Default Funds in U.K. Defined-Contribution Plans (corrected)

Abstract

Most defined-contribution (DC) pension plans give members a degree of choice as to the investment strategy for their contributions. For members unable or unwilling to choose their own investment strategies, many plans also offer a default fund. This article analyzes the U.K. “stakeholder” DC plans, which must by law offer a default fund. The default funds are typically risky but vary substantially among the providers in their strategic asset allocation and in their use of life-cycle plans that reduce risk as planned retirement approaches. A stochastic simulation model demonstrates that the differences can have a significant effect on the distribution of potential pension outcomes.

Most defined-contribution (DC) pension schemes give their members a degree of choice as to the investment strategy to be followed with their contributions. Many schemes also offer a default fund for members who are unable or unwilling to choose their own investment strategies. Previous research has shown that where a default fund exists, the majority of members adopt it. Therefore, the plan provider’s choice of default fund may have a significant effect on the welfare of plan members.

Given the importance of the default fund decision by the pension scheme provider, we analyzed the range of default funds offered by U.K. “stakeholder” pension schemes. These schemes/plans are personal pension arrangements provided by financial institutions that operate on a DC basis. By law, they must offer a default fund. The requirement to have a default fund and the public availability of data on most schemes’ default funds allowed this study of what financial institutions think are appropriate investment strategies for so-called uninformed pension scheme members. We also analyzed the fees charged for the funds.

We found the default funds to vary substantially in their strategic asset allocations and in their use of life-style profiles, which switch a member’s assets to fixed-income investments (and cash) as the planned retirement date approaches. We used a stochastic simulation model to demonstrate that the differences can have a significant effect on the likely distribution of pension outcomes. Our analysis of fees found significant variation among the funds with, for example, fees for passively managed funds not always being less than fees for active funds.

Our findings raise important questions about how providers choose their default funds and about whether the choice is correlated with the characteristics of scheme members. The findings also suggest that employers need to take care in selecting a default fund because, in many cases, it will be the fund used by most of their scheme members. The variety of default fund approaches we document means that leaving the choice of default fund to the scheme provider may not result in an appropriate outcome for scheme members.