Default to Alpha

Actively-managed and well diversified default funds will become increasingly attractive as employees engage with their DC pots says Charlie Crole, institutional director at Jupiter Asset Management 

Charlie Crole, Jupiter
Charlie Crole, Jupiter

A bird in the hand is worth two in the bush, but is it worth three? The answer depends on when we expect to get the birds and our ability rationally to discount the future. Alas, we are not good at this. 

It turns out that we are hard-wired to prefer small payoffs now over larger payoffs later. When offered the choice between £50 now and £100 a year hence, many plump for the £50 in hand. However, when given the choice of £50 in five years or £100 in six years, almost everyone chooses the latter, despite it being the same choice seen at five years’ greater distance. This irrational flaw partly helps explain both the popularity of the National Lottery and why people are not saving enough for their retirement.
It is not just about present and future rewards but about present and future selves. Our inability to imagine ourselves in old age makes saving seem like a choice between spending money today and giving it to a stranger many years from now, because your future self is not “you”. This impedes successful retirement planning; hence the need to encourage suitable contribution levels via the soft coercion of auto enrolment and the imperative of offering default fund choices that can deliver good investment outcomes.
William Sharpe and others have shown one way to clear the first hurdle. Using virtual reality headsets, young people were shown highly realistic versions of themselves as they would be when they are old. In one experiment, young people who saw their elderly avatars reported that they would save twice as much as those who did not. The potential here is promising. With permission, an employee’s photo could be agemorphed and included in the annual pension statement to encourage them to increase contributions.
This takes us to the second hurdle, the nature of a default fund option itself and its implications for the 90 per cent of employees who seem likely to invest in one. Forty years ago the main risk when planning a pension was the premature death of the family breadwinner. Today it is more likely to be pensioners outliving their savings. According to the Association of British Insurers, the average pension pot available to buy an annuity in 2010 was under £26,000. This makes the ultimate investment return vitally important in helping to deliver better retirement outcomes.
Default funds exist so that no member is, explicitly, required to make an active choice about the investment of their contributions. The choice of this default is therefore crucial. With the current focus so much on ‘costs’, often at the expense of ‘investment outcomes’, too many schemes offer only simple, passively-managed defaults. These often offer little by way of dynamism or diversification.
This unsatisfactory state of affairs has not gone unnoticed by oversight authorities like the DWP and The Pensions Regulator who increasingly cite multi-asset diversified funds as crucial to the success of defined contribution schemes. Indeed, in an era of high investment volatility and subdued returns, extracting the best risk-adjusted returns from pensions savings is vital, something that is sometimes in danger of becoming over-looked. Dynamic and actively managed investment strategies are important tools in helping achieve this.
Anecdotal evidence points to increasing investor engagement on such issues. In Australia, for example, evidence suggests that once a pension pot becomes larger than half of their salary, employees begin to take an active interest. Like the youngsters who saw their elderly avatars and vowed to save more, employees are likely to become increasingly motivated as their pension pots grow. Given the new easy-to-grasp flat rate state pension, employees will come to understand that their DC pension is not primarily for survival. Rather it is an additional source of income to provide a better quality of life, with the difference being made at the margin: will they holiday in St Albans or St Lucia? This realisation will increasingly affect the investment options they demand.
As expectations in retirement continue to outstrip likely retirement income, advisers must consider how to help savers maximise the value of pension savings. In the current uncertain and volatile environment, actively-managed and well diversified default funds will look an ever more attractive way of helping achieve this.