Are you invested in your pension's default fund?
However while default funds might be the easy and convenient option they might not be the best option for you - particularly if you have no intention of buying an annuity.
What are default funds?
Default pension funds are a ‘one size fits all' investment fund managed by the insurance company running your pension, for those that don't want to choose their own pension funds. The fund will aim to grow your money through stockmarket investments during the accumulation years but will automatically move your cash into lower risk assets such as government bonds - or gilts - and cash as your retirement draws near.
The aim of this is to lock in your growth and prevent stockmarket losses wiping out large chunks of your pension just as you need to get your hands on the money. If you don't make any active decision as to where to invest, this where your monthly contributions will go.
However according to research from State Street Global Advisers, 49% of default fund investors actively chose to invest in their default fund - 67% believed it offered ‘balanced risk', 26% said it was recommended to them by their pension provider or employer, 24% said it was ‘secure' while 7% said they thought returns were 'guaranteed'. More worrying still only 10% of those invested said that they fully understood how their pension fund operated.
One of the key arguments against investing in default funds is that performance is unlikely to be great. Laith Khalaf, head of corporate research at Hargreaves Lansdown, says: "They are typically very mediocre insurance company funds. Set up and run on a shoe string they are built to be that way." As a result even if funds are not described as trackers, investors can expect little in the way of active fund management. "They are essentially closet trackers," adds Khalaf.
To illustrate the difference quality fund management can make to your returns, Khalaf points to the performance of funds in the balanced managed sector (which are typically used as default funds). £10,000 invested in the average fund 20 years ago would now be worth £32,710. However if that money had been invested in one of the sector's top performers, AXA Framlington Managed Balanced, run by Richard Peirson, it would be worth £48,770. "The performance differential is more than the original investment," says Khalaf.
Another criticism of default funds is that they are very much geared to investors who are going to cash in their pension to purchase an annuity and this will become increasingly significant from April 2015 when new rules come into force which will provide savers with more options for what to do with their pension when they retire. While historically most savers have purchased annuities, going forward more are likely to leave their funds invested and draw an income from them instead.
As the whole fund may not be crystallised in one go, a default strategy could therefore be wholly unsuitable, as Khalaf explains: "Default funds have always been a blunt tool, but investing in one of these now looks like trying to eat steak with a spoon. The explosion in pension withdrawal options will mean each pension saver needs to consider what to invest in, based on how and when they plan to take their pension."
He adds: "There is no longer a definite pension journey. Some people will still buy an annuity, some will take an income others will go into buy to let while some might just buy a Lamborghini. A default fund can't account for all those options."
Even for investors that do want to buy an annuity, it may make sense to manage the de-risking yourself. As Justin Modray, founder of IFA Candid Money, points out, with a default fund "you have little control over when the money is moved." Transferring it right after a major stockmarket wobble, for example, may not make sense.
Khalaf adds that in a market where interest rates are expected to rise, you may also not want to plough huge sums into government bonds which is where your money would be invested with a default strategy.
He says an alternative way of safeguarding your pension might be an investment in what he describes as a "conservative fund" such as Troy Trojan or Newton Real Return. "These focus on capital preservation," he explains. "They take a little bit of risk in return for some growth so they don't make as much in the good times but you wouldn't lose as much as you would in the bad."
Are default funds all bad?
But while default funds may not be stellar performers and not tailored to your exact needs some advisers think they serve a very valuable purpose, particularly if you are not seeking independent financial advice.
Some investors, for example, could base their decisions too heavily on recent past performance, selecting funds that are too high risk, while others might be so worried about losing money that they pick funds that aren't sufficiently aggressive to get the returns their pension needs. Some savers may not have the inclination to spend time and energy researching the best options or the willingness to manage their portfolio.
"For many people the default fund is the right way to go as it stops you going too far wrong. They will be well diversified and prevent you from taking too much risk," says Patrick Conolly, an IFA at Chase De Vere.
Ben Willis, head of research at Whitechurch Securities, also remarks that they can be a very low cost way of saving. "For investors who do not have, or do not wish to pay for an independent financial adviser, default pension funds provide a relatively simple solution for pension investors. In addition fund costs are essentially a drag on performance and as default funds are offered by the pension provider they are also usually cost efficient when compared to third party funds within the pension fund range."
But even though default funds are tempting for those that don't want to do any research, Willis says its still sensible to check the performance of your provider's default fund as some are definitely better than others. "As with all funds there are good ones, bad ones and downright ugly ones. Default funds that can evidence a long-term track record of outperformance versus the sector peer group can provide a suitable long-term investment home for pension investors."
However, if you do have the stamina to research and choose your own pension funds you may well find you are more than compensated for your efforts. As Modray says: "It's no different fundamentally to building your own stocks and shares Isa. It's just about getting a good spread of investments."
McDermott agrees: "A pension is just another investment wrapper," and adds that there are plenty of resources available to those that do want choose their own funds. "There is more than enough information and guidance for investors that are happy to do the research and multiple ‘select fund' lists from investment platforms where the research has been done for you."
Make your mind up
Whether you choose your own funds, go for the default, or pay a financial adviser to do the hard work for you, the key is to think about the pros and cons of each approach and make a conscious, well thought through decision. Don't sleepwalk towards your retirement with no idea what your money is doing or how it is invested.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.