Thought Leadership (Professional Only)

DC after the Budget: avoiding the cash trap

Cash is gaining popularity in defined contribution (DC) default design thanks to last year’s Budget. The changes ushered in by George Osborne, the Chancellor, moved the goalposts for DC retirees.

29 January 2015

Cash is gaining popularity in defined contribution (DC) default design thanks to last year’s Budget. The changes ushered in by George Osborne, the Chancellor, moved the goalposts for DC retirees. From this April, retiring members are no longer pushed towards buying an annuity, but can take their whole pension pot as a lump sum or move into drawdown if they want. Members are widely expected to use this new freedom to unlock their pension savings once they retire, with many expected to try to take as much cash as possible.

This has led many commentators to suggest that cash is the ideal asset for them to have on the eve of retiring. It should therefore be the end point of the glide path used to determine the asset allocation of their DC default fund. Typically, two key arguments are cited. Firstly, they point out that glide paths in place before the Budget typically aimed for an end point of 25% cash and 75% bonds to accommodate individuals who, it was assumed with some reason, would take the maximum of 25% tax-free cash and buy an annuity with the rest of their pot. If we now assume most members will take 100% cash, then the asset allocation should logically also change to 100% cash to reflect the changed requirement.

The second point is that cash is often a good protector of capital value and is probably the asset class best understood by most people. As members approach retirement, their priorities switch from maximising returns to increasing capital protection and liquidity. It is argued that there is no simpler way to achieve both aims than by investing in cash.

The problem is that, while both arguments appear reasonable, in reality they fail to reflect the realities of today’s brave new world. The allocation to cash in the past worked because schemes knew not only that most members would take 25% of their pot as cash, but also roughly when they were going to take it. In these circumstances, a default glide path that switched into 25% cash made some sense as a short-term capital and liquidity protection measure. After April, however, it will be far from clear whether the member will take their fund as cash, use it to buy an annuity, leave it invested and take a drawdown income or adopt a combination of these options. Amidst such uncertainty, we believe that cash makes much less sense. It will certainly protect the member’s capital in the short term, but what it won’t do is protect it over the longer term. Inflation will ensure that, the longer it is left as cash, the worse the impact will become. (See grey line on chart.) 

A further argument is that keeping the pot in cash could encourage irrational behaviour. An all-cash default fund could be seen as an implicit recommendation to the member to take their pot in one lump sum. Such a move might result in them paying more tax than necessary and/or spending money they are very likely to need to support their retirement. We believe there are much better default solutions that can help keep members’ options open at retirement, protecting their capital and their purchasing power for a cost that is not substantially higher than a typical cash fund. For instance, a multi-asset fund is likely, judging by our research, to outperform cash in any but the worst markets or over very short periods. (Our model suggests that it would be better in at least 75% of outcomes – see chart) In light of this, we think trustees and governance committees need to make sure they have reviewed all the options when they put their new post-April DC default into active service.

Important Information: 

For professional investors only. This document is not suitable for retail clients. Past performance is not a guide to future performance and may not be repeated. This article is intended to be for information purposes only and it is not intended as promotional material in any respect. The article is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The article is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations Information herein is believed to be reliable but Schroder Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Forecasts are subject to a high level of uncertainty regarding future economic and market factors that may affect actual future performance. The forecasts are provided to you for information purposes as at today’s date. Our assumptions may change materially with changes in underlying assumptions that may occur, among other things, as economic and market conditions change. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. 

Important Information: The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change.  To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 31 Gresham Street, London, EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.