A low risk approach to defined contribution (DC) pension investment could be an appropriate strategy for use by young employees who have accumulated relatively small investment pots, according to Mercer. However, before deciding to introduce a lower risk stage for young members in any lifestyle solution, the firm recommends that trustees and employers consider both the membership profile and implementation options carefully.
“A low-risk approach, much like the NEST foundation stage* strategy, could be a suitable default for young members who have small investment pots, particularly those at risk of opting out. A higher risk, higher return strategy could be badly affected by a market downturn, leading members to opt out of pension arrangements altogether, “said Martyn James, Principal and DC expert at Mercer Investments. “With a more risk-averse approach, pension pots are less likely to be significantly affected by any poor market performance which means members will be less likely to feel their money is wasted in the short term. The biggest influence on the fund balance over the longer term for young members will be from their own and their employers’ contributions, so encouragement to contribute more is the aim.”
A key principle for Mercer is that default strategies should be designed to be tailored to a scheme with the membership in mind. It is clear that many occupational DC pension schemes will have a membership profile that is very different to NEST and this may necessitate a different default design.
“The implementation of any foundation phase adopted should be carefully considered. One obvious approach is to temper volatility and risk by introducing bond asset classes or cash alongside more risky growth assets,” said Mr James. “However, at current market levels, bond assets do not look good value over a medium to long-term view and cash is unlikely to keep pace with inflation at prevailing interest rate levels. Consequently, introducing either bonds or cash could deliver negative real returns to members, risking criticism and potentially, resulting in members exiting the scheme, the exact behaviour that trustees are trying to prevent.
“In the current environment a well-diversified growth fund including, for example, alternative assets as well as equities, might provide a better performing solution in the foundation phase,” concluded Mr James.
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