Andrew Brown, client director at Columbia Threadneedle, talks to Sara Benwell about how schemes need to think about defaults in light of freedoms and choice

What are the key risks that members are facing in 2016?

The ultimate risk facing members is failure to meet their retirement goals.

In a DC world, members bear all the investment risk so an appropriate default strategy is essential. During the accumulation stage, risks are fairly one dimensional and so the ‘one size fits all’ approach works to a certain extent.

Retirement plans

Post-retirement those risks are quite multi-dimensional. Capital loss during the post-retirement years will impact not only the size of the investment but also the income it can generate and there’s always the risk that inflation will impact the buying power of income.

There’s also the longevity risk to consider. People generally under-estimate how long they’re going to live so generating an income that’s sustainable for the rest of life is a key risk that members face.

Default funds and post-retirement investment strategies need to be appropriately designed for their members’ futures. For schemes that have not done so already – this may mean rethinking the default.

How easy is it for schemes to design their default funds appropriately?

This is a problem that the industry – and pension schemes in particular - is still grappling with.

There is a danger that we over-complicate what a DC pension is. Ultimately it’s a savings vehicle with a goal of creating an adequately sized pot that can provide for our retirement needs.

Of course retirees now face complex decisions about how they use their DC pension and whether that’s income drawdown, cash, annuitisation or a mixture of all three - in an ideal world the default fund will help members arrive at the right investment choices.

It’s clear that the removal of the requirement to annuitise is going to lead to a continual shrinking of the annuity market.

However, when you do ask members what they want in retirement – they generally describe a product that looks something like an annuity. They want a guaranteed income that will sustain them for the rest of their lives.

What members don’t like is the inflexibility not to mention the poor value of annuities at the current time.

One approach trustees can take is to look at a member’s pot size. It can be assumed that people with smaller pot sizes are more likely to take cash, while those with larger pot sizes are likely to use a mixture of cash and drawdown.

What does the new default world look like?

It has been a volatile period and it’s important to remember that markets can be volatile - but a pension is a very long-term investment.

The danger is that falling markets usually grab the headlines and we can equate the falling market with the amount lost from someone’s pension. This is really never good news for the public and can generate a lot of negative sentiment.

We would consider an appropriate investment strategy one that can participate in rising markets, but also protect capital when markets are falling. This can be achieved by diversifying an investment portfolio and actively managing volatility. By adopting this approach schemes will be able to hedge some of the risks faced by members.

Should all defaults look alike?

It’s important that pension schemes take members to the point of retirement.

If a member is still in a default strategy that’s hedging the purchase of an annuity by investing in predominantly long-dated bonds, and if that member is unlikely to buying an annuity, then they are not likely to be making a good investment.

Similarly if a member is looking to take cash and the default lifestyle is investing too aggressively in equities pre-retirement it may not be the optimal solution.

Drawdown is interesting and there are various investment solutions which enable us to achieve a sustainable income. Relying on equity income alone in falling markets will reduce the size of investment and the income it can generate.

And we’ve seen various models of what would have happened had you invested £100,000 in the FTSE in 2000. It wouldn’t have sustained an income at a level of 8% per annum for very long. Of course, timing can be crucial.

The way we address income strategies is similar to the way we address diversification in the accumulation stage.

By combining our strength in generating income and asset allocation we’re able to create a portfolio that invests in a wide range of income generating asset classes. This type of strategy would allocate between equities, fixed income and property.

The strategy aims to hedge some of the risks faced by retirees whilst enabling future fund growth.

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