ARTICLE
3 October 2007

Defined Contribution Schemes - Watching Out For The Workers

A ‘lifestyle’ facility in a defined contribution pension scheme can be helpful to many people – but it doesn’t suit everyone, warns Chris Murray. He looks at ways in which members can lower their investment risk and safeguard returns.
United Kingdom Strategy

A ‘lifestyle’ facility in a defined contribution pension scheme can be helpful to many people – but it doesn’t suit everyone, warns Chris Murray. He looks at ways in which members can lower their investment risk and safeguard returns.

"The value of your investments may go down as well as up." This sombre warning is particularly apt given the recent rollercoaster performance of world stock markets. The final salary pension schemes of FTSE 100 companies can be bounced into deficit or surplus as a result of these changes, making headline news. But what about the workers and their pensions?

Various strategies already exist which help to manage the deficits faced by final salary pension schemes. But these are of little help to the increasing number of people in the UK who are members of defined contribution (DC) pension schemes, which include both occupational money purchase schemes and personal pension arrangements.

It is generally believed that equities (shares bought on the UK or overseas stock exchanges) are likely to produce better returns than other classes of asset over the longer term. Within DC schemes, most ‘default’ funds, which tend to be one kind of managed fund or another, incorporate a significant equity component. Balanced managed funds typically hold about 75% of their assets in equities and cautious managed funds tend to hold around 50%.

Market volatility (investment risk) is not necessarily an issue for people until five to ten years before they retire, as there should be sufficient time for markets to recover before the funds are needed to buy a pension (annuity). But how can people protect themselves against a sudden fall in the value of their investments when they are approaching retirement?

Protecting your investment

Many DC schemes have a ‘lifestyle’ facility that helps to reduce the investment risk for individuals by gradually moving funds out of equities into asset classes that are usually considered less volatile. This typically means moving 75% of the funds into fixedinterest investments, made up of loans to the Government (Government bonds – ‘gilts’) or to companies (corporate bonds). The remaining 25% is usually directed into cash.

Although fixed-interest investments tend to be less exciting in terms of potential return, they have a real benefit as they are closely linked to the cost of annuities. This means that if gilt prices fall when an individual is close to retirement, then the cost of buying an annuity is very likely to fall as well, offsetting a major part of the reduction in fund value. However, if equity prices fall just before retirement, annuity prices are unlikely to reduce. In fact, they could even increase, creating a gulf between expectation and reality.

Given the seriousness of this issue and the inherent volatility of stock markets, it is surprising that there are still many schemes where such a facility does not exist. This can leave members of such schemes financially exposed at retirement.

Addressing individual needs

The introduction of a lifestyle facility, whether as a default investment strategy or by personal choice, may not suit everyone. It would mean that people who wish to, for example, retire five years early, would not have even started to move into the lowerrisk environment. Instead, they may still be wholly invested in a managed fund, holding perhaps 75% of assets in equities, which is potentially very risky.

There are other people for whom a lifestyle facility may also be inappropriate. For instance, if you have a large retirement fund, there may be a case for moving into an ‘income drawdown’ arrangement (more recently termed ‘unsecured income’) on retirement. Arguably, there is little point having 75% of the available fund in bonds of one kind or another (although the 25% cash might be appropriate) if you want to carry on investing the residual fund for another five to ten years, having taken the allowable tax-free cash.

If your DC scheme does nothing to lower investment risk as members approach retirement, then employers (and employees) could be in for a nasty shock if equity markets display excessive volatility during the critical five to ten-year period before retirement.

So how can the interests of the workers be protected? The introduction of an investment strategy that incorporates a lifestyle facility may well alleviate the problem for the great majority of workers, but care needs to be taken to recognise the few for whom this might be unsuitable. An even more effective solution is to arrange for individual investment advice to be given to those who are within five years of their intended retirement, to allow an individual investment strategy to be designed.

So while a lifestyle option can be useful as a default choice for corporate pension schemes, it is not an appropriate route for all individuals. People have different investment needs and attitudes to risk. It’s important that these are considered at the appropriate time.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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