Why we need a default option at retirement

Retirees, who normally seek flexibility and income security, must successfully navigate myriad largely unquantifiable risks associated with opting for an income drawdown option as opposed to choosing an inflexible and ultra low-yielding annuity.

The risk of financial market corrections, especially the sequencing risk posed by those occurring early in the decumulation journey, can threaten the preservation of capital in drawdown products with no income security feature.

Good default option design demands equally good default fund design if it is to support a sustainable income withdrawal rate

Unexpected inflation and typically underestimated longevity risk can also limit the chances of reaching a saver’s desired standard of living throughout retirement.

If not managed well, these risks can lead to an uncomfortable retirement at best or, worst case, lead to people outliving their savings.

In response to this, automatically enrolling people into a drawdown default fund at the point of retirement is gaining more and more traction in the pensions community.

Impediments to effective decision-making

With up to 60 per cent of retirement income for those opting for drawdown dependent on investment growth during retirement, making informed decisions on investment and withdrawal strategies at and in retirement is crucial.

Yet, at a time when the decision burden increases immeasurably, effective decision-making is compromised by a typically low level of numeracy and financial literacy.

This is compounded by the vacuum of advice, guidance, and a lack of frames of reference by which to gauge what is feasible and realistic to achieve.

Furthermore, at a time when cognitive ability and the appetite for taking investment risk often starts to decline, and more reliance is placed on gut feel and past experience, retirees are being asked to up their engagement.

Many will have little experience of making proactive investment decisions, having initially selected the default investment option in the accumulation phase.

Are retirees set up for failure by default?

For most people, a well thought out default with opt-outs remains arguably the best possible option given the structural and behavioural impediments to raising engagement levels.

Indeed, as people increasingly become solely reliant on DC pension pots to support their standard of living in retirement, so the consequences of making a wrong decision at and in retirement will rise exponentially over time.

It comes as little surprise that the idea of automatically enrolling retirees with a DC pension pot into a drawdown default with opt-outs continues to gain support.

These products would sidestep the enormous decision burden at the point of retirement, while providing the flexibility and income security most retirees need.

Prominent among these pragmatic offerings are the ‘auto-protection’ proposal by the Centre for Policy Studies' Michael Johnson, and the ‘speedometer’ retirement expenditure plan by the Pensions Institute's David Blake.

Drawing on key elements of both, particularly collectivity, income security and trust-based governance, one solution might be to use the experience and expertise of those mastertrusts with well-proven credentials in the accumulation phase.

In pooling investment and longevity risks, they would determine the default investment strategy and income withdrawal rate for those defaulted, introducing a guaranteed minimum income.

This could be achieved via phased annuitisation throughout retirement, a deferred annuity much later in retirement when long-term care needs become the priority, or both.

Default fund design has to be stepped up

Of course, as in the build-up to retirement, good default option design demands equally good default fund design if it is to meet the needs of a broad consumer base, not least to support a sustainable income withdrawal rate.

A fit-for-purpose decumulation default fund should target a deliverable inflation-plus absolute return objective, while minimising sequencing risk.

So, if retirement is to be enjoyed and not endured, then the thought given by the pensions, asset management and adviser communities to the design and construction of what can be considered genuinely fit-for-purpose default options, ideally with input from the Financial Conduct Authority, must be stepped up.

However, if better individual retirement outcomes are to be achieved, attention must also be given to increasing the number of savers and the level of saving.

Without sufficient consideration being given to both, inadequate pension provision and outcomes could become the default.

Chris Wagstaff is head of pensions and investment education at Columbia Threadneedle Investments