Pension product design and marketing has an irritating habit of swinging from one extreme to the oth...
Pension product design and marketing has an irritating habit of swinging from one extreme to the other. Back in the late 1980s when defined contribution (DC) individual and group personal pensions took off, it was all about investment choice. The bulk of the products were expensive and very inflexible but they did offer a huge range of investment funds.
In practice, this overwhelming choice was counter-productive and tended to send inexperienced investors scurrying into apparently 'safe' funds like cash and bonds, which are inappropriate asset classes for long-term growth although they clearly play an important part in protecting capital in the run up to the annuity purchase.
Today, the stakeholder revolution is driving down costs and, in many cases, reducing the range of funds on offer. A restricted fund choice is not necessarily a bad thing provided it is accompanied by a sensible education process that explains the importance of asset allocation across the scheme member's entire range of savings and investments not just within the pension plan itself.
For example, if the stakeholder offers a good low-cost FTSE All-Share tracker fund this should be balanced elsewhere in the client's investments with some exposure to overseas equities.
With the growing emphasis on group schemes, many advisers are finding the best way to generate new business is to offer seminars in the workplace. An adviser who makes recommendations in the light of the client's private assets and company benefits is best placed to provide a holistic service and ensure that the asset allocation of the pension scheme dovetails with the individual savings account (Isa) and share portfolio.
The range of funds available will clearly vary but a basic DC pension scheme or plan will offer at least one fund for each major asset class, plus a lifestyle or default option that makes automatic asset allocation decisions for the client.
Tommy Garvey, a consultant with the asset-consulting department at Towers Perrin, says: "There is no right fund for the entire time a client is in the pension scheme. The first consideration is asset allocation. It may look safe to invest contributions in cash and gilts but for a younger employee, this is likely to produce poor results over the long term. At this stage, the main objective is to beat inflation and to maximise returns. Employees should not be too worried about volatility and day to day fluctuations."
Advisers usually recommend scheme members opt for 100% in UK and overseas equities until they are 5-10 years off retirement in order to generate maximum capital growth.
"A sensible approach might be to choose a global equity fund or split the contributions so that 60% go into the UK equity fund and 40% into the overseas equity fund," says Garvey.
There is no standard format for DC investment. GlaxoSmithKline, for example, offers a range of options that includes comparatively aggressive equity funds designed to appeal to the young DC scheme membership. The Body Shop offers its members an ethical fund in addition to the traditional choices. This reflects the company's corporate ethical philosophy.
As clients get older and closer to retirement, they need to switch gradually into safer assets such as bonds and gilts, unless, of course, they plan to move into drawdown, in which case it is important to retain a high proportion of equity investment. As a very rough guide, by the time clients want to buy an annuity, they should be 75% in an annuity-matching fund, which would consist of gilts and bonds, and 25% in cash. This enables the adviser to calculate the value of the cash and annuity at retirement. It also avoids any unpleasant surprises due to stock market volatility.
A good DC scheme will recognise that many employees do not have the time or inclination to make asset allocation decisions. This is why they offer a default lifestyle programme that directs contributions into equities until a few years before retirement and then gradually switches the scheme member into gilts, bonds and cash.
Experts agree that the lifestyle structure is the best default programme for investors who might otherwise put too much into cash and bonds at an early age. However, it does have its drawbacks.
For example, there is no consensus on the right time to start switching out of real assets. The classic lifestyle funds tend to start the phased switching 10 years before retirement but many advisers believe this is too soon. Arguably the effect of compound interest on regular contribution plans is at its greatest during the last decade of investment.
For this reason, some advisers prefer to bypass the default programme and delay the switch out of equities until five years before the retirement date.
Moreover, standard lifestyle programmes do not cope well with those who retire early who may find themselves 100% in equities at the wrong time. In contrast, members who intend to transfer to a drawdown plan at retirement need to maintain a high equity exposure and should avoid the automatic phased switch into bonds and cash altogether.
Debbie Harrison is a freelance journalist
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