When it comes to planning a comfortable retirement income, a 'one size fits all' default approach has long been discredited. But is default innovation actually happening, asks Sophie Baker

Research by the National Association of Pension Funds (NAPF) in October 2009 showed that 82 per cent of defined contribution (DC) scheme members simply tick the box on their retirement options form and opt to save into a default fund, choosing to rely on decisions made by trustees or providers for their income post-retirement.

The problem with this, experts say, is that while the decisions made on behalf of members make logical sense, fiscally they do not deliver the kind of cushioning that retirees require.

"The typical default fund would be some kind of global equity product in the build phase, quite often passively managed, and moving into bonds and cash as you get closer to retirement," explains Emma Douglas, head of DC sales at BlackRock. The main focus at the moment for this build phase is to have 100 per cent of savings in equities, she says, a decision based on the assumption that in the early years of an employee's career, a higher risk appetite is justifiable.

However, she says the "building society mentality" of the public is bringing this high risk profile into question: "people like to see things that go up steadily in value. Our member research with the CIPD (Chartered Institute of Personnel and Development) in 2009 showed that people want to get back what they have put in plus a big more on top - if you give them 100 per cent equities, they're not going to get that; they'll get a rollercoaster ride."

The ups and (largely) downs of the equity markets over the last few years are no big news to pension scheme members whose accumulation phase has been adversely affected by the recession. But more worrying for those edging closer to retirement in a default fund is the fact that they are faced with the knowledge that there is no time to claw back the losses, as in the last five to ten years before retirement, they move into a de-risking phase.

"The global equity passive phase configures to cash and long-dated gilts in the de-risking phase, so in the end around 25 per cent is in cash, and 75 per cent in long-dated gilts," says Peter Cox, head of DC services at HSBC Investments (UK).

"That's very much configured to annuity purchase. This may be OK for most, but for some it will not be ideal as they may want to remain invested to go into drawdown, work part-time or have more flexibility."

Communication
Evidence from Prudential shows that just over half of 45-year-olds and over believe they will be forced to delay retirement for between one and five years. Clearly, therefore, it would be sensible for members to take more interest in their post-work income.

"The key to this is rather than communicating with people just before retirement," says Cox, "there should be a targeted communication approach in the lead up to that switching phase, letting people know what's going to happen in the last five or ten years in terms of their fund - and they may have a better idea of what appeals to them. This lets them decide whether being set up to configure with the annuity purchase is right for them."

However, the inherent paradox in this idea is that people who choose to simply tick the default box have done so because they are either not interested, do not have time, or do not understand investment.

Senior investment consultant and a specialist in DC pensions at Mercer, Brian Henderson, explains: "We have to take a temperature check and remind ourselves that [defaults] are for people who are not engaged, and don't want to make a decision. They don't want sophisticated solutions. The best we can do is try and make these products work as well as they can within these constraints."

Graded options
There are options for improving the chances of a reasonable retirement income for members in the DC default, says Richard Butcher, director at Pitman Trustees Limited (PTL). "They need to be actively managed, and they need to be fit for purpose. Default funds are very rarely reviewed, let alone revised. This is wrong," he says. "The best investment strategy now is unlikely to be the best investment strategy as five years ago or five years from now."

Mark Jaffray, senior investment consultant at Hymans Robertson, thinks a number of default funds, into which members can fall into when appropriate, could suffice. "We may well get into two or three defaults, and a different combination for different people." So a kind of lifestyling throughout the default - Nick Leitch, head of investment marketing at Scottish Life, agrees: "A default approach must ensure that the scheme offers a range of risk profiled investments instead of a 'one size fits all' fund, so that members can easily select the risk portfolio that fits their needs and circumstances. A risk of graded options is needed."

Target date funds
Leading the way when it comes to 'innovation' of this sort are target date funds, which were pushed to the fore earlier this year with rumours that the National Employment Savings Trust (NEST) pension scheme was all set to employ a target date fund for its own default, which will be seen as a benchmark for many DC schemes, for better or worse.

Andrew Soper, head of multi asset class solutions, UK, at State Street Global Advisers (SSgA), says target date funds will really come into their own if the compulsory annuity concept disappears. "Target date funds are usually managed through retirement, so that after retirement, the fund enters a drawdown phase. With the last drawdowns in the fund expected to be at least 20 years after retirement, it is appropriate to retain a portion on the fund in growth assets, particularly in the early years post retirement." He argues that target date funds make managing the proportion of the portfolio in growth assets easier, while compulsory annuities effectively force a complete de-risking of the portfolio at retirement, discouraging anything but the current lifestyling approach.

However, how appropriate these products are is disputed by the experts, particularly as the inbuilt defensive design they boast makes them look suspiciously similar to a regular lifestyling product.

Hymans Robertson's Jaffray, for one, argues that they do little more than lifestyle funds.

Space
The other problem target date funds have is slotting into the evolutionary journey of DC in the UK.

"We have to look at what we have in the UK," says Mercer's Henderson.
"We had DB, switched over to DC and created lifestyle arrangements that were designed to get across a similar type of replacement ratio when members retired to their own DB. There has never been a space nor requirement for target date funds."

Other, simpler changes may make life better for 'defaulted' DC members. BlackRock's Douglas and HSBC's Cox, for example, say that white labeling of funds, particularly for big schemes, could be the way forward. This would ensures that the best performing managers are employed at each time, and avoid any communication exercises that may prove confusing or worrying when changing managers.

So change remains at a slow pace when compared to the growth of DC schemes. This, says Cox, has to change. "The spotlight will fall on the default because that's where most people will be, and trustees, in conjunction with their advisers, will need to ensure that it's delivering positive outcomes for members."

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