Which retirement option should your default strategy target?

First, it suggests that retirement happens at a particular point in time that you are able to predict. Second, it implies there is a choice between discrete options and that pension schemes only need to pick one of those.

Look at lifestyle in a different light

Retirement in its traditional sense no longer exists. The current reality of individuals working later in life, closely interlinked with the increase in part-time working, means that nobody really knows when they are going to retire. In fact, most of us might not retire fully and may continue with a part-time occupation.

Therefore, it is no longer correct to consider defined contribution pension savings as a two-phased process that ends with retirement. Today, DC savings can go well beyond the usual retirement date, as people are able to withdraw funds from their pension from the age of 55, while continuing to contribute into their scheme. This adds one more ‘access’ phase to the typical lifestyle:

The bottom line is that, when constructing a default strategy for a DC pension scheme, it is important to look at lifestyle in this whole new light, well past retirement.

Focus on glidepath length

In terms of default strategy design, this has implications for the length of the glidepath in the consolidation phase. A short glidepath can be detrimental, as the savings will not be moved into lower risk funds until quite late in the savings process.

At that time, pension pots are at their largest, so even small falls in the financial markets would mean substantial losses in monetary values. In addition, if a member takes partial withdrawals from age 55, they could suffer from sequencing risk. This means if they take a withdrawal at a time when financial markets are down, it could be very difficult to recover the lost value once the markets pick up again. 

As a result, it is appropriate to have a longer glidepath – at least 15 years – that aims to derisk members over a longer period. This would crucially take some risk off the table by the time they are 55, providing a degree of protection for members’ pots, should they decide to access their savings early.

While this lowers the expected return, because there is less time spent in higher growth assets, the reduction in volatility of outcomes at the most critical time is of greater benefit.

Designing the access phase

When we talk about the target that a default strategy should have, this would be contained within the access phase. A better approach to default construction would be to analyse a particular scheme’s membership in greater detail to understand people’s needs and preferences.

However, in the absence of scheme-specific data, the key observations of member behaviours post freedom and choice can be a good starting point:

• There are a lot less people buying annuities

• A sizeable proportion of people go for a full cash withdrawal

• The majority of people are taking income directly from their savings

The implication for the design of the access phase is that people will be accessing a combination of outcomes over time, therefore lifestyling them into a discrete outcome on a specific date introduces a plethora of unnecessary risks.

Instead, default strategies should help savers to continue to profit from investment returns with a slowly decreasing level of risk until such time as they are ready to make a choice. There is nothing then to stop them from cashing out their holdings, or buying an annuity, or starting to draw income at any time they are ready to do so.

A default strategy is supposed to provide for the needs of an average investor, and such a combined approach to the access phase most closely reflects this average position.

Maria Nazarova-Doyle is investment consultant and head of DC investment consulting at JLT Employee Benefits