Inflexible DC defaults fail members, study finds

Member loss aversion should be the primary consideration when designing a DC default fund, a study from the Pensions Institute has argued.

Schemes looking to apply the latest behavioural economic theories to their default design have been urged to follow three practical steps: review the existing default fund, research the membership needs and monitor outcomes.

This process should ensure default funds are design to better reflect member needs, and help them maximise their retirement income. It would also reduce the chance of members being exposed to unnecessary and unwelcome risk.

The report, which highlights the benefits of a target-driven approach to default design, has found support from the National Employment Savings Trust (Nest) and DC data analysts DCisions.

“This research suggests – once again – that DC is more nuanced and complicated than the industry has thought,” said Nigel Aston, business development director at DCisions.

“A DC plan can only succeed by taking into account the differing circumstances, behaviours and objectives of its members. Treating everyone the same – as is the case with DB – just doesn’t work.”

The Pensions Institute research recommended more sophisticated default funds which react to changing market conditions in an attempt to mitigate losses.

This is due to the report’s findings – supported by wider behavioural economic theory – that people have a high tendency to risk aversion.

“Investors suffer from behavioural biases and are prone, among other things, to overconfidence in their investment abilities, regret and, especially, loss aversion,” said Professor David Blake, co-author of the report and director of the Pensions Institute at Cass Business School.

“They also tend to monitor the performance of their portfolios – particularly their long-term portfolios – too frequently.

“As a result, they tend to become risk averse when winning and sell winning investments too quickly. They also avoid cutting losses and even take extra risks when they have made losses.”

Review defaults

The research argued the traditional approach to default design – which it termed ‘deterministic lifestyling’ – was too mechanistic and did not take into account members’ attitude to risk and their career salary profile.

It therefore recommended a number of default options which are aimed at achieving a desired target pot size at retirement.

Aston said: “Our research shows most defaults are still largely undiversified blunt instruments investing almost entirely in equities regardless of market conditions and scheme differences.

“This may be fine if the members can tolerate a bumpy ride, but our findings show that a significant number react adversely when they see their savings fall.”

The report called for more sophisticated funds which could react to market conditions, thereby not exposing the members’ savings to too much risk.

Mark Fawcett, chief investment officer at Nest – which is offering a series of target date funds as its default option – said he supported the view that risk should be managed right through the savings career.

“You should not be taking excessive risk just because markets are doing really well,” he said. “If markets have done well, you should be banking some gains because you are looking to achieve your target.”

Research membership needs

Nest undertook a great deal of research into its target audience as part of the default design process. This looked in detail at their attitude to loss aversion – particularly in the early years – and their appetite for saving at different points in their career.

Fawcett said it was hard to provide generic tips for schemes undertaking research of their membership, but added: “It’s important to understand your membership and design the default fund around that membership.

“Different demographics will have different attitudes to risk and different savings cultures.”

Aston said schemes should treat their members like individual, diverse consumers and pointed to the example of supermarkets using data on their customers’ spending habits to better serve them 

Monitor outcomes

The Pensions Institute recommended schemes design their defaults to focus on what members would achieve when they retire and how this fitted in with the rest of their retirement income.

In practice, this meant making use of annuity-matching investments towards the end of a members’ working life 

Fawcett said Nest’s default funds would aim to be 75% invested in annuity-tracking funds and 25% in cash when the member reached retirement, but said this strategy could change if more low-cost drawdown products were made available to Nest’s target audience.

Aston added funds should focus on the outcome for the individual, rather than the performance against a benchmark.

“Consumers largely don’t care about benchmarks,” he said. “The only important question in DC is this: are people on track to get the retirement they expect and deserve.”