One of the least known yet potentially dangerous consequences of the Chancellor’s revolutionary pension changes is the way they render obsolete the investment strategies of virtually all workplace pension schemes. In fact the new rules will leave most providers’ default funds looking decidedly toxic unless they change them pretty quickly.
George Osborne’s decision to sweep away the obligation to buy an annuity has been broadly welcomed. But it has created a need for a complete rethink of the way default funds are structured. NOW: Pensions’ master trust structure allows it to make the crucial changes needed to ensure its default remains fit for purpose without having to bother the employers and employees it serves. In fact we made changes our default fund in July so it’s ready for the new rules.
But for millions of savers in contract based schemes, things are not so straightforward. Here’s how the new rules create a ticking timebomb for many pension savers.
For years most people in default pension funds have ended up using their pot to buy an annuity. But annuity rates can and do fluctuate, particularly when interest rates change – when interest rates go up, so do the payouts from annuities. And when interest rates go down, annuity rates go down too.
Retiring workers would be pretty upset if annuity rates fell by say 20 per cent in the year before they retired, as they would get 20 per cent less income. So to protect scheme members against this risk, workplace pension default funds have traditionally operated glidepath strategies that move funds into assets that will cancel out this risk as they approach retirement.
Unfortunately what has been a clever strategy to protect employees for years could prove costly under the new rules. Here’s why.
Traditional default funds move savers into gilts and other secure bonds to hedge against moves in annuity rates. They do this because gilts tend to move in the opposite direction to interest rates and annuity rates. So when interest rates fall, gilts go up in value. Conversely, when interest rates rise, gilts fall in value.
So if interest rates do fall just before you retire, the cash value of the gilts in your fund rises. This means you have a bigger pot to buy an annuity, even though the annuity rate has also gone down as a result of the interest rate fall. All in all you get more or less the same income as if interest rates hadn’t moved.
These lifestyle structures are all well and good when almost everyone is using their pot to buy an annuity. But the Chancellor’s new Budget freedoms mean that will no longer be the case. In fact, many people will instead be accessing their fund as a cash sum, or keeping it invested in the stockmarket.
Unless they change their investment strategy, workplace pension schemes with old-school default funds face a nightmare scenario. Seeing your fund move into gilts just before retirement is not ideal if you want if you are planning to take your pension as cash or invest in shares. If interest rates rise, then the cash value of retiring employees’ gilts is likely to fall, meaning their fund value will be lower, even though they thought they had been moved into safe assets ahead of retirement. And with commentators predicting rising interest rates in future, the risk of falling gilt valuations is not idle speculation.
With the Budget reforms looming large on the horizon, the risk posed by out of date default funds grows every day. The time for hesitation is over.