Pensions World

The decision on the appropriate default fund is important. Financial journalist, Allison Plager reports

The future is defined contribution (DC). Indeed, Towers Watson’s FTSE Survey 2012 showed that one third of FTSE 100 companies offer DC schemes only to their employees, more than double the number in 2010.

This trend is set to continue with auto-enrolment and the advent of the National Employment Savings Trust (Nest) later this year. As we know, the investment of member contributions is crucial, and most employers will want to ensure that their staff can invest their money efficiently and effectively to produce as good a pension as possible in relation to the contributions made. As Nick Cook of Towers Watson said, findings from a survey of fiduciaries of UK DC pension plans undertaken by the firm showed “that the large majority of fiduciaries want to help employees get the most from their plan and have focused much more on investment options and default investment strategies over the past few years. The default option is where most DC members end up, so this focus on default design can add appreciable value to employees’ standard of living in retirement.”

Given that the most popular option for DC scheme members is the default fund, its structure becomes very important. Andy Cheseldine of Lane Clark & Peacock said “most members are better off using the default option rather than self selecting”. This is because in many cases, the member will make their choice and then probably forget about it for years, perhaps not taking any further action until they are coming up for retirement. Others may be very active in their selection, trying to spot trends, but forgetting other costs such as stamp duty. The default is looked after by trustees or the provider who monitor the risks and know much more about investment than the average scheme members. Therefore, said Mr Cheseldine, “default funds tend to do well”.

First things first

When setting up a default fund, the overriding factor to consider is the membership of the scheme, said Jenni Kirkwood of Mercer – for example, who are they, how old are they, what do they hope to achieve in their pension savings? Although default funds may look similar, they will vary considerably so that one used for an investment bank is quite different from that for a manufacturing business. Ms Kirkwood said it was also important to look at whether or not “members are likely to achieve retirement date”. Is redundancy an issue? If it is, a longer derisking glide path may be required.

Each scheme’s default will be specific to its members and, given that some 85% members go into the default, the planning stage must be thorough.

Where to find them

Finding the right provider is important. A questionnaire sent to providers of default options met with mixed success in gaining a response. Replies came in from the following providers:

AllianceBernstein offers default fund solutions using flexible target date funds (TDFs), available as packaged or bespoke solutions. It also offers multi-asset and single strategy funds that can be used as part of other default fund constructs such as lifestyle arrangements.

BlackRock offers four lifestyle default options, two passive and two active. It also creates bespoke lifestyle profiles for clients. These can be done over different time periods and do not carry an additional charge.

Legal & General offers a range of funds that can be used as building blocks to construct a default fund.

Standard Life provides a range of options from traditional balanced managed lifestyle profiles to newer, risk-based multi-asset portfolios.

Scottish Widows provides a core investment of three lifestyling packages – adventurous, balanced and cautious – and adds that around 80% of its policyholders investing in the core offering will use the balanced strategy.

Zurich provides default options via third parties where it determines the design and where a DC scheme requests a scheme specific design.

Target date fund or lifestyling?

Lifestyling funds have been popular with UK pension schemes traditionally, although increasing interest is being shown in TDFs. Scheme members may be more comfortable with lifestyling, but Nest having gone for a target approach for its default will make TDFs more mainstream, suggested Ms Kirkwood. Alliance Bernstein welcomed the Nest decision, saying that such TDFs are “inherently very simple for investors to understand – a single fund for life where investors look to professional oversight to ensure the best member outcomes”.

Ms Kirkwood said that TDFs and lifestyling funds are “similar” as they both glide to a low risk profile as the member approaches retirement. However, there is more active asset allocation in a TDF which the investment manager deals with. The lifestyle matrix is created by the administrator at the outset, which means that it must be a very thorough process to ensure it works efficiently for members.

A key potential advantage of TDFs, according to Standard Life’s Ann Flynn, “is ‘future-proofing’ where the fund manager has the ability to change the underlying funds at a future date, whereas the lifestyle strategy is locked into the funds chosen at the outset”. However, the advantage of lifestyling is that “the glide path is aligned to an individual’s retirement date, whereas TDFs will be set up to target retirement dates at one, three or even five year intervals, typically giving less accurate alignment to an individual’s retirement date”. She went on to say that lifestyle profiles can also be built around any choice of growth fund, while for each different growth fund used a complete additional set of TDFs has to be created.

However, lifestyling funds are not without problems. For example, last year Scottish Widows experienced a technical hitch on one of its lifestyling default funds which resulted in some members’ investments not being rebalanced according to their fund selection. It sorted out the problem and was quick to pay compensation to the members affected to ensure none is worse off than they would have been had the error not occurred. However, this does reflect the reliance placed on systems. As Mr Cheseldine said, it shows how important it is to check that the default option provider has “robust processes” and find out the measures it takes to cut out risk.

TDFs may be becoming more familiar, but most of the providers who responded to our questionnaire are proceeding cautiously in this respect. For example, BlackRock’s Paul Bucksey said it was considering introducing target dating options in 2012, but added that “lifestyle will continue to be popular”, no doubt because this is what investors are more familiar with. Zurich’s Jonathan Parker believed that lifestyling continues to be the most appropriate way of delivering their default options, although agrees that both have advantages. Likewise, LGIM’s Hugh Cutler said “LGIM does not favour any approach of default fund over another. Although we do not currently offer target date funds, we are currently researching how best to meet our clients’ needs with such a product.” He anticipates more development in this area in the next year.

In praise of TDFs, Katie Weber of AllianceBernstein explained that “whereas lifestyle strategies follow a blind mechanistic approach which makes fund switches at the member account level, the single-fund TDF solution allows for dynamic management with portfolio manager oversight, ensuring alignment with member expectations that someone is accountable for managing the funds on their behalf. Versus the rigid construct of typical lifestyle strategies, the flexible TDF framework allows for better diversification of managers and funds and permits change to underlying fund components or strategy in real time, at little cost or disruption to members.”

Keeping tabs

If you are not happy with the default arrangement, what can be done to rectify the situation? Rob Pearce of HSBC said: “It’s one of the key issues for trustees and advisers and can end up being a logistical and communications nightmare. However, the risks and associated costs can be minimised if the default is administered on a fund platform, where white labelling, blending and rebalancing of funds can be facilitated. If, for example, you need to change the underlying funds that make up a blended risk rated default, amend the glide path under a lifestyle fund or replace one fund manager’s diversified growth fund with another, this can be done simply and without having to change the fund name. From the members’ perspective, it’s like the functioning of a car. They should benefit from enhanced efficiency and performance without having to understand the intricate details of the workings of the engine.”

Ms Kirkwood advised that the default option should be “kept under review both in respect of the provider and its structure”. A full review should be done every three years at least. What might have seemed advanced a few years ago may become mainstream in a short time. For example, the move away from equities and into diversified growth funds felt brave a few years ago but is now common practice.

Likewise, Mr Cheseldine said “don’t set a default and forget it”. Something that looked good ten years ago “may look less attractive now – markets change and asset classes which are good diversifiers today may not be in five years’ time”.

Pensions are evolving all the time and, with increasingly sophisticated systems, the perfect default option may seem attainable. The clue is to spend plenty of time deciding what you want your default fund to look like and then, having decided, keep tabs on it so that you know it remains suitable for purpose as your scheme develops.