Dan Leuty: Default risks at both ends of the derisking spectrum

Schemes are adopting a broad spectrum of approaches to derisking. Both extremes of this range have the potential to be extremely detrimental to members says SSGA UK head of strategic DC clients Dan Leuty, UK Head of Strategic DC Clients, SSGA

Retirement was once a much more straightforward affair. The vast majority of people in the UK retired the year they became eligible for their state or defined benefit pension and they bought an annuity with any DC savings they had.

This made designing suitable default funds for DC members simple. Until the recent introduction of the pension freedoms in the UK, all DC defaults looked very similar as they were all targeting the same thing – annuity purchase at age 65.

In order to better align to the new choices now available to members, schemes have introduced a very diverse range of default strategies. Their perspectives on member needs combined with data from investment models have been vital inputs into their changes.

But there are two extreme directions schemes have taken that have the potential to be very detrimental to members – defaults that glide to cash and those that have minimal or no derisking whatsoever.

Firstly, lets look at default funds that glide to cash. A scheme may implement a glidepath that de-risks 100 per cent to cash for a number of reasons. Their members may have significant DB savings or very small DC pots and so be more likely to take cash at retirement.

But it’s important to consider that many members may choose to take their cash at a later date. This is increasingly likely as we see more people working into their 70s and not necessarily needing immediate access to their DC savings.

Members who do choose to leave their money invested are likely to fare poorly from a glidepath with a singular glide to cash. Based on recent rates of return, leaving money in a cash-only solution would lose value in real terms.

For example, someone who had invested £100,000 in cash ten years ago would have seen a return of £12,269 less than inflation – an 11 per cent reduction in purchasing power. With an annualised 7-day LIBID annualised return of 1.33 per cent over the decade to 2016, £100,000 invested in cash would grow to £114,125, more than £12,000 less than the £126,394 the investor would need to keep up with annualised CPI inflation of 2.37 per cent. And that’s before charges.

At the other end of the spectrum, minimal or no de-risking also poses great risks. Many schemes target drawdown at retirement, but with varying approaches. At the more extreme end are those that ignore de-risking all together and maintain member savings in higher-risk asset classes. The potential spread in member outcomes is significant as they are dependent on the vagaries of market returns and the timing of withdrawals. For members who choose cash or to buy an annuity at retirement, sudden market movements can significantly impact the value of their savings.

Other schemes have sought to build additional glide paths for members who may prefer an alternative route to their standard default fund. The decision to switch typically needs to be made around ten years before retirement – a considerable demand. Indeed our own research, conducted in conjunction with The People’s Pension, which explores consumer decision making and behaviours under pension freedom and choice, found three quarters of members changed their mind about what they wanted to do with their savings in the nine months leading up to their planned retirement date.

The best default structures give members the flexibility to make decisions when they’re ready. That means some level of risk management to narrow the potential for extreme outcomes at retirement. It also means reflecting the range of potential choices a member might make.