Blueprint for the future: the evolution of DC default fund design

17 Dec 2013

Auto-enrolment has raised the bar for default fund design as more people than ever before rely on defined contribution schemes to provide adequately for their retirement. While default funds have increasingly become a feature of the DC pensions landscape, under auto-enrolment legislation the attention to them has increased. Employers now have a duty to auto-enrol certain workers into a qualifying workplace pension and in order to qualify for automatic enrolment, the scheme must have a default investment option in place, so employees – many of whom will be joining a pension scheme for the first time and with little or no experience of investing – can avoid making any active choices in order to save for their retirement

Features

In a target date funds structure a member actively identifies his or her desired retirement date, and is then accordingly placed in one fund (one of a stable of such funds, one for each age cohort), which targets that date. The assets of the fund are then grown and de-risked according to an agreed “glide path” to retirement.

In practice a member may see little difference between target date and lifestyle but there are several key differences. In lifestyle, for instance, the strategic investment decisions are made by scheme fiduciaries and their advisers, but in a target date approach they tend to be made by a third party. Similarly, in lifestyle a member’s assets are switched between funds over time, while in target date they remain in one fund, which has obvious cost implications. A new direction?

Lifestyle funds are overwhelmingly remain the most common offering in larger UK schemes, with £46bn of default fund assets invested in them compared with less than £2bn in target date funds among schemes with more than a thousand members, according research by Spence Johnson.

While lifestyle no doubt is no doubt a viable option for a default fund, it could be argued that its popularity among consultants plays no small part in their ubiquity. As Spence Johnson director Magnus Spence points out: “Consultants promote lifestyle for a variety of reasons, but one of them is that this type of structure needs careful design and monitoring of asset allocation and performance, and consultants are able to earn fees from performing these tasks.

“Target date by contrast is designed and managed at source, so it removes the need for many of these tasks to be carried out by consultants”.

While lifestyle undoubtedly rules the roost today (see chart), target date is expected to take a bigger slice of the pie as understanding grows and more providers offer it.

Says Spence: “We believe that the lifestyle product will increasingly be challenged when scheme fiduciaries start to want to understand more about alternatives to lifestyle, such as target date funds. Lifestyle will continue to grow in value terms, but it will start to lose its dominant share of the growing default fund element of the DC market.”

When the National Employment Savings Trust (NEST) sat down to design its own default fund, which will be responsible for the retirement savings of millions of workers, it opted for target date rather than lifestyle. Head of investment policy, Paul Todd explains: “Target date funds have been fairly popular in the US for the last five years or so, although they tend to work on three or five year tranches. We thought because of our likely scale we would be able to do it on a single year basis.

“We felt the traditional lifestyle route would be too restricting in terms of the way we can manage risk across a whole savings career. Also the whole concept of lifestyle is quite a difficult one to explain to members and employers, whereas with our target date funds we’ve got a really clear message that gets across.”