While the logic of the standard default option is easy to see (average equity returns are more certain over longer periods than shorter periods and are superior to those of defensive assets), it isn’t so clear what underlies the investment mix of the age-based default funds for older members.
Once people approach retirement their main concern should be about how to replace their working income; in effect, how to fund their expenses once they are no longer employed. This is similar to the situation faced by a defined benefit fund: how to invest the assets to ensure that income is generated to meet the promised benefit, which is generally an indexed percentage of final salary.
There are few funded defined benefit schemes in Australia.
However, the UK still has a large number of corporate defined benefit schemes and these can give a guide to an appropriate investment allocation for age-based default options.
Those schemes with a high proportion of pensioners (80-100 per cent of total members) typically have 80 per cent of their assets in defensive assets: 70 per cent fixed interest, 5 per cent cash and 5 per cent insurance policies.
Based on this, it is clear that the level of defensive assets in the age-based default options for older members offered by not-for-profit funds is too low to satisfy actuarial assessments of matching income from assets with pension liabilities.
NO EASY TASK
Most fund members are guided by the default investment option offered by their fund.
However, this option is suitable for younger members rather than those closer to retirement. As a result, the default options favour growth assets, where a long time frame is needed. Older members, who do not have the luxury of time, are ill-served by standard default options, especially when equity markets are priced to deliver below average returns, as now.
Even those funds that recognise the need to provide a more conservative age-based option still have too much allocated to growth assets and need to increase fixed interest investments to better match the cashflow generated in retirement with the members’ living expenses.
John Wilson is chief executive of PIMCO Australia.
