DC after the Budget: is your default dangerous?
Are older savers in defined contribution (DC) pensions sleepwalking into danger? We certainly think many could face a difficult retirement if they continue to use default funds designed for a world that has been turned upside down.
Many default funds have failed to adjust to the new freedoms, potentially causing problems for retirees.
Are older savers in defined contribution (DC) pensions sleepwalking into danger?
We certainly think many could face a difficult retirement if they continue to use default funds designed for a world that has been turned upside down.
Since last year’s Budget, DC savers have been freed to use their pension ‘pots’ almost as they wish when they retire.
The evidence so far is that the majority are going to embrace this freedom and reject the old world of annuities.
Yet most members of UK DC schemes saving in the years immediately before retirement are still automatically pushed into a default fund mostly invested in government bonds (‘gilts’), which assumes they will buy an annuity at or around 65.
This makes sense over the relatively short term. If interest rates rise unexpectedly, the pot is likely to shrink but the price of annuities should fall proportionately, leaving the saver no worse off.
By the same token, a sudden fall in rates will increase the pot, but also the cost of annuities, and the saver’s position should again be unchanged.
However, all bets are off if the pre-retirement saver is not intending to buy an annuity immediately when they retire.
Someone who does not want to use their money for an annuity immediately has a rather different objective.
Even though they may, with luck, have been saving for three decades, it’s quite likely that by this stage – say, the age of 56 – they will have only reached half way to the savings total they could expect at 65.
This is because of the magic effect of compound interest at even quite a low rate on a relatively large pile of money.
When measured against this objective, a gilt-heavy fund could prove disastrous.
Gilts and other fixed-income securities are currently pricing in a rise in UK interest rates some time in the second half of next year.
If, however, rates were to rise faster than expected, a gilt-laden portfolio would be likely to suffer quite severe losses as the bond values adjusted to the new prevailing cost of money.
Over the 115 years since the beginning of the 20th century, rising base rates have prompted at least 13 single-year falls of anywhere between 4.4% in 2006 to 17.6% in 1973, in real terms (see chart).
If the saver ends up keeping their savings invested when they retire, either so they can defer
buying an annuity or so they can draw an income, then the minimal growth typical of many preretirement funds could prove a millstone.
For one thing, the absence of significant money-weighted returns could significantly dampen the saver’s retirement ambitions by restricting the eventual size of their pot.
For another, over the medium term, inflation will start to take its toll. During the high inflation of the 1970s, for instance, gilt values fell by about a third over the decade.*
We believe some type of multi-asset fund is likely to prove a far less risky way for late-stage DC
savers to secure their future in retirement.
Such a fund builds in the prospect of a more reliable level of growth over most periods than gilts and gilt-like investments on their own, while providing suitable diversification against many risks.
Adopted as a default fund, possibly with some level of additional insurance against significant loss, we believe it is likely to be far more suited to the choices most DC savers are likely to make when they retire.
It is therefore urgent, in our view, that schemes give thought to their current default fund to ensure it is not leading their members into an uncertain – and possibly dangerous – future.
* Barclays Equity Gilt Study 2015, with net income reinvested