Take a look at the average default fund – the one you are in unless you’ve “opted-out” and if you are over 55 , you will probably find it is invested not in return seeking assets but what the pensions industry calls “matching assets”.
Matching assets include “cash” which matches the 25% of our pot that we can cash out “tax-free” and they include “fixed interest securities” which are corporate and government loans repayable either at a fixed rate or in line with inflation.
These matching assets are there because of the pension industry’s obsession with LDI or “liability driven investment”. DC pension pots have a liability to pay 25% of the value as cash and a liability to pay the rest as “pension” and pensions are best paid by matching the income stream to be paid with fixed income securities.
This sounds fine in principle but in practice it is anything but fine because only 10% of DC savers buy a pension (an annuity) so the matching assets which increasingly take over your pension pot in your fifties and sixties are only really matching the “pension liability” 10% of the time. The rest of the time, these matching assets are supposed to be matching something else – but what?
The majority of money taken out of DC pension pots at the moment is taken out not as income but as cash. Cashing-out is not helped by an investment in fixed interest securities. Although they are often quoted as “low-risk”, they can be quite the opposite. Over the last 12 months , the cash value of loans to Government (gilts) has fallen around 25% and where the repayment is linked to inflation (index-linked gilts) some funds have fallen by more than half. They have not matched the needs of those cashing out at all.
The second most common thing people who reach 55 are doing with their DC pension pot is nothing. They are simply rolling the pot up so it can provide them with security in later life. How this pot becomes a pension is unclear, it may not ever be touched but become an inheritance, it may be cashed out or it may be drawn down (with or more likely without the help of a financial adviser).
The vast majority of money in DC pots is owned by people over 55 but what those people (who include me) intend to do with the money is unclear either to the people who design the default funds, or to the people who own them.
Liability Driven Investment is about creating certainty and in its purest form , where the liabilities are clear it can create much more certain outcomes. Putting aside the borrowing that most LDI plans indulged in, simply matching liabilities and assets is a good plan.
But in the context of the free for all that has happened since DC pension pots were freed to be spent as we choose, LDI is cooked. You cannot match assets to liabilities if you don’t know what a pot’s liabilities are.
A common purpose
The Australians have sussed it, while everyone has the right to go their own way, the common purpose – which is what a default is supposed to support – has to be clear to those establishing the default. A common purpose has been put forward by Willis Towers Watson. It is a “done for us” income that lasts as long as we do and is more affordable than an annuity.
If we were to establish this as he common purpose of all DC pension pots, then we can agree that people who buy annuities, drawdown or let them roll up their money are the outliers. The mainstream, where the vast majority of money flows, can be invested to meet this purpose. Provided we know the “to and through” , we can make sure that the default is matching on either side of that equation.
How we turn LDI from screwing up to tuning up our pension savings
- Agree the common purpose of pension pots is to pay a pension along the lines laid out by WTW
- Work out what the best investment strategy to achieve this for those who don’t want to choose
- Align the investment strategy before retirement (the “to”) with that into retirement (the “through”) by matching assets using LDI principles)
- Translate the common purpose into common action by making both the “to” and the “through” the default funds we are in unless we “opt-out”.
This is how we turn LDI from screwing up to tuning up our pension savings.