to advisers. The Targeted Income strategy, ( a “fund” designed for defined contribution schemes using defined benefit/liability aimed principles) still needs to be sold directly to pension schemes as the advisers don’t tend to support it. Many would say this is because once set up, it’s intended to work for the employees entire working lifetime and therefore doesn’t need changes by an intermediary along the way.

As investment outcomes are unforeseeable in advance and are infinitely variable between employees and fund choices it remains difficult to decide upon the best default design for any pension scheme. If you can’t determine the best, or at least rank them in some way, doesn’t that mean some schemes will end up with bad defaults? And when we are talking here about the post retirement financial health of the nation’s workforce and households, it becomes a critical debate. There is another important point as well, that in some years, because of auto enrolment, some defaults will be home to billions of pounds of people’s pension assets.

What everyone does seem to agree though is that 90% to 95% of pension scheme members will likely stay in the default fund from their first pension contribution to the date their retirement pension commences. Therefore no one can deny that the default fund is important, but there is less agreement about what its important for.

We talk about it being in the members interest, but does that mean:

  • it would provide the highest net return on contributions?
  • it would provide the least uncertain return over the time invested?
  • it would preserve capital while hoping to benefit from some equity premium?
  • it will enable the pension scheme to fulfil its duties to have an adequate fund?

Probably we would all like a fund to give us a combination of the first three points, but the last bullet is the one that will trump all others as its the only one you can pretty much evidence in the present, and which also carries a legal duty. But it doesn’t sound very positive about maximising or even optimising an individual’s pension, does it?

So should we accept that 90 to 95% of pension scheme members stay in the default fund without understanding their options, including the impact that the visible and possibly hidden cost deductions will have on their final pension, and without having much or any understanding of how to make choices about it?  After all, it will be one of the most important financial aspects of their life.

For the employer a good pension for his workers means that he is able to plan and operate a healthy and dynamic enterprise. (This was the reason pensions were introduced in the very early 20th century.)

Do we want people to understand their finances and take their long term financial security seriously or do we want to default them into an investment fund for their working life leaving them the impression that it will turn out okay because someone else has done the thinking for them?

Many financial commentators say we can’t expect pension scheme members to become investment experts. (‘so its not worth doing much’ is left unsaid). This is a great way to avoid the issue.

What people need to know:

  • is how to watch out for their savings
  • how to value and use the employers and their own contributions
  • to improve their opportunities and
  • safeguard their financial security for what could be a long retirement with little other income.

The knowledge skill for this is no more than that needed for people who know about sports or cooking or gardening or anything else. What is required is that we make the subject engaging.

This can be done. There are lots of reasons why most people are bored, scared or confused by their pension scheme and related issues, but it doesn’t have to be that way. There are small pockets of best practice in all industries where the workforce are engaged with their pension scheme and can make good decisions about it – and value the cost the employer puts into it.

The answer to the question posed in the title is that the right default fund is one that will enable the pension scheme to fulfil its duties to have an adequate fund. So you can have any fund you like so long as it meets the governance criteria but the governance criteria are safeguards only. They do not seek to set out the requirements that the better employers and pension trustees may want from their pension scheme and neither should they.  Employers and pension trustees must have the freedom to decide the pension policies that are right for them and their work force. The right thing to do is to speak to an appropriate expert to find out more in relation to your specific pension scheme and workforce.

CORPIAS  provides company pensions expertise for employers and pension schemes. We do not sell a pension product. Please feel free to speak to CORPIAS as we can support the development of your thinking with default fund and fund range choices. We can also provide engaging pension scheme and investment training to the workforce or to HR personnel in a train the trainer concept.