Make sure your pension fund fits

When your pension contribution comes out of your pay packet and disappears into the pension scheme run by your employer, do you have any idea what kind of investment it ends up in?

The fact is that most employer schemes offer what's known as a 'default' fund as a home for the contributions of anyone who doesn't actively select one of the other funds on offer - and most employees end up investing in it.

Exact statistics are surprisingly hard to come by, but Tom McPhail, head of pension research at Hargreaves Lansdown, estimates that across the UK workforce as a whole, around 90% of workplace pension investors are investing in the default fund on offer.

That's backed up by research from the Department of Work and Pensions (DWP) which shows that "between 60 and 100% of members tended to invest in the default option, depending on the employer".

What's so awful about taking the default option?

Well, says McPhail, "it's certainly better than having no pension investment at all". But the trouble is that default funds tend to be pretty dull, cautious investments that are generally considered a poor choice for younger people with several decades to go before retirement.

In addition, even compared with their equally cautious peers they have a reputation for underperformance.

So why are these funds on offer at all? Why don't pension schemes simply require people to choose a fund when they join up?

The difficulty is that many people have so little understanding of pensions and how they work that they feel too ignorant and nervous to make their own investment decisions.

Default funds are not a new idea, but they have become much more prominent on the pensions scene since 2001, when the government introduced simple, low-cost stakeholder pension schemes with a built-in default fund option.

As McPhail explains: "The basic idea was that we needed to get people saving for retirement, and that it should be possible for them to join a pension plan without having to make what for many are scary, challenging decisions about which investment fund is best for them."

The 2009 survey of employers' pension schemes by the National Association of Pension Funds (NAPF) found that 86% now offer a default investment option, and that figure will rise to 100% in the future.

Default funds will be a compulsory feature of all workplace pensions from 2012, when the auto-enrolment pension regime is due to be introduced.

What kind of investments are you likely to find as your employer's default option?

In over 80% of cases, according to the NAPF survey, it will be a 'lifestyle' arrangement. This means your money starts off in an equity fund where it can grow in value while there's still plenty of time to go to retirement.

As you approach the end of your working life, it starts to be automatically switched over into progressively less risky bond and cash holdings, in order to protect your capital.

This set-up raises several questions. First, what kind of fund is used during the 'growth' phase when your pension is supposed to be enjoying capital growth?

"Over the last 10 years or so there has been a shift in the growth component of defaults, away from balanced managed funds [which hold a mix of assets, including up to 85% equities], and towards global equity investments, usually global equity tracker funds," says Gary Smith, senior investment consultant at pension consultancy Towers Watson.

However, he adds, in the past couple of years some schemes have moved back towards more diversified funds, as they have become more cautious in response to the turbulence of global stockmarkets.

That's backed up by the NAPF survey, which shows a 5% increase in the use of mixed asset/managed funds from 2008 to 2009.

The trouble is that while balanced managed funds might be the best bet for employees in their late 40s or early 50s, for people in their 20s and 30s, capital growth is the big priority, and retirement is so far away that there's plenty of time for their investments to recover, even from a major stockmarket shakedown.

As McPhail puts it: "Default funds are good in that they prevent excess risk - but when you're young you should be taking risks with your pension money."

That said, 100% equities is a risky place to be in volatile times, and default investors may well lose a chunk of capital in such circumstances, even though default funds are generally supposed to be relatively conservative. More risk-averse individuals could feel very uncomfortable with that prospect.

Worse still, says Tony Attubato, technical manager at the Pension Advisory Service, if they think they are in a pretty safe fund and are happy with that arrangement, they may not even realise that they could be fully exposed to the equity markets for much of their working life.

"People don't necessarily appreciate what terms such as 'lifestyling' mean, and many are surprised to find they lost quite a bit of money when the markets are in turmoil," Attubato says.

"The default fund could be appropriate for particular investors - but it's vital that people understand what they've invested in, and what the other choices are."

Investor inertia issues

A further problem is that of inertia. Gary Smith says that if people have simply failed to make an investment choice and so have ended up in the default fund, it's highly likely that they'll stay there. But this problem of investor inertia can all too easily lead to poor performance.

"Many of the big insurance companies' balanced managed funds are pretty mediocre because they are full of 'sticky money' - default investors are simply not interested in how their investment is performing - so providers don't bother employing the best fund managers or putting a lot of resources into research," says McPhail.

Smith comments that because money is unlikely to leave the default fund, it's really important that pension plans are properly run and can easily change managers if they need to. However, that's not necessarily the case.

"Larger trust-based schemes do generally have the structure in place to change managers when appropriate, and some larger contract-based plans are also now putting these structures in place as well," he says.

"Smaller schemes are usually the ones where members are least well served."

However, he believes it's not underperformance of these default funds relative to their peer funds that is the big issue.

"The concern is more whether defaults are meeting the needs of the members they're aimed at, rather than any peer group comparison," he says.

To put that into context: a catering company is unlikely to have a workforce with the same level of investment understanding as a firm of financial advisers, while the youthful staff of a high-tech enterprise could have a different risk profile from the employees of a company running retirement homes.

So what's appropriate for one group may not be best for another.

The key point emphasised by all experts is that employers need to make big efforts to engage with their employees in their pension scheme, so that even if they start off in the default fund, they are encouraged to look seriously at all the alternatives, and - crucially - to understand the characteristics and risks of whatever they invest in.

But Attubato points out that many people are outside their comfort zone as far as making active decisions is concerned.

"Communication from the employer has to be really clear, spelling out the real risks of the fund they're in. There have been big improvements in this respect, but there's still a lot of work to be done."

At Towers Watson, Smith suggests the main thing is to help investors understand their own needs and circumstances, and then help them find the fund that matches those circumstances best, rather than expecting them to get to grips with markets and managers.

That means we've got to be able to trust the people running our pension schemes to do a good job not only picking and monitoring funds, including the default option, but also telling us exactly who these will suit and why.

So default funds shouldn't necessarily be written off. The important thing is that, if you're investing in the default option, you've made an active, informed decision to do so because it's best for you.

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