According to the 2021 edition of the Pension Policy Institute’s (PPI) The DC Future Book, more than 95% of
members of trust-based Defined Contribution (DC) schemes (including master trusts) are invested in their
scheme’s default fund.1 Although many DC default funds and default pathways, which mechanistically de-risk
the default fund as the member approaches retirement, are assumed to meet the needs of most of the UK’s DC
members, a considerable number do not. Therefore, we look at what actions could be implemented if DC savers
are not to be set up for failure by poorly designed defaults.
The power of the default
Behavioural science has long recognised the power of the default option in many aspects of daily life. And for
good reason. Defaults are often perceived, by the intended audience, as being the recommended option and
regularly overcome choice overload, when people are faced with an inordinate number of choices and simply
can’t (for lack of knowledge, information and/or time constraints) or won’t (because of inertia) make an active
decision.2 Moreover, the omnipotence of inertia means that take up (and persistence) rates of the default
typically increase dramatically when, having been (passively) opted into the default,3 people must proactively
opt out to cease participation.4 All of this is, of course, particularly pertinent to the world of Defined
Contribution (DC) defaults.
The DC default fund
The default fund is the fund, almost always passively, selected by most DC savers (choice overload and inertia at
work again), and that which is typically held over the duration of the DC accumulation journey (inertia yet again).
Therefore, a DC scheme’s default fund, and the associated default de-risking glidepath to retirement, needs to be
capable of performing a considerable amount of intelligent heavy lifting if, in the continued absence of a material
increase in DC contribution rates and members’ changed circumstances over the course of the accumulation
period, at least a modest, ideally a comfortable, retirement outcome is to be generated. So what are the key
facets of a fit-for purpose default?
DC defaults – the key facets
Firstly, post freedom and choice, with an ever decreasing focus on annuitisation at retirement and the continued
popularity of income drawdown, as the favoured means by which to access pension savings,5 the DC default
fund and the associated glidepath should target drawdown, not annuitisation. Most defaults do but some still
don’t. That’s not to say annuities don’t have a place in retirement – they do – albeit in the later phase of the in
retirement journey when longevity insurance is provided by the annuity’s guaranteed lifetime income and agerelated
cognitive impediments start to impact decision making.6
Secondly, the typical composition of most DC default funds is one-size-fits-all, positioned to meet the (perceived)
needs7 of as many of an often broadly-based scheme membership as possible. While, in one sense, this is the default fund’s greatest strength, it can also be its greatest weakness in that it fails to distinguish between
members’ varying risk preferences and, to a degree, investment time horizons. Indeed, although not binary, there are those who have a high tolerance for volatility and an investment horizon long enough to withstand periodic asset market drawdowns and those who don’t. The former typically seek to tap into the equity risk premium, via
pure global equity or equity-rich portfolios. By contrast, the latter, usually with a shorter investment time horizon, seek a smoother returns experience, increasingly via a dynamically managed multi asset fund mix, which taps
into a multitude of diverse return drivers and risk premia, albeit typically with a sizeable equity and fixed income component as the mainstay.8 Of course, all risk appetites can be catered for within an appropriately calibrated
default glidepath but very few are. In fact, most default funds in the growth phase either assume one or the other fund structure until the default glidepath begins its gradual mechanistic one-size-fits-all derisking from a
pre-determined point in the run up to the scheme’s normal, or the member’s chosen, retirement age.
So what needs fixing?
Three points stem from this. Firstly, an increasing number of DC default funds now adopt a multi asset fund
mix, rather than a pure equity focus, a move which has been welcomed given that, for many DC schemes, the
former better fits the risk preferences of the majority of members. Moreover, most DC scheme self select fund
ranges include one or a number of global equity funds for those members with a tolerance for volatility. However,
unless included within a scaled down core fund range, this does, of course, often require the member to
overcome choice overload and make an active decision. That said, even if the member gets past these cognitive
barriers, most then fail to revisit their fund choice until the end of the accumulation phase (inertia again), by
which time their fund choice is likely to have been inappropriate for some time. To address these, long known,
shortcomings, some schemes offer dynamically managed adventurous, balanced and cautious defaults in the
accumulation phase, each with their own de-risking glidepaths. Others use target date funds.9 However, only
once a more analytical approach to members’ risk tolerances is adopted, will these somewhat approximate
approaches to default fund risk budgeting be refined to more closely meet member’s individual needs.
