Default funds – considerations one year on from pension freedoms

Default funds need careful consideration says Jenny Holt, Standard Life head of investment solutions. In association with Standard LifeJenny Holt, Standard Life

Q. How have April 2015’s pension reforms driven changes to default investment strategy?

A. Since the reforms were implemented, the asset mix in the glidepath of many existing default strategies exposes people to potentially unrewarded risk when their pot is biggest. The risk is that they will not benefit from the compensating change in annuity rates following a fall in the value of their funds if they do not go for an annuity.

To address this, many providers have already introduced new investment solutions designed for people who may want to do a variety of things at different times. These new options typically have a well-diversified asset mix right to the end of the glidepath designed to reduce volatility and the risk of large falls in value over the period when people can start taking benefits.

These solutions are being adopted by many employers as it is now much more difficult to anticipate what the majority of employees will do with their pots, and there is risk associated with trying to do this. For employers with a scheme demographic that makes it easier to anticipate member behaviour, some providers are also offering solutions with glidepaths targeting specific outcomes such as drawdown, annuity or lump sum. These solutions are also available on a self-select basis for members who know in advance what they want to do.

Q. Why is future-proofing a default investment strategy so important?

A. Having a default with a structure that allows ongoing changes to be made is now much more important. Those changes can be driven by economic conditions, customer behaviour or further legislative change.

That is an advantage from an employer’s point of view because, as things change, it does not constantly have to consider changing or reviewing its default if it knows that its provider will take on that responsibility. Equally, for advisers who are designing solutions for their clients, these structures provide the flexibility to implement changes without needing to move members into new solutions that, for contract based schemes, can be challenging.

Q. How do challenges differ between trust- and contract-based schemes?

A. For trust-based schemes where trustees are responsible for making investment decisions on members’ behalf, providers can work with the scheme to move existing members into an alternative solution.

For contract-based schemes, most providers’ T’s & C’s do not allow them to move members between options without their consent. This means that members must take action themselves and proactively choose an alternative investment solution. For this to happen, they first need to be aware of the potential risk they are exposed to and then make a decision about what to invest in instead. Some of these customers will have a financial adviser who may already have discussed the pension reforms with them and helped them make changes, but there are many who will not.

As many of these non-advised members are disengaged investors and have previously either avoided making or not had to make an investment decision, providers face a challenge in both explaining the risk to these customers and making it easy for them to pick an alternative option without crossing the line from guidance to advice. Response rates to these types of communication are usually very low, with a recent exercise carried out by Standard Life resulting in only 6 per cent of customers choosing to switch their investment.

This presents a challenge for the entire industry and it will require a co-ordinated effort from employers, providers, advisers, the regulator and the Government to find an effective way of getting as many members as possible into more appropriate investment solutions.

Q. What else can be done to help these members?

A. Communication and opt-in exercises are the only option. Providers can continue to work with employers and their advisers to raise awareness among members and make it easy to change their investment if required.

Employers have a vital role here because there is still an element of distrust of financial services organisations among employees. As a result, they may be more likely to trust messages coming directly from their employer.

And there is an opportunity for advisers to support employees with their decision-making if a scalable process to deliver targeted advice in the workplace can be developed.