For those designing a suitable default investment strategy for a defined contribution (DC) pension scheme, an important issue to consider is members’ behaviour. The investment result of the pension scheme during the early years has very limited impact on the final retirement outcome but can hugely influence members’ faith in the value of long-term saving and investment. We know that the best DC results come from early and material commitment to appropriate levels of pension contribution. Poor experience is likely to blunt any appetite for pension savings and, at worst, lead to complete disengagement.
A study of 25,000 UK DC pension savers in December 2007 and September 2009 (i.e. immediately before and after the financial crisis) found that contribution rates and fund-switching activity, which had been trending upwards during preceding years, fell in the immediate aftermath of market lows.
(NEST: Improving Consumer Confidence in Saving for Retirement 2014, see Chart 1).
For members to remain engaged, the default must not only deliver good consistent outcomes but must also match their risk expectations.
Another critical challenge for scheme providers is that there is no one default design that will optimally meet the needs of all its members. That being the case, how do we decide whose needs are paramount? In our view, it is a mistake to try and cater for the ‘average’ member; the wealthiest have means and access to independent advice and so will remain in the default only if it happens to be aligned with their needs. Those who make little or no commitment to the scheme in terms of contributions cannot reasonably expect to rely heavily on the outcome. The needs of these two groups should not therefore be foremost in the design of the default investment strategy.
The default fund is the engine of growth that is vital in delivering a good outcome for those who are truly dependent on the scheme to sustain their living standards through retirement. We argue that default fund design should prioritise the needs of committed savers, the ‘squeezed middle’ who are most dependent on a favourable outcome but have limited resources. With this in mind, how can we change the default strategy to materially improve the results for this group?
We challenge the traditional DC default ‘lifestyle’ approach geared towards tax-free cash and annuity purchase. Now that we have pension freedom, annuity purchase is uncommon. Rather, we should provide for the reality of continued investment activity into retirement, that much is clear. However, equally anachronistic is the typical cash pot that is typically built up in later years to provide tax-free cash at retirement.
For the squeezed middle, for whom the pension is critical and likely to be only just adequate, these assets are unlikely to be spent rashly. We question the logic of building up a large and unproductive cash pile in the lead-up to retirement. It would surely be more beneficial for these assets to continue being invested for growth through into retirement to seek a better outcome.
In our new paper (Rethinking DC Default Design – budgeting for behaviour) we show how ‘tax-free assets’ in place of tax-free cash would work in practice. We also explore members’ behaviour and why it is vital to take it into account when designing the DC default investment strategy.
The value of an investment is not guaranteed and can go down as well as up. An investor may get back less than they invested. Tax rules may change.
To find out more, visit www.standardlifeinvestments.com/dc