Default funds – the quest for the ideal

Martin Palmer, Head of Corporate Pensions Marketing, Friends Provident

Accepted wisdom is that default funds that deliver according to expectations are the way forward. But is there such a thing as the perfect default fund or should we conclude that it is the financial services equivalent of the Philosopher’s Stone?

This was the subject of a Friends Provident survey and debate at the recent Corporate Adviser Summit. There seems to be broad agreement amongst EBCs and advisers that there are several key approaches that could deliver a more “optimal” default fund.

It is now taken as read that upwards of 90% of DC investors wind up in the designated default fund. The advisers at the summit agreed unanimously that the vast majority of these members assume, rightly or wrongly, that the default option is actively managed to deliver a good retirement income against all market conditions, and will provide good performance with relatively low risk! “Set and forget” is what the majority of DC investors want and expect. Despite all good efforts to educate and encourage active choice, the majority of advisers present acknowledged that education still hasn’t changed investor behaviour. That’s why many felt it was time for the industry to shift its view of the default from the “last choice” to the “best choice”.

The consensus was that in this light an optimal default fund would:

  • provide maximum diversification to deliver returns while controlling risk
  • be actively governed with regard to asset allocation
  • utilise passive underlying funds to the greatest possible to minimise cost
  • be managed over the long run with lifestyle overlay to de-risk approaching retirement.

When it came to discussing existing approaches, the group broke down into two clear camps: 40% had been using Passive Global Equity (the majority using 50%/50% UK/Global) as the default option, while the other 60% opted for Managed Funds (mostly balanced funds, but some bespoke fund of funds). All used lifestyle overlays already, with 75% of the group recommending that de-risking begins between 7 and 10 years from retirement.

In looking at the future, 60% of advisers consider diversified growth funds as ideal candidates for the core “growth” asset for default funds, given their wide diversification across asset class. The view is that they seek to achieve roughly similar overall growth to equities, but with just half the value at risk through very broad diversification across domestic and global equities, and fixed interest as well as small allocations to alternative assets such as property, private equity, commodities, infrastructure. One participant captured the overall sentiment in saying, “It’s more about diversification of risk, than diversification of return”.

One EBC suggested incorporating diversified growth into a long-term lifestyle strategy, where the first fifteen years in a plan would be invested in passive equity, then switched into diversified growth, followed by subsequent de-risking into bonds and cash, at the 10- and 5-year stages.

A surprise result was that more than 20% of advisers suggested that an ideal default option would incorporate some form of downside protection whether through a CPPI overlay or other mechanisms. Many thought the industry should revisit the concepts of “guaranteed value at retirement date” through new vehicles that overcame the lack of transparency that has historically plagued With Profits. All agreed, however, that additional protected versions probably could not be offered as the “default” due to higher cost.

With these kinds of robust and diversified options, many at the summit suggested it is time to revise the term “default” fund to something that more accurately befits the role these key funds will play in building investors’ retirement nest eggs. In conclusion, there is plenty for the industry to take on board and this is an area where we should expect significant developments.

Martin Palmer

Contact: m.palmer@friendsprovident.co.uk
or follow Martin on Twitter: www.twitter.com/PensionsWomble.