Many defined contribution (“DC”) pension plans were established before April 2015, when “Pension Freedoms” came into effect. Until then, most people bought an annuity at retirement and even those who had initially adopted “income drawdown” were obliged to purchase an annuity with their residual funds by age 75. The advent of “Pension Freedoms” changed all this …
There is no longer a requirement to purchase an annuity by age 75, so interest in income drawdown has greatly increased. 100% cash is another option but can attract a significant tax charge.
Annuities have also fallen out of favour because they appear expensive (a £100,000 fund today would produce an income of around £4,500 per annum at age 65) and because income drawdown funds can be passed through successive generations (and to others) on death.
Sponsors of all types of DC pension plans need to review the default investment strategy of their plans to establish if they reflect current retirement choices. If the default investment strategy no longer reflects members’ choices, it needs to be changed.
There are usually two phases of pension plan investment; the “growth” phase and the “de- risking” (“lifestyle”) phase. The latter typically runs for five years although some schemes have lifestyle phases as long as 15 years. Analysis carried out last year by one of the leading UK pension providers identified a shorter period as being more appropriate, on the basis that to “de-risk” too soon would severely limit potential growth.
This leaves us with two investment phases to consider, with the growth phase running until say five years before a member’s selected retirement date, and a lifestyle phase then running up to retirement (the “end-game”).
Bearing in mind that this is to be a default fund, we should not be taking too much (or too little) risk in either phase.
Diverse views exist on what might be an acceptable level of risk during the growth phase of investment. Those with younger staff who are financially aware are likely to favour a higher proportion of equities than companies with a more balanced age range. In companies with a workforce that is a more representative cross- section of society, we might expect to see 60% 75% equities in the default investment portfolio.
Passive (“index”) funds are widely used for default investment strategies, as these tend to attract low charges and funds can be found in most markets of the world (both equities and bonds).
A further consideration is what proportion of equities should be sourced from the UK stock market and what should be sourced from overseas markets. Although the FTSE 100 Index has performed better in early 2019 than might have been expected (possibly because many FTSE 100 companies do much of their business outside the UK) considerable uncertainty remains.
Lower-paid workers (end-game)
Lower-paid employees rarely enjoy contributions much above auto-enrolment levels so their funds tend to be smaller. Such employees are more likely to take their entire retirement fund as cash (25% of which would be tax-free). A default investment strategy targeting cash might therefore be more appropriate for this cohort than one targeting income drawdown. This could be achieved by selling growth assets in equal tranches over the five year period leading up to retirement, replacing them with investments in a cash fund.
Nearly everyone else (end-game)
Income drawdown is becoming the most popular retirement choice so the objective is to create a portfolio that represents a lower degree of investment risk than might be considered appropriate during the growth phase. Few would be prepared to accept a level of investment volatility in retirement that seems acceptable whilst working.
Holding around 40%-45% equities (suitably diversified) at the point of retirement could provide a reasonable balance between risk and growth potential for those with a “middle-of- the-road attitude to investment risk, who adopt income drawdown.
Individual investors are recommended to seek advice periodically whilst in drawdown because their objectives may change and asset allocation can go awry if disinvestments are made from the “wrong” funds or one asset class performs substantially better (or worse) than another. It is therefore prudent to seek to rebalance the residual portfolio periodically.
Action for employers
A good course of action for employers is to commission a consultancy to review their plan’s default investment strategy. Bearing in mind that many schemes which target annuity purchase are likely to have been established before 2015, it is almost certainly time for a full review, which would also include the default investment strategy.