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Why U.K. Pension Plan Sponsors Should Consider Target-Date Funds

Given changing demographics and investment climate, pension plan sponsors in the U.K. should look beyond the status quo.

Target-date funds are the future of the U.K. defined contribution industry. Before you dismiss that as a suspiciously self-promotional statement on behalf of J.P. Morgan Asset Management, let’s consider the reality of rapidly changing requirements facing a modern-day defined contribution pension plan — and question whether its default fund structure is still suitable.

Of those individuals investing in a pension, 9 out of 10 rely on their scheme’s chosen default strategy to get them to a point at which they can retire. At present, the most common defaults are lifestyle funds, which mechanistically change asset allocation over time, based on age. These structures are woefully outdated. Let’s take, for example, the prevailing expectation at the time of lifestyle funds’ introduction that equities could be expected to deliver 8 to 10 percent or more per year, with little attention paid to the downside risks of equities. In today’s world, those return expectations look foolishly optimistic. Times have certainly changed, with 6 percent returns representing the new normal in asset returns.

Further evidence that lifestyle structures are no longer appropriate in today’s market can be seen in their decreasing popularity in light of the recent U.K. pension reforms. Under these rules, savers are no longer effectively forced into purchasing an annuity at the point of retirement. Given the repeated cuts to annuity rates in recent years that have reduced this income, this is good news. According to a recent report, however, 74 percent of FTSE 350 employers — the majority of which offer a lifestyle structure plan — still shuttle all of their participating members into a default investment option targeting a level annuity. In other words, a significant proportion of U.K. default plans are invested for a future that no longer matches the reality of member behavior.

Perhaps more concerning is that the objective for 90 percent of default funds is a focus on investment returns, rather than what income the end users will actually receive in retirement, and whether such a figure is one that can realistically support them.

As asset managers, we have a fiduciary responsibility to challenge what is clunky, old-fashioned and no longer works. Unlike for past generations, there is far less certainty around sources of income in retirement — with cash, drawdown, annuities and a mix of all three as options. In addition to this, people are working longer and living longer. The average pension plan — that is, one that by default shuffles members into a lifestyle structure — simply cannot offer the flexibility needed to accommodate these changing requirements.

This situation leads to the urgent need for resetting the preferred default choice in the accumulation phase of a defined contribution scheme. Target-date funds, which are far more dynamic, are the natural next phase. We can learn a lot from the U.S. market, where the growing majority of investor savings are increasingly flowing to target-date funds, which hold more than $650 billion of pension assets in the country.

One point of contention often raised in response to this view is that because the majority of individuals are enrolled within a default plan, these savers are disengaged and don’t care how their money is managed. But I wonder how this argument will hold up in 50 years, when people will be retiring solely on a defined contribution pension pot. At that point, it may become all too obvious how some individuals have been left far behind what should be an achievable income at retirement.

This leads us to another significant challenge around the inadequacy of common default fund options in the U.K.: the startling lack of clarity about fund performance and lack of comparative data available for pension trustees to benchmark their choices and make an educated decision as to which investment choices will best serve retirement savers. Looking to the U.S. again, which can act as our test case with its mature defined contribution market, there is a wealth of competitive information available to pension trustees and members.

In an industry representing more than £227 billion ($346 billion) in assets, is it good enough that the expected outcome for retirees can be so vague, with no way for individuals to measure if they’re getting a good deal (other than price)?

Steps are being taken in the U.K. to address the issue of fund tracking, beginning with the launch of the FTSE U.K. DC Benchmark Index Series toward the end of 2014. This gives the performance for both lifestyle and target-date fund strategies, providing returns since 2009 for a range of projected retirement dates. But more can certainly be done. According to chancellor of the exchequer George Osborne, the U.K. is going through the “biggest changes to pensions in 100 years.” Yet there’s a risk that set-and-forget structures, which dominate the market, do not change with the times — and in turn, risk damaging the likelihood of a fair income in retirement for the mass market.

Do we have to wait until people have the vision of hindsight to start questioning what went wrong? After all, you only get one shot at retirement.

Simon Chinnery is head of U.K. defined contribution at J.P. Morgan Asset Management in London.

See J.P. Morgan’s disclaimer.

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