This week marks the end of one tax year, and the beginning of the new 2017/18 tax year. For investment ideas, back to basics education and advice from the experts read Morningstar’s Guide to Planning for Retirement.
Thanks to auto-enrolment, by the end of 2018 there will be 10 million more employees in the UK saving into a pension for the first time. But what will they be invested in? More than 90% of workplace pension scheme members are invested in the “default” fund. This is a one-size-fits-all scheme that makes investment decisions on behalf of members, pooled by their age group.
Simplified, the investment strategy is this; the younger you are, the longer you have until retirement, the larger proportion of your portfolio that should be in riskier assets. As the member approaches retirement, the default scheme will de-risk the portfolio on their behalf, moving out of stocks and alternatives and into cash and bonds, prioritising capital preservation over growth.
For the vast majority of savers, the default is the right place to be. Many employees have little interest in markets and would prefer to outsource asset allocation to the professionals. The success of auto-enrolment itself is reliant on inertia – that the member is disengaged enough not to opt out, and over time grows a significant pot of retirement savings.
But there are downsides to the default fund – the fact that it is a one-size-fits-all solution, means that is it unlikely to be the perfect fit for every individual.
Pension Portfolios Made of Passive Funds
Even with wiggle room afforded by industrial scale there is no getting around the fact that active management costs more than passive funds. A 2014 report from Hymans Robertson into the role passive funds within the local government pension schemes recommended trustees opt for wholly passive portfolios.
The report admitted that there were some active funds that performed consistently well relative to their peers, but found that for the local government pension scheme taken in aggregate, equity performance before fees for most geographical regions had been no better than the index.
The report proved prophetic. Fast forward three years, and thanks to downward pressure on fees across asset management and financial services, plus the inflexible implementation of a 0.75% charge cap on default funds in 2015 and default schemes are almost without exception made up entirely of passive funds. An estimated member record keeping charge of around 0.25%, leaving just 0.5% to pay for the investment solution.
While passive funds cover the vast majority of the market, there are certain sectors which analysts argue are better served by active management – which are out of reach for members of the default scheme.
Inflexible Retirement Date
Default funds make assumptions about a member’s retirement date based solely on their age. This is necessary to run a pooled portfolio, and benefits the scheme member by leveraging assets under management to drive down costs.
But what if their assumption about your retirement date is incorrect? Nathan Long, senior pension analyst at Hargreaves Lansdown, says investors should be wary about their scheme’s glidepath – that is the de-risking investment process in the run up to retirement.
“Some glidepaths are as long as 15 years,” says Long. “Which means a scheme will start to sell you out of equities as young as 50. If you are not planning to stop working until 70 this jeopardises the size of your pension pot at retirement. It could mean that you have to put more money in, or accept a lesser standard of living.”
Data shows that the majority of workers do not know their retirement date until as little as three years before the event, meaning taking an investment decision a decade and a half in advance is inappropriate for some.
Low Risk at the Wrong Time
Investing 101 suggests that the longer your investment horizon the higher the level of risk you can afford to take on – maximising your potential for financial reward.
But Nest, the government-provided default scheme disagrees with this. Their youngest scheme members first enter a “foundation” phase, where the objective is to “keep pace with inflation while preserving capital”.
“Our research shows that while scheme members expect to see growth in their savings they’re uncomfortable with the idea of extreme volatility and concerned about things like stock market crashes,” Nest says. “Many people told us that they’d prefer a bit more smoothness in the journey and outcomes that are reasonably predictable. They were less keen on chasing bigger but less likely returns.”
Their idea was that if new investors saw losses in the first few years they might opt out. So instead, the foundation phase is lower risk, building up risk a few years later when their is a bigger lump of capital.
Many other schemes have followed suit, putting investors in their early 20s in lower risk assets at a time where arguable investors should be maximising their exposure to assets offering the greatest upside potential.
Who Should Opt Out of the Default?
The lack of active funds, an inappropriate glidepath or a portfolio which is too low-risk for your investment horizon are all potential reasons to opt out of the default. Investors can instead themselves choose the funds they wish to hold within their workplace pension portfolio. But this level of responsibility is not right for everyone, and ill-informed decisions can damage your retirement prospects.
John Deacon, of Conduent HR Services, says that the debate should be about educating all scheme members to make the right decision for their personal needs.
“Opting out of default funds should be carefully considered and arguably only with the help of an adviser, where the member’s retirement savings strategy is not aligned with that of the default fund,” he suggests.
Long agrees, saying that those that make a success of coming out of the default fund are members who are educated on investing, engaged with the process and comfortable taking on greater levels of risk.
“We have found that of those managing their workplace scheme through our platform 50% of members have opted out of the default, and on average they have seen returns of 3% more a year,” he said. "But these members have high levels of engagement. We do a lot to educate them."
