What is the default investment option?
We mentioned earlier that when joining a DC scheme the member will have a default investment option that traditionally was a Lifestyle option aimed at members who want to take some of their benefits as a Pension Commencement Lump Sum (PCLS), with the remainder being used to purchase an annuity.
Although a member can access benefits flexibility from age 55, there will be some who want to continue with the traditional options.
Let’s look at some questions a member may ask before making a decision.
Do I understand enough about investments to make my own decisions?
Would I prefer to have someone else manage my pension savings?
Do I intend to work until retirement and purchase an annuity?
Would I prefer an investment strategy which automatically switches my investments as I approach retirement?
If the answers are mostly "yes” then the lifestyle option would be better.
Traditional Lifestyle Investment Strategy
Members’ funds are automatically invested and they do not have to make any decisions.
The trustees (in conjunction with their scheme advisers) make the decisions on their behalf.
Growth Phase
The aim is to maximise potential investment growth over the long term by investing in equities, these are more risky investments but tend to give higher returns in the early years when members can afford to ride the ups and downs of the investment market.
Protection Phase
As members approach retirement age the investments are automatically switched into safer funds where there is more certainty. Depending on the scheme rules these switches usually start either 5 or 10 years before retirement.
Since the new flexibility options were introduced from 6 April 2015 this type of strategy is no longer appropriate and schemes are revisiting their default investment options.
The scheme’s default investment option is suitable for members who are not financially aware or who don’t want to have to pay attention to their investments.
It is designed to meet the needs of a typical member, and will be based on the trustees’ assumptions of the benefits the members will take and the date at which they will take them.
Freestyle Investment
This is for members who want to create their own investment strategy from the available fund choices. It is suitable for members who are financially aware of investment types and the associated risks and who want to take control.It is essential that members actively manage their investments and keep track of their funds by regularly reviewing their performance.
A member needs to consider:
The member will need to understand the types of investments, how they perform and the associated risks. The aim is to balance the right level of risk at the right time. The main asset classes are outlined in the table below:
| ASSET CLASS | CHARACTERISTICS | RISK AND RETURN PROFILE |
| Equities | Company shares traded on the stock market | Value goes up and down, higher risk funds but most likely to achieve best returns over the long term. |
| Property | Industrial, retail or commercial | Prices go up and down but not as volatile as equities. Over the long term they are likely to earn more than bonds or cash but not as much as equities. |
| Corporate bonds | A type of loan where the borrower pays interest and pays the loan back when it matures. Bought and sold in the same way as equities. | Prices go up and down but are considered less risky than equities or property and the investment return will be less. |
| Gilts | Bonds as above but issued by the UK government. | Used to protect against changes in the cost of annuities. Lower risk rating and less investment return. Index-linked gilts give protection against inflation increases. |
| Cash | Short term investments such as bank deposits or other money market securities. | Over the longer term the growth will be low and the value may not keep up with inflation. |
Switching Investments
Freestyle
Schemes normally allow members to switch investments a number of times each year. The member will need to decide if it is just future contributions they want to be invested in the new funds or if the total fund value is to be moved.
Sometimes the member needs to complete a switch form however it is becoming more common for members to be able to perform this exercise directly via the pension scheme’s website.
Default Investment Option
Many schemes perform switches on a monthly or quarterly basis, others will perform the switches on the member’s birthday or anniversary of joining the pension scheme, or on a fixed annual date.
With automatic switches, no account is taken of what is happening in the market at the time, consequently a switch may take place from a good performing fund into one that is not performing so well. However, the overall risk will be reduced as retirement age approaches.
