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The Actuary The magazine of the Institute & Faculty of Actuaries

Default investment funds

IT IS CRITICAL TO THE SUCCESS of defined contribution (DC)
pension schemes in the UK that the asset allocations
and investment styles adopted by members are appropriate
for their circumstances and retirement objectives.
The government’s prescriptive stakeholder regime
has been instrumental in forcing providers to improve
charges and terms on their contract-based DC products,
but there remain flaws in terms of investment choice.
Blind faith
It is a legal requirement for stakeholder schemes to offer
a default fund to make retirement saving simpler for the
inexperienced investor.
However, the legislation
does not specify the
nature of the default
option, despite the fact
that 8090% of members
passively accept this
choice. The provider’s
choice of default fund
will have a major influence
on the returns
earned by most scheme
members. Pensions Institute
research demonstrates that in accepting the default
fund the majority of members assume that it is endorsed
by the employer, the adviser, and the provider.
Commercial considerations
Irrespective of the implicit responsibility of the parties
involved in the selection, there are commercial considerations
at stake. Providers must offer competitive products
to secure the high market share required to make this
low-margin business profitable. Advisers and employers
must ensure that members achieve a satisfactory outcome
to avoid the prospect of legal action on the part of
employees. For the adviser, the selection of a default fund
structure that is demonstrably suitable for the membership
may help to prevent future claims that the product
did not live up to reasonable expectations. This point is
of interest to professional indemnity insurers, which may
cut premiums where advisers can show that they have
reduced their risk exposure in this way.
Many of the default funds used in stakeholder schemes
include a ‘lifestyle’ mechanism, whereby the individual’s
pension assets are automatically moved out of higher-risk
investments as the planned retirement date approaches.
Lifestyle funds provide important protection for the
unsophisticated investor who might otherwise adopt a
recklessly conservative asset allocation at younger ages
and an excessively risky allocation just prior to the annuity
purchase. From April 2005, lifestyling will be a prescriptive
feature of the modified stakeholder pension that
forms part of the new ‘Sandler’ simplified range of investment
and savings products. As with the default option, it
appears the choice of lifestyling mechanism will be left to
the provider.
Current practice
So, what have pension providers chosen as the default
funds for their stakeholder schemes? The answer can be
found in a recently published study from the Pensions
Institute, which examines the default funds of 35 stakeholder
schemes listed on the Occupational Pensions Regulatory
Authority (Opra) register. The schemes examined
include those offered primarily to retail investors, those
offered via employers, and those offered to affinity
groups such as trade unions or members of professions.
While the research focused on stakeholder schemes, the
conclusions are applicable to all contract-based DC
arrangements where there is no trustee board to make the
selection on members’ behalf and where members receive
little or no personal advice.
Asset allocation
The authors have found considerable variety in the asset
allocation strategies in use, with three broad categories of
default fund:
°? Balanced managed funds, which are typically made up
7080% of equities, with the balance in bonds and a
small percentage of cash. Just over half of the schemes
had a balanced managed fund as their default.
°? Equity funds, which either invest entirely in UK equities,
or with a 7030 split between UK and overseas markets.
Just fewer than half the schemes fall into this
°? With-profits, where the underlying asset allocation is
typically a 6040 split between equities and bonds, with
the provider applying a smoothing mechanism to the
year-to-year returns. Only a small number of schemes
take this approach as their default.
It is interesting to note that all of the default fund categories
can be regarded as relatively risky, with fairly high
equity contents. This is a marked contrast to DC defaults
in the US where money market and fixed-interest funds
are commonly used, although clearly the US approach
can be problematical for different reasons.
The balanced managed funds used as the default in
more than half of schemes have been highly criticised
by Paul Myners, for example for their peer-group asset
allocations and near-index style of investment. They also
adjust their equity weightings in line with market trends
rather than adhering to an appropriate allocation, regularly reweighted. With a typical allocation to equities
of 80%, these funds will be excessively risky for many
Investment style
In addition to this variation in asset allocation, the
default funds differ in other important respects. First, in
relation to investment style, the schemes are split
approximately evenly between those that use a passive
approach and those that use active management,
although few of the actively managed funds appear to
invest aggressively. Second, about half of the default
arrangements involve some form of lifestyle profile. Several
of the schemes that do not make lifestyling an automatic
feature of the default fund offer this mechanism as
an option that the member must actively choose (and
most members probably do not), but others make no
provision for lifestyling at all.
Where lifestyling is the default, the process typically
starts five years prior to the planned retirement date and
switches progressively from the initial investment fund
towards a final asset allocation of 75% long bonds and
25% cash. The bonds are intended to partially hedge the
cost of buying an annuity, while the 25% cash is
intended to match the proportion of the fund that can be
taken as a tax-free lump sum. However, even in the
lifestyle profiles that are in use there is much variation.
Some schemes start to switch investments eight or ten
years prior to retirement, while others start with only
three years to go. Equally, the 75% bonds and 25% cash
final allocation is not the only practice in use. Some
schemes move towards 100% cash and others target
100% bonds.
How to select a default fund
With this wide variation in asset allocation and lifestyle
profiling, a pension scheme member passively accepting
the default fund faces an effective lottery. For occupational
schemes, the nature of the default fund will ideally
be an important consideration in the employer and
adviser’s selection of the pension scheme provider. This
means the default fund should be appropriate for the
‘average’ member of the scheme, which may mean that
members with atypical requirements are not as well
served by this arrangement.
However, it is easy to see why scheme providers might
be chosen for reasons other than asset management, for
example for their commission rates, charges, and administration.
In this case even the average scheme member
has much less assurance that the default fund will be
appropriate to his or her needs. Provided there is a range
of more interesting funds available for the executives and
directors, advisers may give little thought to the main
default option beyond ensuring that it is at least an
average performer within its peer group. For non-occupational
stakeholder pensions, asset management is likely
to be even less important in the purchasing decision,
with brand playing a much more important role.
From the provider’s perspective, the choice of default
fund is important for commercial reasons. The overwhelming
majority of
the members’ contributions
will end up in this
fund, so the cost of providing
this fund will
have a major effect on
the profitability of the
scheme. While suitability
for scheme members
will be one factor in the
selection process, the
marginal costs of production
are also likely to enter the equation. For a life
company with a range of balanced funds, a balanced
fund is likely to stand out as an appropriate choice of
default fund, while a fund management house with
passive management skills may see an equity tracker as
the ideal choice. These decisions may produce an appropriate
outcome for scheme members if the least riskaverse
investors, or their employers, have chosen the
fund management house, but there is considerable
doubt as to whether these selection criteria are adopted
in practice.
In conclusion
The Pensions Institute research analyses the current
default asset allocations and investment styles offered to
contract DC members. It raises questions about the
choices stakeholder pension providers have made in terms
of the default funds in their schemes. The current range
appears to represent an arbitrary approach to matching
the risk/return profile of scheme members.
Ideally, the way forward is to reduce reliance on default
funds by encouraging more scheme members to make
active investment choices that match their particular
requirements. However, it is unlikely that much progress
can be made on this in the short term, so we are left with
the challenge of designing default funds that are suitable
for scheme members while being cost-effective for
scheme providers. The research we have highlighted
suggests providers, advisers, employers, and regulators
have much more work to do in reaching an appropriate