The investment strategy a member follows in their DC scheme can have a big impact on their retirement outcome, but how well are default options doing at delivering results?
We have analysed the long-term returns expected from “off the shelf” investment defaults offered by 15 leading Defined Contribution (DC) providers and found that a 25-year-old today could receive a DC pot at retirement age that is 40 percent smaller than it might have been had she been a member of the best default scheme, not the worst.
Such a stark difference in potential retirement wealth really matters, particularly when we see default participation rates above 80 percent across most industry sectors.
There has to be a risk and concern around the impact on members when they realise their pension pot is much smaller than it could have been had they joined sooner, contributed at a more meaningful level or invested in a more appropriate investment strategy.
Currently, default members are expecting that someone else (employer/trustees) is making investment decisions on their behalf. This places greater importance on employers/trustees to focus on getting that default strategy right.
For a 25-year-old today who puts 10 percent of their £30,000 pensionable salary away every year and retires at 65, the size of their pension pot could be £100,000 smaller than it might have been based on a range of expected outcomes from the provider defaults.
But 'expected outcomes' assume that returns are in line with our assumptions. What happens if things don’t work out that way?
Our analysis also found that a severe market correction ten years from retirement could result in members’ expected pots falling by more than 25 percent for some defaults – typically those carrying more equity risk into the later stages of a default strategy. If that were to happen, a member would have little chance of recouping those losses in full unless they were willing to increase their contributions significantly.
In our view the defaults with the lowest expected outcomes have relatively cautious investment allocations in the early years. They also fail to take enough risk while members are young enough to be able to withstand market volatility. For example some strategies hold as little as 40 percent in equities and may have similar levels of exposure to bonds. Additionally, many defaults fail to diversify their portfolios sufficiently with almost half of the DC providers in our research group only investing in equities, bonds and cash with no allocation to diversified funds or alternative investment classes.
Currently, default members expect someone on their behalf – typically the employer or trustees – to make decisions about when, how much and where they start putting money into a pension. This places great importance on employers and trustees to focus on two key issues:
Designing a default option with the best expected outcomes and with the best risk control is the silver bullet of DC investing, and something that is very hard if not impossible to achieve. The different approaches adopted by providers indicate that there is no consensus on one solution. Yet members are relying heavily on default options and hence it’s critical for the industry to develop and evolve these, and for employers and trustees to understand what their default could deliver and the risks it carries.
We also believe more could, and should, be done to educate and engage with members sooner to get them making contributions earlier – not least because this is the single greatest determinant of how big a pension pot ends up being. Showing a generation that they have control over their retirement outcome won’t be easy. However, employers and trustees who can demonstrate the impact of compounding returns and the benefits of more active control of their investments have the best chance of raising engagement.