Most defined contribution pension schemes and Personal Retirement Savings Accounts (PRSAs) offer a default investment strategy (DIS) for contributors who do not wish to make a specific investment choice. This means as you approach retirement your funds will be moved from more risky assets, usually equities, into less risky assets, usually bonds. The rationale for a DIS is to reduce the difficulties in setting up a defined contribution pension due to the financial inexperience of the contributor.
A DIS is not intended to be free from risk or volatility and the benefits ultimately provided by a pension product will be affected by investment conditions, the wider economic environment and the skill of the investment managers in exploiting them. The default investment strategy is unlikely to be able to fulfill the expectations of all contributors at all times.
A study in May 2005 of defined contribution investors in a typical managed fund looked at the range of outcomes they and investors in a more balanced portfolio would receive and the impact of life-styling on the outcomes. Life-styling is the most common type of DIS.
The somewhat surprising result is that life-style doesn’t reduce the number of bad outcomes. It simply reduces the average outcome but the probability of bad outcomes is much the same.
Life-styling is typically justified by the scenario of very strong equity returns followed by very poor equity returns. Life-styling is certainly a positive in that environment. However, less consideration is given to the alternative outcome which is the scenario of investors first experiencing poor equity returns and then, as they get close to retirement, quite positive equity returns.
The movement into cash via the life-style process prevents them from gaining from that upside and essentially entraps the investor in their bad outcome.
In the current economic climate there is a significant bubble under bonds. Earlier this month, German government 30-year bond yields rose from 0.20% to 0.80% in one day. This caused the capital value of the bonds to fall by 22%. Bonds are not the safe haven we once thought.
It will pay those close to retirement with a pension fund in a default investment strategy to get qualified professional investment advice.