What is a default fund?

Your life savings are most likely in a default pension fund and you probably don’t even know how the fund is invested.

In fact, according to research by the Pensions Regulator, 96% of people that have a defined contribution scheme are invested in the pension scheme’s default fund.[1]

What is a default fund and is it a good option for you?

Since 2012, your employer has been legally required to enrol you in a pension scheme. Your pension provider is obliged to offer an investment option to its members to grow their pension fund.[2] This is, typically, a low-cost investment fund with some level of diversification applied. It’s common for them to be a medium or low-risk profile, and often, they’ll contain passive equity trackers and fixed income holdings.

Low cost, diversified, trackers, what’s not to like? Well, potentially a fair amount…

The benefits of a pension default fund

Some positives come with default funds: the costs are low and are capped by the regulator at 0.75%, so you know this won’t escalate over time.[3] However, the primary benefit is that you won’t have to make any decisions.

It’s an easy solution for those without any interest in investing as your pension is more likely to grow than if you were just holding cash. Unfortunately though, our inherent laziness and lack of engagement with our money continues to be served by default funds and you could be losing out as a consequence.

Why default funds might not be appropriate

Default funds attempt to be appropriate for the young, the old, risk-takers and those who are more cautious. By definition then, they are rarely appropriate for anyone as we all have different feelings towards risk, varying capacity for loss and differing objectives for our money. Your investment strategy should reflect this if you want to achieve the best outcomes. In reality, the ‘new joiner in their early 20s’ probably shouldn’t have their pension invested in the same way as say an employee that’s been with a firm for 30 years and is starting to look towards retirement.

To tackle this issue, many default funds have life-styling properties.[4] When you join the pension scheme, you will select a retirement age. At a set period before this date, usually in the region of five to ten years, the fund will start to automatically de-risk by reducing the equity exposure and often moving portions to cash. Given that most individuals fail to engage with their pensions, it is understandable that steady de-risking towards retirement is considered a sensible generic position to take. However, retirement does come abruptly in many cases – one week you are at work and the next you are attending your leaving party. De-risking your investments ten years prior to this event then, seems likely to negatively impact the growth potential of your funds. Perhaps unnecessarily so, given that your life at this stage will look very different to how it might at retirement.

It’s also worth highlighting that a significant number of default funds move entirely to cash at retirement age. This is more common in older schemes and is a hangover from when pension funds were typically exchanged for annuities. ONS data shows that someone in their 40s can, on average, expect to reach the age of 85. They’ll also have a one in four chance of reaching 95![5] So, if you retire at 65, your pension is probably going to need to continue being invested for another twenty and possibly even thirty years. You’ll likely need to continue to grow the funds over and above inflation to meet your needs. The last thing you’ll want is swathes of cash or an overly de-risked strategy that doesn’t align with your retirement objectives.

Why default funds have a lack of diversification

Recently, there have been significant criticisms of the 0.75% charge cap that is in place.[6] The limitations on costs have often resulted in highly UK-centric default funds that have a very limited asset allocation. Quantitative easing and the recent inflationary environment have exacerbated this issue. Bonds and equity have become positively correlated and rising interest rates have seen bond prices fall at a rate we haven’t experienced since the 1990s. More sophisticated alternative instruments need to be deployed to attain diversification, but these aren’t always cheap options. This often means that default funds aren’t sufficiently globally diversified and can suffer unnecessary levels of volatility due to a lack of diversification in asset classes.

Ultimately, your money should be invested for your circumstances and in line with your objectives, whilst considering your attitude towards risk. The asset allocation of your strategy should be flexible in current market environments and have access to a wide range of options to provide sufficient diversification to protect your capital in drawdown. It’s unlikely that a default fund will be able to achieve all of this. I’m not suggesting that this means everyone should sell out of their default funds though. Unless you are an experienced investor, they are still going to be a preferable option compared to trying to build your own portfolio. However, if you have a reasonably sizeable pot and can access advice – please do so. A professionally managed investment strategy supported by a robust financial plan will undoubtedly improve your chances of success.