Simon Hildrey reports on shifts within the asset allocation of UK DC default funds - the most popular option for DC scheme members

As the unrelenting march from defined benefit (DB) to defined contribution (DC) schemes in the UK continues, greater investment responsibility falls on members. The vast majority of members, however, do not make an investment decision, with between 80% and 99% going for the default option.

Such a high proportion should not be surprising. In many cases, little investment advice is provided to DC members. Default funds are key in persuading employees to join DC schemes, with an NAPF survey in 2006 showing that 83% of DC schemes have a default fund.

"One of the main reasons why people do not sign up to schemes is because of the investment options," says David Ferris, consultant at Punter Southall. "Members do not want a choice of 80 to 90 funds because they often lack confidence to select funds."

Default funds, however, have been criticised for failing to meet the investment needs of members.

Marc Haynes, manager of the fund strategy and selection group at Friends Provident, says the first incarnation of default funds were with profits funds. "Schemes then migrated to balanced managed funds." The majority of these funds have been invested in equities, often through index trackers. Many of the balanced managed funds have as much as 50% to 70% invested in UK equities.

Critics say default funds often have a simplistic investment strategy in that they lack multi-asset diversification and are not actively managed.

Ideally, default funds would be tailored for each member, taking into account other investments and pensions funds they have, how long they have until retirement, how much income they want in retirement and the level of investment risk they are willing to take. But the employer or employee would have to pay for this customised advice.

Nevertheless, there are ways in which default options can be better tailored to the particular membership of schemes, says Ashish Kapur, DC product specialist at SEI Investments. For example, he suggests, there could be one default option for high earners and one for low earners.

"High earners with large contributions do not usually need to take the same level of investment risk as lower earners," says Kapur.

Crispin Lace, senior investment consultant at Watson Wyatt, says schemes can introduce a degree of customisation by having further boxes to tick than merely whether members want the default option. These could provide an indication of the risk profile of each member and might result in more than one default fund.

There is no shortage of suggestions on how the investment proposition of default funds can be improved. A key part of improving default funds is governance.

Ferris says: "The executives, unions, personnel and payroll departments and other representatives of one group personal pension scheme are producing a governance guide that may run to 20 to 25 pages. They may appoint investment managers or consultants."

The intention is that this leads to an appropriate default option for members of this scheme. It should also result in closer monitoring and changing it if necessary. The level of governance, of course, varies between trust based and contract based schemes.

It is argued that for most of the life of default funds they should try to deliver as much growth as possible. "This is because people need to generate as great a return as they can and younger people have the time to make up any losses they suffer," says Neil Walton, head of strategic solutions at Schroders.

"This will be focused on equities but should be through funds that are actively managed. They will be unconstrained and alpha funds."

In the years leading to retirement, Mr Walton argues that funds should move into a multi-asset allocation. "This provides diversification and reduces volatility.

"This avoids the situation where the fund is hit if equities fall just before the fund moves into bonds and cash. Then, in this scenario, if the member does not buy an annuity after retirement and moves back into equities he may have missed out on any recovery in the asset class."

A number of asset managers are promoting such diversified growth funds. "These use multi-asset portfolios that may include UK and overseas equities, high yield, property, currencies and hedge funds," says Julian Webb, head of DC business development at Fidelity.

"They have a pre-agreed strategic asset allocation and can have an actively managed tactical asset allocation. Such funds can be used in the early years of members' contributions and then later on they can switch allocation to bonds and cash."

A challenge is to fit such funds within the charging structure of DC schemes. One option is to devote a portion of such multi-asset funds to index trackers, such as for US, UK and continental European equities, to reduce the overall cost.

Multi-asset and multi-manager funds feature in default options in other countries, such as Australia and Denmark.

Lace argues that such funds can be structured to comply with the low cost world of DC schemes. "Multi-asset funds can have annual charges as low as 0.6% while under the Swedish state default system fees have come down to 0.4%. Balanced managed funds under contract based schemes have had charges as high as 1.5%."

There is growing interest in funds that "bank" gains to minimise losses from market falls in later years. Paul Black, partner of LCP, says: "One scheme we work with has equities and gilts but we are talking about the ability to actively take profits if equities do really well to safeguard the gains."

This could be taken further with the introduction of downside protection, says Kapur. "This could be in the form of put options. In Germany, there are guarantees that members will receive at least the value of their contributions when they retire. The employer generally pays for this protection."

There is a compelling argument for schemes to offer a suite of risk-profiled funds. "They would be labelled according to their risk profile so making it easier for members to choose," says Simon Pearse of Mercer. This could be adventurous, balanced and cautious, for example.

Pearse says Mercer's research indicates that around 86% of default funds use a lifestyle approach. Typically, the strategic asset allocation is pre-determined. They start with 80-100% exposure to growth assets, such as UK and global equities, and switch to safer assets between three and 10 years before retirement.

They are criticised, however, for not making tactical asset allocations in response to changing market environments.

There is a great deal of talk about target date funds although few asset managers have offered them so far. They are similar to lifestyle funds in that they switch the allocation towards safer assets in the lead up to the end date. Members choose the target date fund closest to their retirement date, such as 2040.

But members can choose different target date funds to alter their risk profile and extend their exposure beyond retirement. Target date funds asset allocate tactically to reflect the current market environment.

Pearse, however, says they can provide less flexibility for sponsors. While they can choose the provider of the target date fund they do no have any say in the underlying funds. "In our view, no one manager can consistently out-perform in every asset class and so a variety of different managers managing different asset classes would be preferred within a lifestyle mechanism."

Providers of default funds also need to consider the changing retirement patterns. Some people want to retire early while increasingly members will look to retire later. It is also more common for people to use income drawdown and delay taking an annuity until they reach age 75. Furthermore, as life expectancy increases so members will need their retirement funds to last longer.

Therefore, rather than moving completely into fixed income and cash as they approach retirement age, a growing number of members will require their funds to retain exposure to equities and other growth assets beyond retirement.

There is an increasing choice of options for default funds. Schemes, therefore, need to involve members in the selection process so they choose the most appropriate one.

 US experience

The US may be considered a world leader in DC developments but the country has also struggled to produce acceptable default funds. In contrast to the UK, only 20%- 30% of DC members in the US have invested in default funds.

Traditionally, default funds in the US have comprised money market funds and cash management mandates. Jam Zovein, managing director of the institutional services group at Nuveen Investments, says these mandates were used because they ensured members had more money in their fund on retirement than they had paid into the scheme.

But Mr Zovein says the real value of members' fund has been at risk of being eroded in real terms by the rate of inflation.

Steve Utkus of the Vanguard Center for Retirement Research, says that at the end of October 2007, the Department of Labour introduced the final regulations of the Pensions Protection Act 2006 on default options in DC schemes, which are known as QDIAs.

This has outlined three broad categories of default funds. These are target date funds, balanced managed funds and managed accounts.

Managed accounts are customised portfolios for members but they require higher fees and other costs such as administration. Therefore, Mr Zovein says it is uncertain how many of these accounts will be taken out.

Mr Utkus says the Department of Labour has outlined these three board investment options as part of Congress' efforts to encourage employers to move from voluntary to automatic membership of DC schemes. If this is successful, more members will use the default option as they have not chosen to join their DC scheme. Mr Zovein expects the proportion of members using default funds to rise to 50% to 60% in the future.

The new default funds were boosted by Safe Harbour legislation. This provides protection to plan sponsors from being sued by members over the performance of default funds.

The cost of default funds is less of an issue in the US because of the size of DC schemes. "Passive mandates, for example, can have annual charges as low as five or 10 basis points. Even actively managed mandates can be less than 1%."