What is a default pension fund?
Generally, default pension funds are index-linked and are ‘middle of the road’ in terms of their level of investment risk. They are applied to every member of a pension scheme when they take out the pension regardless of their age, selected retirement age or other personal circumstances.
Default pension funds exist for two very good reasons. Firstly, they keep your money invested in a fund which is not too aggressive while you decide if you want to keep it there. Secondly, they are a low-cost option for people who don’t want to make any decisions about their investments or perhaps don’t want to pay for financial advice. They can take the investor through their working lives to the point of retirement.
Without a default fund, your money would be held in cash and the rate of growth would be similar to that of a bank account. It is assumed that your return would be higher if the money is invested in a default fund than if it was held in cash, although it is important to remember that with any type of investment, you could get back less than you originally invested.
What are the potential drawbacks of staying invested in a default pension fund?
Although default pension funds serve an important purpose, there are some potential drawbacks when staying invested in these funds over the longer term.
Different opinions between different pension providers
“One of the biggest problems with default pension funds is that every pension provider has a different opinion over what constitutes a suitable default fund,” says Bertrand Pole, one of Tilney’s pension technical specialists. “All investments held within a fund involve an element of risk. But this level of risk is measured by looking at historical performance and can vary depending on how far back a fund manager looks. As such, different asset classes will have different levels of defined risk depending on the parameters used.”
A generic approach to investment
Default pension funds assume a ‘one size fits all’ approach, but when you have investors with different time horizons until retirement, this can be an issue. “As default funds must satisfy both young and older savers, different providers will put a different emphasis on how cautious or adventurous a fund should be,” says Bertrand. “This can have a significant bearing on long-term growth for younger savers if the level of risk is low, or there might be too much volatility for those approaching retirement.”
While this is not the case for everyone, often when you are younger, you can afford for your investments to be more volatile as you have plenty of time for them to recover. Although there is the potential to lose money by taking risk, there is equally the potential that you may miss out on a substantial amount of growth by staying in a default fund. If you stay invested in this fund for the entirety of your working life, your pension may not be able to provide the level of income that you require once you reach retirement. The suitability of a fund should not be left to chance and instead be tailored to your specific needs and length of time you have until you plan on accessing your pension savings.
Lack of diversification
Often, older workplace pensions are invested in a default fund which only has a small amount of asset allocation. According to Bertrand, “the old style funds tend to be very UK-centric and are often not that well diversified.” This means that a whole pension can be fully dependent on the UK market. “You could be missing out on growth in other regions and potentially increasing the volatility through this lack of diversification.”
The more modern default pension funds have been subject to greater scrutiny and that has led to an increase of multi-asset funds being used as the default option. While this has increased the diversification of the funds to some degree, it’s important to realise that a number of these funds are still largely invested in fixed interest assets, which may or may not be suitable for you.
How do I decide where to invest my pension contributions?
Managing your own investments effectively and deciding where you want your money to go takes time, dedication and knowledge – this is why in many cases people stay invested in the default pension fund.
Some people need help with making their investment decisions. Your pension provider will not be able to advise you on where to invest your money, but some employers do provide their employees with a pension adviser who might be able to help you. Without this, you may wish to seek professional advice. A financial planner will consider your personal circumstances and your finances as a whole. To help decide where best to invest your pension savings, they will ask questions such as:
- When do you want to retire?
- What do you want to do with your retirement?
- Will you be wholly reliant on your pension income?
- What is your attitude towards investment risk?
- What other funds are available within the scheme?
- Do you have any strong feelings towards investing in ESG or ethical funds?
By establishing this information and with their expert knowledge, they can see which pension investment funds are the most suitable for you, which in a number of cases is not the default one offered by your provider.
Speak to Tilney
If you want to know more about your pension and investment options, Tilney can help. Book a consultation online or call 020 7189 2400.
This article does not constitute personal advice. If you are in doubt as to the suitability of an investment please contact one of our advisers.
Issued by Tilney Financial Planning Limited.
* Source: The Pensions Regulator, DC trust: scheme return data 2019 - 2020
This article was previously published on www.tilney.co.uk prior to the launch of Evelyn Partners.