Secondly, despite most DC schemes being characterised by positive cash flow and a long investment time
horizon, almost all DC default funds still predominantly invest, via insurance platforms, in highly liquid asset
classes. As a result, most are missing out on the many longer-term less liquid, or less easily realisable, asset
opportunities that populate the asset portfolios and returns of most defined benefit (DB) schemes – many of
which have shorter investment time horizons than their DC counterparts. Principal among the diverse risk premia
and return drivers that would potentially enhance both the growth and defensive qualities of the multi asset mix
is the illiquidity premium associated with those heterogeneous less liquid real, private markets and alternative
asset classes, which typically offer a markedly different risk-return profile and pattern of returns to that of public
equity and credit markets, upon which many DC default funds overly rely.10
Moreover, the key impediments to DC schemes investing in illiquid assets, both real and imagined, while
manifold, are not insurmountable.11 Indeed, a recently published report by The Productive Finance Working Group
(TPFWG)12 encourages DC scheme trustees, trade bodies and consultants to consider how increasing investment
in less liquid assets could generate greater long-term value for their members13 and to find ways to invest in
less liquid assets as part of a diversified portfolio. While the report cites the role that, soon to be launched,
Long-Term Asset Funds (LTAFs) should play in this respect,14 asset managers also have a crucial role in better communicating to DC schemes how the inclusion of illiquid assets in diversified portfolios improve member outcomes. The TPFWG also recognises the risk to schemes of focusing on the cost, rather than the potential value add, of illiquid assets and, unsurprisingly, adds to calls for consolidation in the DC market so that schemes
have the necessary scale and investment governance to make a meaningful allocation to these heterogeneous
assets.15 Suffice to say, NEST, the £20bn, government-backed DC master trust, continues to lead the way in allocating to illiquid assets and, in so doing, has facilitated the ease with which others can tread the same path, not least by challenging some of the more punitive illiquid asset charging structures.16
Thirdly, default glidepaths fail to recognise that, for many people, retirement is not a one-off event with a defined
destination point. Rather, it is a gradual process. Therefore, as was concluded earlier, more detailed member
data gathering is required to ensure that members are appropriately invested throughout the accumulation
journey, especially as they approach the start of their at retirement journey, which will build over time.
Walking the ESG and climate change risk management walk
Finally, and by no means least, there’s the question of how DC default funds can most effectively meet the
Environmental, Social and Governance (ESG) and climate change risk management (a big part of the E)
responsibilities owed to members, who ultimately seek to retire in a world worth living in.17 However, while there
is no one-size-fits-all approach to integrating ESG factors within an investment process, with techniques ranging
from negative screening, or exclusion, to more sophisticated engagement and social impact approaches, there
is a growing dichotomy between that adopted by actively managed ESG defaults and their increasingly prevalent
index-tilted counterparts. Indeed, while the former tend to focus more on engagement to effect positive change,
the latter, with their limited exclusions and tilts away from potentially unrewarded ESG and climate risk factors,
ultimately fail to move the ESG engagement and ESG risk factor management agenda further forward. Moreover,
the challenge for traditional non-tilted index funds is having the necessary bandwidth to meaningfully engage on
ESG and climate issues with the, often many thousands of, constituent companies within their chosen index.
Some do but many don’t.
Ultimately, ESG analytics should be an integral part of a DC default fund’s risk management, as failure to build
sustainability themes into portfolios will inevitably make defaults more susceptible to sudden and potentially
sizeable return impacts. This again is where many illiquid assets step in, given the strong ESG credentials of
social housing, renewable energy and social infrastructure. In addition, there are increasingly calls from all
directions for DC defaults to align with the Paris Agreement, governments’ climate targets and for guidance on
setting net zero emissions targets.
Why does this matter?
The well publicised reluctance by DC savers to materially increase contribution rates means that if modest
to comfortable retirement outcomes are to become the norm, and sub-par outcomes are to be avoided, the
composition of, and glidepaths adopted by, DC defaults will become increasingly important. However, as has been
identified, there are a number of impediments to be overcome if the necessary change is to make this a reality.
Principal among these impediments are that few DC schemes have the requisite scale and investment
governance bandwidth to capture a wider range of long-run rewarded risk premia, by embracing those less liquid
asset classes increasingly utilised by DB schemes. This process will, of course, be greatly assisted by, amongst
other things, much needed DC scheme consolidation, the launch of LTAFs and changing the prevailing cost
minimisation mindset applied by many schemes to investment to one of maximising net value added. The latter,
in particular, remains a challenge within the world of charge-capped auto-enrolled DC default funds as, although
well intentioned, with the aim of ensuring that members receive value for money, the charge cap has instead
seen a race to the bottom with very little spent on investment. Sadly, the result has, in many cases, been to stifle
innovation and creative thinking to the likely detriment of member outcomes. However, if implemented, these
measures could collectively not only add as much as one per cent per annum to long-run risk-adjusted returns18
but also do so more sustainably, given the strong ESG credentials of many illiquid asset classes. Moreover, the
very distinct and varied pattern of returns from illiquids could also further improve the defensive qualities of DC
defaults when liquid asset markets turn tail.19 For many people, this could be the difference between retirement
bliss and retirement penury.
There also needs to be much closer attention paid to the risk budgeting of defaults over the accumulation
journey and a much wider recognition that retirement is, for many people, no longer a one-off event but a phased
process. Doing so would greatly enhance outcomes.
