The DC default investment model is quickly evolving beyond mechanistic lifecycle structures towards more sophisticated target date fund solutions
As DC schemes become the primary retirement savings vehicle for a rapidly growing number of UK workers, regulators and plan sponsors continue to look for ways to help members become better prepared for the realities of self-funded retirement.
- One of the most important choices DC schemes make is the selection of an appropriate solution to meet the needs of roughly 80-85% of members currently relying on the default strategy to get them over the retirement finish line. The most commonly used default options are lifecycle structures however, an evolution in default design appears to be underway with the growing adoption of target date funds. These DB-calibre, all-in-one portfolios are designed to put members’ assets to work in a more efficient manner, and offer notable advances in expected investment risk/reward characteristics, as well as in overall member experience.
Target date funds increase the number of members positioned to achieve safe levels of replacement income in retirement
DC investment success is ultimately measured by how many members can afford to retire. Our research shows that the wide dispersion of outcomes and the limited diversification offered by many lifecycle structures expose too many members to significant risk of falling short of their replacement income needs.
- In contrast, the more sophisticated diversification, dynamic asset allocation and greater flexibility provided by the single-manager structure of target date funds mean they are better positioned to address market volatility and reflect real-life saving behaviour, increasing the likelihood that members will achieve safe levels of retirement income.
Target date funds are much easier to understand and communicate than lifecycle structures
The benefits of a target date fund extend beyond pure investment considerations.
Target date funds eliminate some of the communication and monitoring challenges of lifecycle structures. As standalone portfolios, there is no need for schemes to communicate complex ideas about investing, so plan sponsors can instead concentrate their communications on improving savings rates. Meanwhile, members only need to make one simple choice: the date that they expect to retire. Furthermore, this date need not be fixed. Members can typically extend beyond previously anticipated timelines either by remaining in their chosen “cohort” for longer or moving cohort to one with a later target date.
- The strategic asset allocation in target date funds often de-risks gradually over time, therefore should members decide to retire later their portfolios would not have to change significantly, unlike in lifecycle structures where de-risking can happen over as little as five years. This capability of target date funds to adapt to meet changing member needs is invaluable in the rapidly evolving pensions market.
The evolution of default design
With auto-enrolment expected to contribute to a near threefold increase in DC members over the next decade—from six million today to around 16 million by 20201—getting the default option right is more important than ever before.
The lifecycle structures widely used today represent a significant evolution from the 100% equity structures and simple balanced structures of the early days of the DC default. In recent years, a further wave of evolution has come in the form of diversified growth funds (DGFs), which have been used by many plans to increase diversification in lifecycle structures. However, given the corresponding evolution of the DC marketplace, the lifecycle structure may no longer be the best solution for maximising the number of members positioned for retirement success. Lifecycle structures are often too mechanistic, rigid and confusing to serve the needs of the rapidly growing number of members who will come to depend on DC plans to accumulate the vast majority of their retirement savings.
Given the evolution of the DC marketplace, lifecycle structures may no longer be the best solution for maximising the number of members positioned for retirement success.