Auto-enrolment: the fault in default funds
One of the perceived strengths of the auto-enrolment pension scheme is its simplicity – indeed, it is actually a greater effort for an employee to opt-out of a workplace pension than it is to be enrolled into one. No further actions are required, and the retirement fund grows as the months and years pass by.
However, that simplicity does, of itself, bring about an inherent weakness. Workers who find themselves in workplace pension schemes are invariably enrolled into what’s known as a default fund. These are one-size-fits-all investment funds for all employees within an organisation, and tend to have a lower risk profile.
This is fairly intuitive, given that employers want to limit the risk of their workers’ pension savings plunging in value, and being in the firing line as a result. But to what extent is this costing employees in terms of the future value of their retirement pots?
A chasm over time
According to recent analysis conducted by the Tax Incentivised Savings Association (Tisa) earlier this year, the difference in pension fund performance can be stark – even for the average earner. The study looked at the comparative performance of default funds managed by the various fund houses, as ranked by Defaqto. It found that, for a worker on a starting salary of £30,000 locked into the lowest-ranked default fund (with an annual growth rate of 3.4 per cent in the three years to December 2018), he or she would expect to accrue a pension of £153,600 when they reach retirement (assuming wages rise with inflation, and a 5/3 percentage split in employee/employer contributions).
However, if the same individual were to switch to a fund generating 8 per cent growth – the mean rate among the funds studied by Defaqto – this retirement figure would soar to £618,000. And switching to the market-leading fund, which achieved average growth of 11.9 per cent per year, would swell the same worker’s pension savings to a whopping £2.27m.
There is some mitigation to the above. Many of the top performers were funds which track a specific market or index. Given the bull run for the stock market over the last few years, it is understandable that the level of daylight was so extreme. And it is reasonable to assume that this gap would close in the event of a downturn. Auto-enrolment launched in 2012, so only once longer-term data analysis is available will we have a complete and balanced view.
Nevertheless, the contrasting performance figures still highlight the fact that, while contributing adequate amounts to a pension is important, the real gains are to be made in optimising fund performance. In fact, the Tisa study concluded that even a 1 per cent uptick in fund performance over a 50-year period equates to a 3 per cent increase in contributions over the same timeframe.
So is it time to bin default funds?
Aggregating the various research suggests that nine out of 10 people who save into defined contribution pension funds opt to stay within the company’s default fund, although some studies put this proportion at 99 per cent. Either way, it seems many of us are reluctant to look further afield – be that out of ignorance, or a conscious choice.
Incidentally, for those less au fait with the nuances of investing, branching out from a default fund isn’t as daunting as it may seem. Some workplaces will have other off-the-shelf funds on offer, which you can easily switch to. These might include funds which have varied levels of risk, or which are geared towards specific types of investments. These need not require any additional elbow grease in terms of day-to-day oversight, although for those who do seek proactive involvement in managing their fund, there will be alternatives to cater for this.
Making changes to your pension fund is usually straightforward, and you need not wait until you have built up a sizeable balance before doing so. It may be worth paying a little bit extra to consult a financial advisor or investment broker. They’ll have a list of funds which have performed best, and can help you tailor a portfolio to suit your needs. Especially for those who do not have the time, nor the expertise, going down the advisor or broker route can pay dividends in the long run.
It’s not all about the money
One apparent shift in public opinion could have an impact on default funds sooner than expected; namely, a desire for pension investments to be more ethical. A 2,500-strong survey by Franklin Templeton, published in This is Money, found that only one in five savers between the ages of 22-38 believe their pension fund reflects their personal values. Roughly half believe responsible investing should be a cornerstone of default funds, while 45 per cent said they would increase their pension contributions if it were being put towards responsible investments.
Although 43 per cent of respondents within this age bracket said that free employer contributions were the biggest incentive for saving into a workplace pension, nearly a third (29 per cent) put responsible investing as their most important criterion. Given that this generation of workers will be the first to depend heavily on defined contribution schemes (with final salary schemes all but disappearing), their preferences cannot be ignored, and reform becomes inevitable.
Solutions to cater for this shift in demand could be that employers set up two standalone default schemes – one for standard investments, and the other for responsible investments – and give employees the option to choose when they are enrolled. Or the default itself could be a 50/50 split between the two. Or, to keep it simple, there could simply be a mandatory minimum level of responsible investment options built into default funds.
Take the time to think about your pension
First and foremost though, a pension serves to secure your financial future, and auto-enrolment will continue to play an important part. Default funds are part and parcel of this too. For the employer, they are cheap to operate, and for the employee, no additional work is required in managing a workplace pension.
Yet the above serves to illustrate the importance of giving due consideration to how you can optimise your pension fund. Just a small outlay now in terms of time and money can have a monumental effect on the level of wealth you enjoy in retirement. And, if you can further align your investments with your values, then that really is the icing on the cake.
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