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Poor quality default funds are putting DC pension pots at risk

The prognosis does not look good for workers in defined-contribution schemes. Many US workers, who were early adopters of DC, are already waking up to the fact that their pensions are not what they had hoped for.

In the UK, the past decade of volatile equity markets and tumbling annuity rates have rammed home how fragile DC pensions are in their current form. At least the vast majority of those retiring now will have the comfort of being able to fall back on some DB pension they will have accrued.

The crux for DC is the default fund. It is well known that four in five workers opt for this fund, or rather are put in it because they do not make a choice.

Education and commun-ication to engage workers to take responsibility for their pension is a slow burn and this puts the spotlight firmly on the quality of the default fund. Yet the quality is often questioned.

The Cass Business School warned that DC pension schemes will be putting employees’ retirement prospects at risk unless they acted to improve the quality of default funds.

In its report, Dealing with the Reluctant Investor, it found most traditional default funds did not match members’ needs in terms of asset allocation and risk profile.

The industry is acutely aware of this and has been moving to generate new strategies for DC. For example, diversified growth is deemed an ideal fund but trustees are not exactly falling over themselves to adopt it.

The consensus is that a default fund should have a lifestyle or target date strategy, which is to be used by Nest when it goes live 12 months from now, because they at least de-risk their pension funds as they count down to retirement.

However, a report published this week by the Cass Business School and BNY Mellon, says lifestyle arrangements will lead to workers having “a poorer retirement” because lifestyling is too rigid. It treats people as one, failing to take into account age, contributions and, crucially, what they need in retirement.

According to Cass, a DC member beginning a 10-year lifestyling approach in 1980 required a DC pot of £5,766 to achieve a pension of two-thirds of his or her final salary. By 2001, this figure had risen to a staggering £152,986.

Cass said that in 1980, its representative DC member would have needed a DC pot equivalent to just under twice his annual salary at 55 in 1990. By 2001, the necessary pot size would have needed to be just over nine times his annual salary at 55 in 2011.

Had average DC scheme members begun their lifestyling in 1980, assuming they did not take any tax-free lump sum from their fund, they would have been able to purchase a level payment annuity equivalent to 73 per cent of their final salary, or an RPI-linked annuity equivalent to 40 per cent of their final salary.

Contrast this with average scheme members beginning their lifestyling journey in 2001. They can only afford a level payment annuity equivalent to 21 per cent of their final salary, or an RPI-linked payment equivalent to just 12 per cent of their final salary.

Much of the focus on DC is on Nest and whether it will be a success or a failure. That is all very well but it seems to me that millions of workers are already being asked to save in a pension that is still in the testing phase – and no one knows whether people retiring after 2020 will be happy with their lot.

Paul Farrow is personal finance editor of the Telegraph Media GroupMoney Marketing

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  1. Surely the headline is wrong and it’s DC funds that are at risk?

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