How many default funds should a DC scheme have?

Defined contribution (DC) pension schemes are becoming the mainstay of retirement income provision. Most schemes have a default fund for members who don’t want to make their own investment choice. The majority of members – often more than 90% – tend to stick with that option.

This creates the challenge for trustees and pension providers of making sure the default is suitable for the membership. A2Risk was delighted to collaborate with USS – the pension scheme for UK universities’ academic staff – on a 2016 project to understand the needs of their membership ahead of introduction of a new defined contribution scheme.

Following from that project, The Pensions Institute has recently published a working paper based on analysis of the data obtained from a sample of 9,755 USS scheme members who completed the A2Risk attitude to risk questionnaire and provided details on their demographic profile and other characteristics.

The paper considers the number of default investment funds appropriate for DC pension scheme. The authors – including Professor David Blake and Dr Alistair Haig from A2Risk – apply cluster analysis to identify distinct groups of members. The cluster analysis identifies just two distinct groups of members in their 40s and 50s – the most important age cohorts in terms of the timing, size and compounding of returns on pension contributions. One group displays higher pay, longer tenure, less interest in ethical investing, lower risk capacity, a higher percentage of males, and a higher percentage of academics than the members of the other group – and significantly, all of its members have previously taken the active decision of making additional contributions, whereas none of the members of the other cluster have made additional contributions.

Further analysis indicated that the risk attitudes of the two groups were not significantly different, allowing the authors to conclude that a single lifestyle default fund is appropriate. Characteristics that other studies have found important determinants of risk attitudes, such as age, income and (pension) wealth, did not turn out to be as significant for USS members. Further, despite being on average more highly educated than the general population, USS members are marginally more risk averse than the general population, controlling for salary, although the difference is not significant.

The survey also responses indicated that in some other dimensions apart from risk attitude, the scheme members segmented into mutually exclusive groups. Two prominent examples are whether members were (1) interested in ethical investing or not, or (2) required a Shariah-compliant fund or not.

Overall, the authors find there is no evidence of a requirement for multiple defaults within the scheme. USS decided on the basis of this research to introduce a single default lifestyle fund which would de-risk gradually in the 10 years prior to retirement.

The project provides an interesting case study of how attitude to risk can be considered in the context of occupational pension schemes rather than individual financial advice. If you’d like us to help analyse your scheme, please get in touch.

The paper also contains a useful comprehensive summary of the academic literature relating to risk tolerance and can be found here.