How to design your DC default pre-retirement phase

Prior to the chancellor’s speech it was all so easy. Strategies were designed to cover the three main investment risks borne by members, as follows:

• Inflation risk: the ability of the investments to achieve a return significantly above inflation, thereby securing an adequate retirement income. Inflation risk was minimised by emphasising assets that generate high real returns, most commonly equities.

• Pension conversion risk: the risk of pension purchasing power changing, due to movements in long-term interest rates. This was typically achieved by investing in long-dated gilts, the theory being that if yields on gilts rise, with an expected corresponding increase in annuity rates, the capital value tends to fall; but conversely if gilt yields fall, with an expected corresponding fall in annuity rates, the capital value tends to rise.

• Capital risk: the risk of the investments suffering a large fall in value. Capital risk approaching retirement can be addressed by building up a cash holding to provide the tax-free lump sum.

Debate has historically centred around active v passive, equity v multi-asset, 'mechanical' lifestyling v target date funds – but fundamentally default funds were all about targeting annuities and tax-free cash.

Generally, not much thought was given to investment strategies for members who may choose drawdown as it was presumed these wealthy elite all had their own advisers.

So where does that leave us in this brave new world beyond April 2015? The biggest difficulty in designing a default option is deciding what you are targeting: annuity, full withdrawal or drawdown.

The strategy you need to adopt if you are targeting an annuity is very different from that you would adopt when targeting full withdrawal of pension savings on day one. This is made more complicated if you factor in drawdown, where the investment strategy will vary enormously depending on whether you are looking at it as a short or long-term solution. 

We should consider if we can learn from other countries who already offer similar flexibility. In Australia, experience shows members do not tend to take all their money on day one.

In the US, drawdown is much more common than an annuity purchase. In the UK, the jury is very much out on whether 'worry-free' annuities will continue to be the most common option or whether drawdown or full withdrawal will come to the fore.

The most common option chosen will also vary from employer to employer, and scheme to scheme.

For many auto-enrolment schemes with close to minimum contributions, in the short term at least it is highly likely full withdrawal will be the most popular option.

Over the next few years, members will be retiring with smaller pots and are unlikely to want small annuities, and their funds will be too small for drawdown. A default option targeting cash could therefore be the most prudent option.

However, as these schemes mature and members accumulate bigger pots, annuities or drawdown are likely to become more popular. With this in mind, schemes need to consider having more than one default option, possibly based on age at entry.

More mature DC schemes with higher contributions may adopt a different strategy, as it is less likely members in these schemes will take their money and run.

Drawdown for these members may therefore be preferred and, in this case, the default investment option will need to be designed to generate a sustainable income post-retirement.

Some trustees and employers may take the view the default should continue to target an annuity – after all, schemes have historically been set up to provide a pension and it could be argued that the government’s intention is to offer members more choice, not change the intended purpose.

Whatever option is chosen, it is more important than ever to educate members as early as possible on their post-retirement options and direct them to appropriate investment strategies. The danger is the government’s guidance guarantee will come 15 years too late for many members.

Martin Thompson is a director at Premier