EUROPE – Current defined contribution (DC) default funds need a better risk-management framework, according to a paper by asset manager PIMCO.

The paper, entitled 'Auto-Enrolment: Risk Management for Default Investment Strategies', outlines a framework through which it believes fiduciaries must manage DC default investment options going forward.

Will Allport, vice-president of defined contribution for Ireland and the UK at PIMCO and author of the report, told IPE: "The current designs of DC default plans are likely to result in disappointing outcomes, if four fundamental factors are not addressed.

"First, current default funds do not have enough diversification.

"Second, there is little evidence of inflation protection in the default design.

"Third, typical DC strategies do not have enough downside protection from extreme capital market outcomes that may affect a DC member's savings behaviour and money-weighted returns. It is up to asset managers like us to create some downside protection to minimise black swan events, but, at the same time, maintain the upside potential.

"And finally, there needs to be a de-risking approach sensitive to the prevailing market environment."

PIMCO's recent research showed that, contrary to popular market wisdom, capital market losses in default investment strategies do negatively affect DC members' savings and investment behaviour.

But Allport believes that, over time, companies will compete on the quality of their pension offering and therefore have to improve their DC default vehicle.

He added: "Whether DC plans have a lifestyling or target-date approach does not matter – these are just delivery mechanisms.

"As asset managers, we need to create a strategy that is deliverable through all mechanisms by combining three or four investment capabilities that address those issues of downside protection, diversification and inflation and embed them in one strategy.

"We need to embed the nature of diversified growth funds in default strategies, which have the flexibility to move between growth-oriented assets and de-risking."

Allport said the market belief of 'cheap is good' was not a good approach when it came to DC pension funds.

Instead, portfolios need to be sensitive to market sentiment and have dynamic asset allocation, leaving investors to focus on net-of-fee outcomes rather than absolute price.

A longer paper will be published in February.

The PIMCO paper is included in an industry report from publisher Clear Path Analysis.

The 'Auto-Enrolment for UK Pension Plans 2013' report brings together pension scheme managers, HR directors and finance directors approaching or passing their staging dates to discuss the latest solutions for streamlining auto-enrolment and overcoming challenges from scheme design, employee responsibility, technology and data considerations to costs of implementation.