Designing good DC default funds for members can be a difficult and daunting task for trustees. Michael Klimes explores how they can do it
Much of the debate about defined contribution (DC) trustees' fiduciary duty to members revolves around how to create successful default funds. Discussions usually touch on themes such as value for money and investment strategy, but another vital area is having a good understanding of members' needs.
This becomes particularly significant when they start to access their savings. The fact most people do not engage with pensions until the twilight of their careers and will be in default at some stage of their lives, only adds to the pressure on trustees to get the design right.
Society of Pension Professionals (SPP) president Hugh Nolan acknowledges the risks that trustees face when designing default funds.
"Default funds are a challenge for trustees as they could get things totally wrong and design something which members do not want when they come to give retirement some thought. Usually members only look at what they want [from their pensions] a couple of years before they stop work."
Broadly speaking there are three options trustees can go for, according to Nolan. The first is to build a profile of an average member based on basic data. Trustees of a scheme with more affluent members could design a fund with a drawdown option while those with small pots will take cash. While this approach still has potential to displease members, Nolan thinks it involves the least risk.
The second is to have an arrangement which combines drawdown, cash lump sum and annuities. Here perhaps some trustees admit they do not know what members want, hedge their bets and effectively hope for the best. These would probably have to be put in three separate default funds, and the downside is members can be confused by the complexity and end up unhappy.
The third is trustees can use the lack of knowledge about members' preferences as an excuse to not take the initiative. "An example of trustees who rely on an old strategy is where the scheme's default targets annuities even though the members do not want to buy one," says Nolan.
Clearly the shortcomings of three approaches are that trustees create defaults based on assumptions of members which are not being rigorously tested. How can trustees survey what their members want and review it regularly?
The People's Pension director of policy and market engagement Darren Philp says trustees can start by realising that a default fund is a mass market solution targeted at the average scheme member. Trustees do not need to know every single detail about all their members for the default to work.
"Ultimately a default will never be optimised for every individual at a specific time in their journey. A scheme could optimise outcomes for every person but then you are running a personal pension scheme. This is different from mass market solution. Furthermore, the bigger the scheme, the more difficult it is to craft a bespoke solution for each person as it is not cost effective."
A default fund has to be aligned with a general grasp of what type of scheme the default is being designed for. "What are the wider circumstances of the scheme? For instance in an AE scheme there are probably workers who move around a lot, make minimum contributions and are never going to be that engaged," Philp adds.
Trustees can acquire more specific insights about members by asking questions about the average level of contributions, how frequently people change jobs, and what age people want to take their money. Also, what are their preferences to take money whether it is drawdown, a secure income or taking a mixed approach.
Trustees can then use that information to think about the risk profile of members and appropriate investment strategy for the default.
The only catch is that while obtaining the information is relatively easy, the analysis is potentially expensive, time consuming and complicated. "It costs money to research information, run focus groups and pull that all together in terms of what does this actually mean?" Philp continues.
Doing this sort of research could cost a scheme tens of thousands of pounds but he thinks it is necessary. "I would argue if a scheme cannot afford to do that or is not willing to do that, is it really doing best by its members? Should it be run as a scheme?"
Coming to the end
For PTL client director Colin Richardson, it is particularly challenging when members come to retire, because basic scheme data might not tell the trustees enough about what members want and more information will be required.
"The main issues here are assumptions as how members may take benefits, and attitude towards risk. While they are not insurmountable, they are challenging. More information helps and big schemes probably have an advantage as they have more resources, but designing a default should not be too onerous."
Communication is also important for trustees as it helps manage expectations of what the default offers but should also keep them informed if and when members' needs change. "Trustees must review and challenge their assumptions about what members want from the default. This relies on communication."
Pensions Administration Standards Association (PASA) chairwoman Margaret Snowdon agrees with and allies it to a broader point about simplicity. "A default fund is intended to be just that - a default for those who don't choose and not something to fit every possible person and every possible circumstance."
She thinks trustees put themselves at risk if they make defaults too complicated and centred on individual members. "If trustees try to be too specific and target individual suitability (the ultimate outcome of gathering information for a default to suit complex individual circumstances would be a ‘tailored default'), and they could be deemed to be making a recommendation, rather than providing a reasonable option for those who can't or won't engage."
Clearly there are challenges for trustees when it comes to designing default funds. But simplicity, effective communication and not assuming what members want are all good points that trustees should bear in mind.
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