The 2017 edition of The Future Book suggests many default funds are not diversified enough to protect savers against market downturns, James Phillips reports.
Having the right investment strategy is more important than ever for defined contribution (DC) savers bearing all the risk for investment performance, with no guaranteed wage in retirement.
And with many savers remaining in their scheme’s default fund, making sure this allocates assets in a way that provides both security and growth in as consistent a way as possible is vital to boosting retirement income.
Yet, according to this year’s edition of The Future Book, compiled by the Pensions Policy Institute (PPI) and Columbia Threadneedle Investments, default funds are trending towards high-risk and low-reward lifestyle strategies, inhibiting pension fund growth.
To some extent, the responsibility for the final retirement pot and investment decisions lies with the individual, but if schemes can do more to help their members, they should be doing so.
The report seeks to find a way for the industry “to generate better retirement outcomes that can be enjoyed rather than endured”, according to Columbia Threadneedle head of pensions and investment education Chris Wagstaff (pictured).
Perhaps the core message in the 2017 edition of The Future Book is that the predominant investment strategies adopted by master trusts and multi-employer schemes for their default funds may not necessarily be fit for purpose.
This is particularly a concern as nearly all savers in master trusts have remained in the default fund; some 99.7% of master trust members have not appeared to make an active decision about how their money is invested. Many of these are staff in their first pension scheme thanks to the introduction of automatic enrolment (AE).
Specifically, the book states lifestyle funds, commonly adopted by schemes including master trusts and multi-employer schemes, expose savers to too high a possibility that 5% of invested monies will be lost within the first five years.
This is due to their typically high allocation to equities until up to 10 years before retirement, leaving the fund exposed to high-risk assets that could be significantly hit by any sudden financial market downturn.
The two firms analysed the possibility across a range of investment strategies, and concluded that lifestyle funds were the second most likely to see such a loss, after high-risk funds, with a 20.7% and 25.5% chance respectively.
Columbia Threadneedle Investments EMEA head of multi-asset Toby Nangle, says the problem with lifestyle funds is their late phasing of assets could see savers’ funds depreciate significantly just before retirement if a market downturn suddenly occurs.
“Equities have delivered phenomenally strong returns,” he argues. “These may be a fantastic savings vehicle for the long term. However, there are unpredictable downturn periods. These sorts of downturn can take a long time [to come about] but have been proven to be significant. What if you don’t have a timescale to recover?”
He adds exposure to more diversified asset classes, through diversified growth funds (DGFs), would enable savers to fare better in such downturns.
He points back to the analysis, which recorded that DGFs, depending on their performance, had between a 5.8% and 11.9% chance of seeing a loss of 5% or more within the first five years.
Of course, by itself, this does not necessarily mean these strategies are wrong simply due to their risk; therefore the book also analyses the potential returns of different investment strategies.
Based on a woman earning median wages, and saving 8% of her banded salary consistently from age 22 to state pension age, the analysis states a high-performing DGF could provide a median retirement pot of £92,000.
This is the second-best investment strategy for returns, coming after high-risk funds, which could provide a pot size of £102,000.
For these reasons, the report advocates DGFs as an investment strategy providing the best risk/return pay-off.
This concern is perhaps exemplified by the fact that many members are not au fait with how their DC provision works for them.
Indeed, The Pensions Advisory Service (TPAS) chief executive Michelle Cracknell believes savers’ lack of understanding could mean they start thinking about how to fund their retirement too late in their working lives.
“Changing the pensions landscape is the easy bit; changing customers is the hard bit,” she says. “This is a real immediate issue because by the time we get to 2030/40, people retiring will be relying on DC. They cannot wait until then; they need to be thinking about it no later than 2020.”
She argues that savers’ awareness of pension concepts is very low, drawing on experience from enquiries to TPAS where savers have shown they do not understand what a DC scheme is, and that it in itself is not a pension.
Certainly, a lack of awareness around the way investment works, and how funds can fall in value from time to time, could prove a big problem to the average AE saver. If they are likely to keep an eye on their pension, a fall in equity returns caused by a market downturn could see them lose confidence in their pension.
PPI head of policy research Daniela Silcock comments: “People in the AE target group tend to be lower income and more risk averse, and are more likely to get scared and stop contributing.”
Better explanation and communication of investment is therefore needed to improve a saver’s understanding of how their fund value moves.
For Cracknell, there is a concern that savers do not have a sense of personal ownership for their pension, in contrast to ISAs. This could be helped somewhat by instilling better personalisation into scheme communications, namely around significant life events, such as marriage, death, a first child or divorce, she argues.
“I don’t think we do enough in the pensions world to get them to talk about themselves. We need to get much better at making pensions real by talking about people’s life events.”
Advice and guidance
The Future Book notes the increasing purchase of drawdown products without receiving advice first, a finding also made by the Financial Conduct Authority (FCA) in its retirement outcomes review earlier this year.
Drawing on Association of British Insurers (ABI) figures for 2014 to 2016, the report notes that there was a small increase in people purchasing annuities without advice post-introduction of Freedom and Choice – rising from 70% in 2014 to 74% in 2016.
However, there has been a surge in the number of consumers buying income drawdown products without advice; between 2014 and 2016, this figure rose by 23 percentage points, from 9% to 32%.
At the same time, the purchase of drawdown products has grown significantly, with around £7bn of sales across 81,000 products in 2016, compared to £3bn across 40,000 in 2014.
Considering the apparent lack of awareness among savers, it continues to be somewhat concerning that they make such big decisions at retirement without advice.
Cracknell believes these figures demonstrate the need for more concerted action from the government, noting that drawdown “sounds a lot sexier than wanting to do an annuity”.
“Drawdown is a very sophisticated investment proposition. There needs to be an intervention,” she argues. “The only way we create a social norm is to create a social intervention. We need to change people’s normal behaviour.”
She advocates the introduction of a ‘mid-life financial MOT’ – a proposal made in Jon Cridland’s independent review of the state pension age, published in March – to help people plan for later life.
However, the new pensions advice allowance – which allows savers to access £500 once a year, on three occasions, tax-free from their pension pot to pay for advice – could improve these figures.
Silcock states: “The use of advice is falling; the proportion of people buying drawdown without advice has almost tripled. We are not sure how many people have been using pension guidance or getting support from other places.
“What will be interesting to see is how government measures allowing people to use [their pot for advice] impacts these figures.”
The continuing rollout of AE and somewhat early days of Freedom and Choice have the DC market in flux; some of their effects are still to be found out.
Yet, it is clear that delivering the best possible returns should be a primary focus of a pension fund investment team, supported by quality advice for the at-retirement decision-making process.