Defined Contribution

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.


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.

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