Need to know:
- Trust-based pension funds are obliged to re-examine their default funds at least every three years.
- Default funds are typically mixed-asset funds, because they must suit all of the three options members can take at retirement: annuity purchase, cash and income drawdown.
- If the scheme’s default fund is deemed no longer appropriate, it can be a major task to move employees on to a new default, requiring consent from individual members.
In mid-2019, The Pensions Regulator (TPR) carried out spot checks on at least 500 trust-based defined contribution (DC) schemes. Its aim was to ensure that trustees were fulfilling their legal obligation to review their default fund strategy and performance at least every three years, and more frequently if there is any significant change in the member profile or the investment backdrop.
Before the Pension Schemes Act 2015, default funds were structured with the assumption that employees would buy an annuity on retirement. Many were lifestyle funds that progressively shifted from a high component in equities at younger ages to more in bonds and cash in the approach to retirement.
Once compulsory annuitisation was swept away, the default fund investment strategy had to be suitable for whatever employees decided to do, whether they take cash, go into drawdown or still prefer to buy an annuity.
However, a lifestyle fund is not suitable for members who want to go into income drawdown, because the progressive switching into bonds in the lead up to retirement limits the pot’s growth just at the time it is at its biggest.
For the most part, pension schemes have instead adopted default funds based on a portfolio of mixed assets, equities and bonds, and perhaps illiquid assets such as infrastructure, which provide growth but also an element of protection as they are diversified across different asset classes.
Default strategy review
According to TPR, trustees should understand the needs of their members before reviewing the default strategy. They need to focus on when employees expect to take their pension, and how they expect to do that, such as taking cash or receiving an income.
Advisers usually say the default fund should be tailored to the scheme’s membership. If the trustees do not already have sufficient information, they can ask employees for their views through interviews or an online survey. If it is not possible to get enough data from employees, they should ask their advisers about their experience of similar schemes.
Ann Swift, senior director, DC investment at Willis Towers Watson, says: “A review can simply look at whether the default matches the member demographics with reference to age, salary and the average value achieved at retirement. It doesn’t have to be a massively expensive and time-consuming exercise. For example, how engaged are members? Are they making higher contributions than the minimum? A high contribution level at younger ages can indicate a greater risk appetite.”
However, discussions about tailoring funds to the scheme’s membership might be misleading, says Nathan Long, senior pension analyst at Hargreaves Lansdown.
“The central issue is: how risky do you make these funds?” he says. “The higher the risk, the better for the employee usually, but the employer does not want staff to be unnerved in times when pension values fall, and dealing with worried members could create a lot of extra work.”
After conducting a review, the trustees must revise the pension scheme’s statement of investment principles (Sip), unless no action has been taken.
If the default fund must be replaced, employees cannot be switched wholesale to the new arrangement: explicit consent is required. This requires a communications exercise, using a variety of mediums suitable for different cohorts.
Regular reviews
For contract-based DC schemes, where investment funds are offered by providers on an off-the-shelf basis, the design of the default fund has typically been a secondary consideration to administration and pricing. However, it is important to regularly review the scheme’s performance and its value for money for employees, including charges.
Sponsors can talk to the Investment Governance Committees (IGCs) that provide independent oversight, and can exert pressure for a change if the fund’s strategy or performance falls short.
Kirsty Ross, senior investment proposition manager at Royal London, says: “One of the biggest attractions of a default investment solution is that it is ultimately the provider [that] takes responsibility, from a regulatory point of view, for ensuring ongoing suitability. This means that it should be easy for employers and their advisers to access the information needed to make themselves comfortable that the default solution is suitable.”
Punter Southall Aspire publishes an annual report on default funds, which shows huge variation in their construction and performance. According to its chief executive Steve Butler, providers with an investment arm, such as Standard Life, may be able to offer more progressive investments than others that do not. For example, Scottish Widows’ multi-asset default fund is statically invested in 85% equities.
Long-term reviews
Many default funds were set up in preparation for auto-enrolment in 2013, so how they might hold up in a crash has not been tested.
Entering the next stage of the investment cycle, likely to be characterised by low returns, pension funds are making higher allocations to assets such as infrastructure and private equity, which are a good fit with the long-term horizons of pensions.
Brian Henderson, director of consulting at Mercer, says: “Default funds have typically enjoyed double-digit returns for five years, but it won’t be so easy going forward. The industry is looking at infrastructure, property, emerging market debt, private markets, anything to get through a low-growth environment. We are also talking a lot to clients about environmental, social and governance [ESG] and impact-related investments.”
Many schemes have been adding an ESG element into the default fund. Since October 2019, Sips must also state policy on ESG issues, and the extent to which members’ views have been taken into account regarding investments.