According to The Pensions Regulator[1] , over 11 million people have been newly enrolled into their workplace pension since the introduction of auto enrolment in 2012. The majority of these people are in defined contribution schemes and rely on their employer and/or pension provider to decide how best to invest their money.
Pension product providers must ensure they consider what is in members’ best interests and how best their savings can be utilised to create income options for their members in retirement.
Legislation
There is different legislation depending on whether the product provider offers a contract-based plan, for example a group personal pension where there needs to be an independent governance committee in place responsible for decision oversight, or where the product provider offers a trust-based scheme where typically they would have a selection of independent professional trustees, as well as company representatives on the board who are responsible for decisions.
This article considers design nuances of qualifying auto enrolment default strategies offered by mainstream defined contribution schemes. Default strategies are in place for members who either do not wish to choose their own funds or who rely on their provider to make these important decisions on their behalf.
Lifestyle
Lifestyle strategies aim to deliver growth by investing the pension scheme members’ funds in a greater proportion of equities in the early years, with a gradual movement into lower risk, less volatile assets in the later years as they approach retirement.
There is a general consensus that most pension scheme members can tolerate greater volatility with their investments while they have a longer term to retirement than those who are getting closer to retirement and wouldn’t have the opportunity to make up any losses. Afterall people getting closer to needing to access their pension fund for income, need greater certainty at this crucial planning stage. As they approach retirement, there is usually a trade-off where unpredictable growth assets are exchanged for more defensive and less volatile investments.
Pension providers tend to use a number of pooled funds at each stage throughout the life of the plan. The lifestyle switching process is an automated mechanism that usually happens gradually and passively over time.
From a positive perspective, automation provides security to the scheme member that their pension will be less exposed to adverse equity markets as they draw closer to retirement. The fact that the funds are switched gradually over time allows for a smoothing of any adverse movements in the stock market.
Conversely, this automation does not allow for adjustments during any period of prolonged adversity such as the issues experienced in the bond markets in 2022. In order to address these periodic challenges, a number of providers have a tactical asset allocation committee in order to adjust the lifestyle strategies to a changing market.
Timeframe for switching
Let’s consider default strategies and the ideal timeframe to start the derisking process.
There is not a one size fits all answer for this, because each provider’s approach to asset allocation in the growth phase differs. For example, where the product provider invests in a greater proportion of equities in the early years, a steady transition to bonds and fixed interest assets may require a longer transition phase, for example 10-15 years. Where the provider chooses to adopt a more diverse strategy for growth, including other less risky asset classes in the early years, the phasing may start closer to retirement, e.g. 5-10 years out.
We note that these strategies are all based on a member actually looking to take benefits at the retirement age that the provider has on record, which is often not the case. Not only does the most likely retirement age need to be selected by the individual, but they need to advise the provider of any changes.
Members are fickle when it comes to choosing when to take their benefits. Since 2016, there has been an increase in the amount of options available to all members in relation to how they draw down their funds, be it via annuity, cash, income drawdown or a combination of these options. This makes product providers’ decisions tricky when setting an appropriate asset allocation and derisking timeframe for their default strategy.
Experience from discussions with members and our financial education team note that a proportion of members are drawing tax-free lump sums, approximately a quarter of them are accessing funds at age 55 (the earliest age currently for pension access) and, of those members, just over half of them are leaving the rest of their funds invested for a later date. With experience such as this, product providers must consider member choices when structuring their lifestyle strategies.
The UK think tank ‘Policy Exchange’ has written a report, ‘Lessons from Australia’[2], which argues that members who have been ‘lifestyled’ can end up with worse outcomes at retirement than those who have a different set of objectives during the saving years, such as an objective which targets good outcomes for the member at retirement (rather than solely the safety or value for money during the investment period) and therefore prioritises investment outperformance.
What can employers do?
While the responsibilities for structuring the default strategy usually sit with the provider in the case of contract-based schemes, or trustees for master trusts, employers can undertake the following actions:
- ensure the default strategy complies with current legislation
- monitor who is involved and responsible for reviewing and making changes to the strategy
- consider a pension provider review where there is consistent underperformance
- help employees engage with their pension through financial education programmes
- nudge employees to ensure they keep their retirement age target under review on their policy
If you would like help in reviewing your default investment strategy, or discussing how members could ultimately be encouraged to take control of their own plans, please contact your Mattioli Woods consultant.
