Money-purchase or defined-contribution (DC) pension "default" investments can be seriously flawed, and yet they are used by 85 per cent of scheme members, according to actuarial consultants. If you don't check for suitability before you invest in the default option, you could end up in the wrong asset classes for your age and circumstances and suffer poor investment management.
DC pension arrangements build up a fund to provide an income at retirement. You can either draw that income directly or use the fund to buy an annuity from an insurance company, which pays the guaranteed lifetime income. Either way, the income will depend on the size of your fund at retirement, and this in turn will depend on making the right level of contributions, investing in the right funds and avoiding excessive charges.
Choosing funds that are just right for your changing circumstances can be hard. So almost every money purchase scheme offers a "default" option, usually selected by the employer or trustee.
Research from UK consultants Lane Clark Peacock (LCP) and Hewitt Bacon Woodrow reveals that about 85 per cent of members use the default option.
"These employees are unlikely to check what type of fund this is or how well it is run," says Ms Sally Bridgeland, an associate with Hewitt. "What's worse, members may assume that it is recommended personally by the employer or trustee."
In older schemes, the default might be a single fund run by a life office. Where DC schemes offered life office managed unit linked and with-profits funds last year, 22 per cent and 19 per cent respectively of the entire scheme assets were invested in these options, according to the 2003 survey of pension schemes by the National Association of Pension Funds in the UK.
For most members, such deals may prove a poor compromise for such a long-term investment. Both rely on a "balanced" approach to asset allocation and this could mean anything from 30-80 per cent in equities, depending on the provider's view of world markets.
Some of the life offices that run unit-linked funds have a poor reputation for asset management, while many of the with-profits providers are unable to provide attractive returns currently because they are financially weak. This constrains their investment philosophy and forces them into a very low-risk/reward strategy.
A more sophisticated default option is the "lifestyle" fund. This recognises that your risk profile and asset allocation requirements will change according to the number of years to retirement and moves you from equities to gilts and cash over the past few years.
The aim is that, by retirement, you will have 75 per cent in bonds and gilts to align you with the assets that back annuities, and 25 per cent in cash to provide your tax-free lump sum. So sudden movements in the markets will not significantly alter your annuity income and tax-free cash expectations.
"While traditional lifestyle models were the best default available until recently, we recognise that they have weaknesses and we believe it is important that those who offer this option should appreciate these potential flaws," says Mr Jonathan Camfield, a partner with LCP.
Ms Bridgeland adds: "Lifestyle is a one-size-fits-all solution. Ideally what members need is a range of lifestyle funds to match their circumstances."
The biggest problem with lifestyle is that, as a dynamic asset allocation model, it links the phased switch from equities to gilts purely to your term to retirement, at which point it is assumed you will buy an annuity.
This is not a flexible model, nor is it responsive to stock market conditions. In practice, few employees can predict their retirement date with certainty. An unexpected early retirement/late redundancy could pitch you into the annuity purchase market at precisely the wrong time. Nor does lifestyle cater well for those who go in to drawdown, as the move into bonds and cash will be premature.
A better alternative is, for example, a simple choice of asset class funds. Behind the scenes the consultant or a separate manager of managers will ensure that each fund is run within strict risk/return parameters and will hire and monitor the underlying managers. The investor gets access to top managers within a range of asset classes, all via a single pension investment vehicle.
While multimanager asset class funds are ideal for the more knowledgeable investor, many members would still prefer a dynamic and automated asset allocation strategy.
One second-generation lifestyle model is "DCisive" from LCP.
The model uses a mathematical formula that links the automated switch from equities into bonds primarily to actual performance rather than to the period to retirement. This locks in gains in favourable markets by switching a proportion of the member's fund to bonds when predetermined targets are met.
Regular reviews and easy internet access allow each member to keep abreast of progress and to take timely decisions to reduce or increase contributions where this is necessary to keep on target for the desired retirement income. The idea is to take the unwelcome surprise out of DC retirement arrangements.
But bear in mind that, even with a sophisticated lifestyle strategy such as DCisive, much will depend on the trustee or employer's choice of investment managers for the equity and bond funds.
A well-monitored multimanager structure is ideal provided the costs do not undermine the return. - (Financial Times Service)
