Changing demographics, freedom and choice, and low member engagement has complicated default fund design. But there are options to help ensure trustees and members alike are satisfied with the investment outcome, finds Luisa Porritt

Role of the default fund

Default funds came about as a response to low engagement of scheme members in their pension investments. According to consultancy firm JLT Employee Benefits (JLT), member data shows that an overwhelming proportion of individuals–at least 80%–are invested in default funds, even those who work for financial services companies.


This is understandable, as default investment strategies typically outperform individual retail investors’ decisions, says David Hutchins, UK head of AllianceBernstein’s multi-asset pension strategies business. Sweden’s government also conducted a study on the outcome of individuals’ decisions, which found their pensions performed less well than the default, says Alistair Byrne at State Street Global Advisers.

Default funds invest members’ contributions on their behalf should they fail to choose an alternative.

Traditionally, a pension fund switches from riskier to less risky assets as retirement age approaches, involving shifts from equities to bonds to cash at different stages of the de-risking process, known as ‘lifestyling.’

There is no one size fits all anymore”

This is much easier to manage in a Defined Benefit (DB) world, whereby members tend to retire at the age of 65 and are owed a specific income based on their earnings and years of service to the employer.

But in a Defined Contribution (DC) context, which will increase alongside auto-enrolment, trustees have the difficult task of finding an appropriate strategy for members who may retire as early as 55 and do not know what they want to do with their pension pot.

“There is no one size fits all anymore,” says Maria Nazarova-Doyle, deputy head of DC investment at JLT. “It’s a serious decision to choose to take cash and deny investment returns,” she adds, saying that what from JLT has observed, only 10% of individuals now purchase annuities, compared to 90% last year.

Trustees’ responsibilities in creating and monitoring the fund

“The default fund has to be appropriate for as many members as possible,” and this requires understanding average member behaviour and risk profiling, says Nicola Rawlinson, client portfolio manager within J.P. Morgan Asset Management’s global multi-asset group.

The default fund has to be appropriate for as many members as possible”

The Pensions Regulator has laid out guidance as to trustees’ responsibilities when it comes to investment strategy and fund performance, including for default arrangements. It emphasises the need to ‘regularly review and monitor investment options’ to ensure they remain suitable for members and meet their objectives and performance targets.

From April 2015, it became mandatory for trustees to state investment principles for default arrangements. And the regulator said trustees must ensure the strategy and performance of any such arrangements are reviewed at least every three years.

Default fund investment techniques

De-risking as retirement approaches is a common technique of the default fund, though not all commentators agree as to when the strategy should be implemented and to what extent, given variance in individuals’ retirement ages, goals and circumstances.

According to Legal & General Investment Management (LGIM), there are three main de-risking approaches trustees can adopt:

1) Assumptions-based de-risking: trustees make assumptions on likely retirement ages and choices and de-risk members accordingly.

2) Partial de-risking: partially de-risk members as they age, while recognising many individuals prefer some de-risking over time but may make different retirement decisions.

3) Decision-based de-risking: keep individuals in their ‘steady growth stage’ asset mix–what they might be invested in between the ages of 50 and 55 for example, until they indicate a likely retirement decision.

All of these approaches however carry risks, including market and conversion risk; loss of return potential based on retirement timing; and product mismatch.

White labelling

White labelling is proving popular amid regulatory change, as this ‘unbranded’ approach allows employers or trustees to adapt underlying funds and investments without communicating every change to members. White labelling removes the need for communication on, for example, a change of fund manager, which few members tend show interest in, as long as the type of fund and its objective does not alter too much.

The same rationale is driving take-up of target date funds (TDFs) against the more traditional lifestyling approach. TDFs allow for simple changes of a fund’s asset mix, important in a volatile investment and regulatory environment. Simon Chinnery, head of UK defined contribution for J.P. Morgan Asset Management, thinks automatic switching into a 25% cash structure is no longer appropriate, and that schemes should be seeking a professionally managed ‘glide path’ attuned to different ages.

TDFs allow for simple changes of a fund’s asset mix, important in a volatile investment and regulatory environment”

Hutchins at AllianceBernstein thinks this single-fund approach allows for different strategies at the same time as providing trustees with transparency on performance. With lifestyling, members tend to incur transaction costs via selling and purchasing of different funds.

Trustees are becoming more interested in this approach as they find it useful to set a desired outcome with a fund manager and track their performance against that objective, says Hutchins. TDFs also provide access to a wider range of illiquid investments, such as infrastructure, property and private debt.

Master trust NEST has been an early adopter of the TDF approach. But NEST’s decision is more the exception rather than the rule. A culture of inertia means many schemes remain attached to lifestyling, even if that may be costing members investment returns, while few have caught up with the implications of changing demographics.

Monitoring the default fund

Trustees must still be able to hold managers to account, regardless of approach, warn providers and consultants alike. “The investment issues are the same whether you are in lifestyle switching or a TDF,” says Emma Douglas, head of DC solutions at LGIM. “Trustees need to monitor and understand what is happening and where members should be at retirement,” she says, adding both strategies are valid but require the ability to ‘look through’ performance.

Amid complex changes, the onus on trustees of monitoring the default fund has grown. Advice is becoming more important than ever, particularly for schemes which do not have the internal resource and expertise to effectively monitor that a fund is achieving what it should.

This has created an opportunity for consultants, such as JLT, which is bridging the gap between fund managers and trustees by advising managers on product design.

Trustees need a consultant to help them find a strong multi-asset manager and carry out appropriate due diligence”

“Trustees need a consultant to help them find a strong multi-asset manager and carry out appropriate due diligence,” says Nicola Rawlinson at J.P. Morgan Asset Management. But some consultants are straying into an awkward middle ground between being an investment manager and adviser, creating conflicts of interest, says Hutchins.

Some believe schemes should focus more on increasing member contributions, as long as a robust governance process is in place. The degree of regulatory pressure on trustees–the Pensions Regulator has asked them to adhere to 31 principles–is another reason experts think such decisions should be outsourced.

Trustees must ensure the appropriate default fund is in place by analysing performance reports and make sure this fits with member objectives. But even this is challenging, as trustees must make assumptions about what their members are likely to do in future, says Douglas. “Members don’t know what strategy is right for them, when they are going to retire, or what with; it’s even harder for trustees to make that decision.”