How to use bonds in default funds after freedom and choice

The role of bonds to match annuity purchase at retirement has diminished. The experience of member choices at retirement since April 2015 is starting to come through.

Whatever the expectations for the picture nationally, and also for a given scheme, the proportion of retirees purchasing annuities may be quite low and default fund blending towards 75 per cent bonds at retirement is no longer appropriate for most schemes.

A difficulty is that future member choices are unknown. Patterns may change. Members themselves may not know their retirement intentions.

The answers however remain vital because most members do utilise the default strategy. A solution therefore has to cater for unknown patterns of needs as best it can.

Allocation strategy

Most new designs are seeking to allow for a proportion of members to use drawdown after retirement.

This has to allow for a possible post-retirement drawdown allocation that may imply a mix of growth types of funds, bonds and cash.

This means the pre-retirement strategy will phase towards such a mix, but with a higher allowance to bonds and cash than would be implied merely by the drawdown mix.

Bonds have significant capital risk for members who may be taking benefits as cash, and the longer-term drawdown member may need a more growth-orientated allocation

In some way, this moderates for members who may wish to take cash lump sums or purchase an annuity – a mix of all worlds, it could be called.

This may take growth assets from a very high percentage before the phasing period towards somewhere in the range of 35 per cent to 40 per cent at retirement. 

The bond fund-type allocation may be, for example, 20 per cent to 40 per cent. This compares with a pre-freedom and choice bond allocation of commonly around 75 per cent at retirement.

Points to bear in mind

Communication is vital, and the need for more communication in the years before retirement is acute.

When changing default funds it needs to be determined whether the change applies to members currently near retirement, leading to potential investment switches, or only to those not yet in pre-retirement phasing.

Members must be informed clearly that they have many choices at retirement. The default fund cannot be ideal for all, and indeed may be very inappropriate for some – for example if an annuity purchase or cash lump sum is intended.

Although there needs to be a central default mix, options targeting cash, annuity purchase, and growth-orientated, longer-term drawdown should be retained if possible, allowing individual choice for members who have clear intentions for a given route.

Members must be told they can choose these options but that if they don’t, the default will be whatever mix it happens to be.

During the pre-retirement phasing, members must be frequently reminded of their current choice and the ability to change. Clearly, the easier it is to change the better.

Importantly, this is specific to each scheme or workplace pension. For example, if most retirees in the near term may have reasonably modest funds at retirement, then the percentage of retirees taking cash sums may be very high, which materially impacts default design.

But there is no exact science here. Experience since freedom and choice is new. Future member retirement choices are unknown, and even most members won’t know their own intentions.

Overall there is a role for bonds because they remain a natural match for a stream of income, whether in an annuity purchase or in drawdown. They also have lower volatility than growth assets.

However, they have significant capital risk for members who may be taking benefits as cash, and the longer-term drawdown member may need a more growth-orientated allocation. The allocation of bonds will reduce; the task is to find a good balance.

Colin Richardson is client director at professional trustee company PTL