Savings & Investing

One glidepath doesn’t fit all: are you a trowel or fork?

May 19, 2016
By Claire Finn

When we British think of retirement, we tend to think of gardening. Granted, many of us might have other plans. But images of the flower show scene from Mrs. Miniver—or for the younger set, in Downton Abbey—still encapsulate the national character. And thanks to Pension Freedoms, we now have even more flexibility in how we pursue this dream of the retirement Garden of Eden.

What does that mean for defined contribution pension schemes and default designs—that is, the funds in which members’ money is automatically invested if they don’t make an active choice, or if their employer only offers one option? Under the old rules, there could be one investment product because nearly all people were required to purchase an annuity with their pots of money. When the vast majority of individual pots are destined for the same outcome, it made sense to manage them all in the same way. In gardening terms, think of it like a trowel: one blade leading to a single point. That is, under the ‘trowel’ approach, all members’ pots of money ‘de-risk’—move away from riskier assets such as shares and toward less volatile assets such as bonds—in the same way and on the same schedule.

But now, with the freedoms in place, people have more choices. Many are still choosing annuities. But, as expected, many are not. According to the Association of British Insurers (ABI),1 their choices break down roughly in thirds. In the first year since Pension Freedoms went into effect, of those who’ve withdrawn their pots:

  • 31% of people are staying with annuities;
  • 39% have invested in drawdown products; and
  • The remaining 30% are taking their pots in cash.

Yet the de-risking strategy for the vast majority of U.K. DC schemes—as many as 80%, based on our observations—remains focused on annuitisation. Even though, for more than two-thirds of retirees—and presumably also for many nearing retirement—their investment goal has changed.

This is not to criticize scheme sponsors and trustees. From a fiduciary perspective, it’s hard to predict how any one person or group is going to exercise these newfound pension freedoms. Also, what people are doing now is not necessarily an indication of future trends. Many of today’s retirees can count on multiple sources of retirement income—including final salary, defined benefit schemes and the state pension.

But the further out one looks, that picture stands to change dramatically. In the future, defined contribution pensions will be the primary source of retirement income for most people in the UK. It’s not surprising, therefore, that many fiduciaries—those charged with looking out for the best interests of those they serve—have opted for a wait-and-see approach before implementing changes.

Returning to our gardening analogy, we may distinguish between the ‘trowel’ approach and the ‘fork,’ which provides options. For schemes with good insight into their membership’s likely retirement choices, designing the optimal default investment strategy can be straightforward, particularly for cases in which most members are expected to make the same choice. Equally, where there is an expectation that members will actively make a choice, offering a tailored approach with multiple strategies allows members to exercise their pension freedoms even before they retire.

But what about cases—probably the majority—in which such expectations are not clear? How do trustees go about creating a single default solution that can work for most members, even when nobody—not even the members themselves—knows exactly what members are going to do with their pots at retirement?

To some extent, all investment strategies—independent of the client’s choice—typically look similar leading up to retirement. They usually aim to de-risk over time, and more rapidly as retirement nears. Also, as retirement approaches, the aim of moderate growth often gives way to an element of capital preservation. Finally, we believe, a sound portfolio should seek to control for downside risks, including potential interest rate hikes.

Beyond this, however, the investment strategies geared toward each different choice at retirement—annuity, cash-out, drawdown—should diverge. Perhaps one way to address this divergence is through a version of the ‘fork’. Under this approach, within a series of target date (TDF) or life-style funds (funds that automatically de-risk as the member ages), the glidepaths—specific asset allocations that change over time—remain identical until the member is ten years from retirement. At that point, they would diverge depending on the member’s preference. One series targets drawdown, another cash, and the other purchasing an annuity. Each approaches de-risking differently, based on one of the three typical objectives at retirement. These series could even be blended to achieve a mix of outcomes. For example, retirees can dedicate part of their money toward an annuity purchase for a measure of secure income, and another part toward a drawdown product to help fund their retirement dreams.

There are still considerations for fiduciaries. What should happen when members don’t actively choose an option? Which of the three should be the default? Should there be different defaults for different demographic cohorts? Which is more appropriate for a given membership, a life-style fund or a TDF?

A key advantage of the trowel approach is that it seeks to avoid most of these complications. Scheme members don’t need to make any decisions until they reach retirement and fiduciaries only need to construct and monitor one default and pre-retirement strategy. But if the trowel approach is chosen, we believe it makes more sense, post-Pension Freedom, to set a default that helps steer members toward a drawdown portfolio rather than an annuity.

Yet the drawbacks of the trowel in a Pension Freedom world are undeniable. One size no longer fits all because everyone is no longer one size. More than two-thirds of British retirees are choosing not to annuitize. We believe the ‘fork’ can help millions tend their gardens in retirement—and help those whose thumbs are not so green.

1ABI Pension Freedom Statistics: One Year On, 2015.