New demands on defaults

The new audience for default funds will have to be dealt with in a different way says Hamish Wood, head of investment sales at Aegon

Over the next few years over 10 million individuals will start to save towards a pension as a result of auto-enrolment, with the first staging date due to happen in October this year. There may be many reasons why these individuals have not started saving towards a pension, from lack of knowledge to inertia to a genuine mistrust of pensions. For auto-enrolment to have the intended consequence of all relevant employees making provision for their retirement, generating confidence in pensions is key to individuals staying with it and not opting out.

Perhaps the most crucial factor in building confidence is the design of the default fund. Typically more than 80 per cent of members of a DC arrangement, whether trust or contract, invest in the default fund. Auto-enrolment is likely to result in a higher percentage relying on the default.

As the nominations in Corporate Adviser’s Ultimate Default Fund surveys have shown, there is no universally accepted view as to what approach makes the ideal default fund. There is however clear guidance as to the factors that should be taken into account.

There are two primary sources of guidance; the DWP paper issued in May last year and the Investment Governance Group (IGG) principles issued in 2010. The IGG was established by the Pensions Regulator in 2008 and aims to bring the Myners principles, first proposed in 2001 for DB schemes, into DC. The DWP guidance for default funds under auto-enrolment was largely based on the IGG principles. The default fund has to be fit for purpose delivering a good outcome for investors.

The structure needs to take account of the diverse range of individual risk tolerances and varying periods until retirement that will apply to all workforces. It must also take account of the specific objectives of the fund, how are they monitored and communicated and the amount of risk taken by the fund to achieve its objective. From the investors’ perspective this means how volatile the fund is likely to be rather than how far away from the relevant benchmark the manager can move.

As the nominations in Corporate Adviser’s Ultimate Default Fund surveys have shown, there is no universally accepted view as to what approach makes theideal default fund

It should also consider the glidepath that is in place as individuals approach retirement, the level of charges, their appropriateness to the fund structure and how they compare to charges for other fund types.

The guidance also makes clear that the responsibilities of each party involved in the pension should be clear and there should be effective governance of the default fund.

Traditionally, default funds have either been global equity or balanced managed options with a lifestyle approach. However the volatility of equities, and losses made in 2008, has caused attention to turn towards building default funds that better manage volatility, while offering a similar growth potential to equities. Diversified growth funds which invest in a much broader spread of assets than conventional managed funds are often central to these new structures. Target date funds with an element of dynamic asset allocation and funds targeting a specific risk also form part of the new thinking about defaults.

One challenge facing the industry is how to implement some of the new default thinking for contract plans. Diversified growth and the other funds mentioned have higher costs than conventional passive equity or managed funds. If they are used as the default, or a part of it, the charge will be higher than for some of the other funds available to individuals. Under an occupational DC plan, the Trustees can implement a default approach with higher costs if they believe it appropriate. However under a contract arrangement it is more challenging for the provider or adviser to put forward a default with higher costs.

It will also be interesting to see how the market develops in terms of adviser nominated defaults. Auto-enrolment means that an individual must not have to make an investment choice. The current joining process employed by many providers pre-populates the application form with a fund choice. That fund may not be the provider’s own default but will have been selected by the adviser in the belief it is the most appropriate for the employer’s workforce. Under auto-enrolment, if the adviser does not use the provider default, the adviser becomes the responsible party for the default. This has implications for their ongoing role and potentially the FSA permissions required.

There will be plenty more debate about default structures and responsibilities. One aspect though is clear. All those in the industry have a duty to develop default funds that will deliver good customer outcomes.