For the millions saving into a workplace pension, fund performance, the charges levied and how much you contribute greatly determines the size of your pension pot when you retire.
There are around five million employees paying into a defined contribution (DC) pension scheme which will rise to nine million by 2018 with auto-enrolment legislation.
Automatic enrolment into a pension scheme was introduced by the government as statistics showed we are living longer, yet the amount we save for retirement fails to reflect this major demographic trend.
As auto-enrolment comes into effect, millions of workers, who have never before saved in a workplace pension, will be asked to make a decision on how they want their pension savings to be invested. But experts predict that more than 95 per cent will not make an active decision and will end up in the scheme’s “default” fund.
“While members should be encouraged to make informed decisions about their plans for saving for retirement, many members have neither the inclination nor expertise to make an educated decision on their fund selection,” says David Adkins, chief investment officer of The Pensions Trust. “For most, the concept of financial risk is a hazy idea.”
David Blake, professor of pension economics at Cass Business School, believes that savers should leave it the experts. “In general, people are not sufficiently skilled to make their own investment decisions,” he says. “Those who are skilled typically do not have the time to monitor their chosen fund. This is why there should be a well-designed default fund in every scheme which most members should invest in.”
Morten Nilsson, chief executive of NOW: Pensions, warns that members are disinterested in pensions, so trying to get them to make an active investment choice is fruitless. “Anecdotal evidence suggests that new scheme members have an attention span of just 15 minutes when considering their pension arrangements. In those 15 minutes, the time is better spent considering retirement date, retirement ambitions and contribution levels, rather than attitude to risk and investment options,” he says.
Most providers prioritised maximising exposure to equity returns as long as possible, before switching investment into less volatile asset classes, such as cash and bonds, as the member nears retirement
Although designed to accommodate the majority of members who do not want to make active investment decisions, default funds vary widely in their design and investment strategy.
A study by the Department of Work & Pensions (DWP) found that most providers have a preference for some diversification of assets, with use of de-risking (typically a lifecycle strategy) as the member approaches retirement. Most providers prioritised maximising exposure to equity returns as long as possible, before switching investment into less volatile asset classes, such as cash and bonds, as the member nears retirement.
Jamie Jenkins, Standard Life’s head of workplace strategy, says: “Most defaults should include an element of diversification to ensure the risk isn’t too concentrated, an element of de-risking as members approach retirement to ensure values are protected, a prospect for growth above inflation to ensure real returns over the long term, and some element of future-proofing to allow for changes to be made as circumstances change.”
Mr Nilsson believes diversification is imperative within default funds as, traditionally, there has been a heavy reliance on equities, which can expose members to a high degree of volatility.
“Members need an actively managed fund that mitigates risk by diversifying investments across various asset classes. This diversification strategy, coupled with active management, can provide the risk framework to ensure the value of a portfolio is less drastically impacted when there is a shock to the system. This enables the fund to produce more stable returns,” he explains.
“An aged-based investment strategy, during both the accumulation and decumulation stages, will be a key feature of a well-designed default fund,” adds Professor Blake. The decumulation stage, when the worker might be ten years away from retirement, will see default fund strategies limit the risk of losing money by investing in bonds and cash.
Here, as you get older, your savings will go into safety-first assets because the “cliff-edge” moment – the very moment you retire – is when so much is at stake.
Some providers have been adopting “new” investment approaches, though many have been inherited from the defined benefit world. Such funds, called diversified growth funds, attempt to invest across a range of assets helping to spread the risks inherent in investing in equities, for instance. They will consider other investments, like property and currencies, to make the investment journey smoother.
The National Employment Savings Trust (Nest), the state-backed scheme, recently made its first direct foray into property, saying the allocation would help give members “access to long-term and sustainable investment growth”.
Irrespective of strategy, ensuring a strong governance structure is in place to oversee the performance of the default fund is imperative.
“A default fund committee, whether it is set up under a trustee structure or as part of a governance system put in place by the sponsoring employer, should ensure members’ interests are paramount,” says Mr Adkins.
But while the government and pensions regulator are both focused on raising standards within default funds, last month, the pensions minister Steve Webb announced a consultation on capping charges on retirement savings made through auto-enrolment at 0.75 per cent.
“High charges do need to be tackled. They eat away at pension pots, foster mistrust in the industry and act as a disincentive to savers,” says Mr Nilsson. “But, with charges under pressure, it’s almost inevitable that many providers will be tempted to push members into cheap, passively managed funds which won’t necessarily deliver the risk-managed returns savers deserve.”