What is a good default?

The pension freedoms, introduce 2015 in the UK, removed the (near) requirement to buy an annuity and members were given the possibility, from age 55, to take all of their savings as they see fit. Before the pension freedoms, DC default de-risking strategies typically targeted 25% cash and 75% long duration bonds to reflect the ‘liabilities’ of the lump-sum and assuming that people would buy annuities for the rest.

Seven years later, we have data on what people do. According to research by Legal & General, roughly 80% of savers with pots larger than ￡150,000 tend to prefer drawdown and only 3% buy an annuity; the rest cash it out. For all savers, of which the majority has a small pot, more than 80% cash out their pot. This has completely changed the context for designing a default strategy. Today we simply don’t know what a member will do, nor when they’ll decide to do it.

Lifecycle investing – the theory

The idea behind lifecycle theory is to smooth consumption throughout an individual’s life. To do that there are two main assets: human capital (future income) and financial assets (savings). Lifecycle investing theory puts this concept into a portfolio perspective. As someone gets older, their ‘allocation’ to human capital naturally decreases and it makes perfect sense to de-risk their financial assets.

Providers often use this theory as an alibi for implementing a de-risking strategy. As you get older your allocation to cash is automatically increased. This narrow interpretation of lifecycle investing is probably not that useful for most members.

The objective of lifecycle investing is to smooth consumption. The theory is defined in real terms which means cash is far from a safe asset. Holding cash in times of high inflation erodes the purchasing power with absolute certainty. The affection for cash is a well-known bias that behavioural economists refer to as the money illusion.

The definition of financial assets is broad. Financial assets consist of, among other things, property, savings, investments and workplace pensions. For many the largest, but often omitted, financial assets are tax-financed social security benefits which include the State Pension, Pension Credit and other public transfers. Applying lifecycle investment theory only to a small part of the overall financial asset - the pension pot that the member has with a specific provider - is a classic example of mental compartmentalisation which almost certainty leads to a sub-optimal solution for the member.

Is there a middle-of-the-road lifecycle?

In the UK, the State Pension is an inflation-linked lifelong annuity with a market value of at least ￡250,000 GBP (in September 2022). Some of the other social benefits are means tested, which result in what economists call implicit marginal tax effects. This means that for those who have hardly any financial assets, it could be economically rational to withdraw their pension savings as a lump sum at retirement.

The small potter

As auto enrolment is ‘only’ 10 years old, the size of the savings pots that AE members will retire on are likely to remain relatively small for years to come. Someone with a pension pot of say, ￡25,000, has at least a financial capital of ￡275,000 when including the state pension. If their pension pot represents all their financial savings, it means 91% of their financial wealth is already invested in the ‘safe’ asset. De-risking the remaining 9% towards cash does not make sense from a portfolio perspective since the member already has over 90% of their financial capital in the safe asset. The potential financial downside of the investment risk will, to some extent, be compensated for by pension credits and other social benefits.

The middle-sized pots

The group that needs to think about lifecycle investing and de-risking has a decent amount of financial assets to start with and needs to think about how to de-risk their financial assets. For someone with a workplace savings pot of ￡250,000, their total financial capital is ￡500,000, excluding other assets. That means 50% of their financial assets, earmarked for pension, are already invested in the safe asset. Roughly 80% of savers with pots larger than ￡150,000 tend to prefer drawdown. In that case, the pension savings will stay invested for quite some time beyond the retirement date, which allows for some risk-taking before retirement. Therefore, it is not necessary to de-risk that much in the lifecycle, and when de-risking, the safe asset should definitely not be cash.

The happy few

Those who are struggling to keep their workplace pensions within the Life Time Allowance limit most likely have a significant amount of other financial assets. This group can stay invested in return-seeking assets, since the adverse market conditions are not likely to significantly affect their consumption. The main problem for this group isn’t running out of money, but how to pass it on to the next generation. This means they have a very long investment horizon and their main concern is around tax efficiency rather than financial risk. This group typically seeks financial advice so we should not worry too much about them.

Behavioural reasons for de-risking

Knowing this, one might wonder why so many providers apply a lifecycle that starts 10 to 15 years before retirement and de-risk part of the portfolio into something like cash. I think the answer boils down to a set of behavioural drivers.

• Money illusion – focusing on pounds and pence instead of purchasing power
• Mental accounting – analysing workplace pensions separately from the State Pension
• Loss aversion – experiencing a sharp fall in assets before retirement might result in members blaming their provider
• Groupthink – from a self-preservation perspective, why do something different from competitors?
• ?Planning fallacy – we have a plan which gives us the illusion of control

An interesting observation is that these behavioural drivers are mainly related to the industry itself and have little to do with members. Perhaps it is about time to change the industry practice on de-risking, especially the destructive practice of considering cash as the safe asset when the inflation hovers around 10%?