As published in Professional Pensions, 17 December 2009:  When searching for the owner of the glass slipper, the handsome prince soon came to realise that, with fancy footwear, one size does not fit all. The same can be said for DC pension schemes. Each member of a DC scheme is an individual, with their own differing retirement goals and approach to risk. Surely, therefore, the current practice of providing one default fund that is often used by the vast majority of members fails to effectively meet the needs of all of the members of a scheme. Without over-complicating matters, how can trustees and companies design DC schemes that will genuinely provide the best “fit” for their members?

One of the most important issues for DC members, and one which is normally given little or no thought when joining a scheme, is the level of income that the individual wants to achieve at retirement. Some fortunate DC members will have other sources of income in retirement – inheritances, other investments, property etc – and the income they need from their pension may be only a relatively small proportion of the total income they plan to live off in retirement. For others, a DC pension may be the only income that they receive in retirement. Getting members to think about the level of replacement income they will need at retirement and how much of that needs to be provided from their DC scheme, is therefore, a critical first step. Interactive retirement planning tools available on a pensions website have a crucial role to play in this first stage of the education process as do pensions booklets and benefit statements. Once the member has set a target replacement income, they then have an objective to work towards.

The next stage is for the member to consider the relationship between investment returns and contribution rates. When targeting a replacement income, one option a member has is to pay a high level of contribution and to take a relatively conservative approach to investment.  Similarly, a member who is unwilling, or unable, to pay a higher contribution rate has to accept that they may have to take a relatively high level of investment risk in the hope of achieving higher investment returns to meet their retirement income objective. These messages, communicated in an effective way, may help to avoid the worst case scenario – that is, the risk-averse member paying a low level of contribution but still assuming that they will achieve an adequate income in retirement.

If we were to criticise past practice within DC schemes, it would be that too little emphasis was put on helping members understand and manage the risk they want or need to take and too much emphasis was given to arguably confusing esoteric fund choices.  Far better for members to have a choice of risk-graded ‘off the shelf’ options where the consideration for the member is simply how much risk they need to take than ask members to invest in one single default option (or alternatively construct their own strategy from multiple fund options).  If all DC members are unique, with different needs, objectives and tolerances to risk, how can the “one size fits all” approach represented by default funds be appropriate?

Of course, we are not advocating introducing more (unnecessary) complexity to the decisions that members have to take by providing an infinite number of strategies to meet the precise needs of all members! A more practical solution might be to offer a few simple “off the shelf” strategies such as: Adventurous, Balanced and Cautious options. These options should be accompanied by literature to indicate which option is appropriate for which type of member.  In addition, an on-line “attitude to risk” tool that asks the member various behavioural questions and then directs them to one of the options (‘A’, ‘B’ or ‘C’) would also help members.  

Looking forward  - we can envisage a member being presented with a ‘pick and mix’ range of options relating to the growth phase, i.e. A, B, or C, their retirement date and the lifestyle period. Ultimately members could also choose the target asset mix at retirement, which could depend on whether they wish to purchase an annuity or remain invested and take a form of income withdrawal.

If the current default fund is 100% in equities, could this mean that some members are taking too much risk. Some members will need to take this amount of risk to have any chance of achieving a meaningful income in retirement but others may not need to take as much investment risk.  

There are arguably better ways to construct ‘growth’ options for members than just relying on equities as the growth asset.  If we look at defined benefit schemes as an example, few have their growth assets invested 100% in equities – most have at least diversified some of their equities into “alternative” assets. Over recent years, Diversified Growth Funds (DGFs) and Target Return Funds have emerged as realistic default options for DC schemes. Furthermore there now exists a range of these types of funds, each with different levels of risk and target returns; these funds could usefully be used as a very efficient ‘growth’ vehicle behind the risk rated options discussed above.

We all know the prince eventually found his Cinderella – but not without some “challenges” along the way. DC schemes must now move forward and face their challenges. Many were put in place when DB schemes were closed; realistically, little time was committed to ensuring that they really met the needs of the members. It’s now time to carry out a fundamental review of DC offerings and start to build offerings that will genuinely help members to make suitable more choices for their retirement.