DC default funds should consider human capital and financial wealth – Pensions Institute

An age-dependent approach to DC default funds, which takes into account a member’s human capital and financial wealth, is better than traditional lifestyling, research shows.

Two studies by the Pensions Institute at Cass Business School identified three factors which should be considered when designing DC plans: a member's human capital as represented by their salary profile over their career, their attitude to risk, and their preference for current versus future consumption.

The first study - led by Pensions Institute director David Blake, alongside Cass senior lecturer Douglas Wright - looked at members considered ‘rational life cycle financial planners' who choose the investment strategy which maximises the expected utility of the pension fund value at retirement.

It found an age-dependent annual contribution rate, in which employees wait until they are several years into their career before starting to contribute, would better serve these members' interests.

It said for a male worker with a typical career salary profile, the optimal contribution rate increases steadily from zero before the age of 35 to about 30% to 35% after the age of 55.

The research also found an age-dependent investment strategy through ‘stochastic lifestyling' to be optimal. The strategy begins with 100% of the contributions in equities or a diversified growth fund before the equity weight is reduced prior to retirement. However, unlike traditional lifestyling this does not occur at a predetermined point but is dependent on what has been happening to equity returns and labour income.

Cass said stochastic lifestyling is justified by recognising the importance of human capital - defined as the present value of lifetime labour income - and treating it as a bond-like asset since it generates a fairly predictable labour income stream which depreciates over the member's working life.

It added the findings have implications for the popular model of single ‘one-size-fits-all' default investment strategies, which do not have the flexibility to accommodate these personal factors.

Blake (pictured) said: "This study highlights the inherent problems with default funds. When it comes to the optimal investment strategy for a DC pension plan, three factors - salary profile, attitude to risk and personal discount rate - need to be taken into consideration.

"These factors vary too much from person to person for one default fund to fit all circumstances. But we don't need hundreds of different funds either - people shouldn't be overwhelmed by choice - a very small number of well-defined choices will suffice."

The second part of Cass's research looked at the optimal default strategy assuming that ‘human' investors have so-called behavioural biases that restrict them from investing in a fully rational way.

It examined how they would optimally invest if they suffer from the most significant behavioural bias, namely loss aversion.