UK - The use of target date funds as the default for the personal accounts system is a “serious proposition” to be put forward in an investment consultation from the Personal Accounts Delivery Authority (PADA) later this year.

Speaking at the National Association of Pension Funds (NAPF) annual investment conference in Edinburgh last week, Mark Fawcett, investment director at PADA, told delegates at a breakout session that the design of the default fund of the new account would be “critical”.

He said the consultation, scheduled for publication in spring 2009, is designed to gather the best ideas from around the industry and avoid the pitfalls, as research suggests personal accounts “clearly have to design a default fund that at least 80% want to come into”.

Fawcett told the conference a “very high percentage” of default funds have 100% equity holdings followed by five to 10 years of ‘lifestyling’, but warned there were concerns this strategy would not be appropriate for the personal accounts target market - of low to medium earners - because of volatility and persistency issues.

He revealed the target market’s attitude to investment was either risk-averse or mildly risk-averse, and suggested “as people’s risk aversion changes over time it is wrong to put them into a too high risk fund” and added “clearly where we balance the risk and reward will be critical”.

Instead of a ‘lifestyling’ approach, which can mean people switching out of 100% equities into bonds near retirement regardless of the state of the market and with little time to recoup any potential loss of income, PADA is considering the use of target date funds.

Fawcett claimed an advantage to this approach is the fund can “manage the glide path less mechanistically and more intelligently over time”, and confirmed it is “something we are putting forward as a very serious proposition in personal accounts”.

The use of guaranteed funds may meanwhile be ruled out as they are “expensive”, though Fawcett suggested a possible solution could be to structure the default fund so that “a portion is lower risk so that it feels like a guarantee”.

The proportion of this potential split is “still to be decided”, but he suggested one possibility is to have a “neutral” position in the default fund of “around 50% in relatively low risk assets and 50% in higher risk investments”, although he highlighted this would “obviously be subject to consultation and the trustees decision”, as “ultimately the trustees can ignore our recommendations if they want to”.

Fawcett added PADA is also looking at what level of an active/passive balance the default should have, as “it can’t be all active because of the low cost imperative”, but confirmed the organisation is considering what asset classes would most benefit from active management.

He said defined contribution (DC) schemes should be considering alternatives in their investment strategy, and admitted although there are constraints, particularly around liquidity, Fawcett told delegates PADA is “looking at how much those constraints affect the use of alternatives in personal accounts”, including the extra resources needed to explain to members what they are.

In response to a question regarding fees and capacity constraints for alternative investments, Fawcett also admitted to attendees there are a “number of challenges but it would be irrational to eliminate it as a possibility now”, and said while the consultation questions how personal accounts would deal with liquidity and pricing issues he suggested even with these challenges “there may still be a role” for the asset class.

Meanwhile, the investment consultation is also expected to explore how corporate governance and responsible investing will affect personal accounts, and to consider whether a traditional DC investment strategy is suitable for the new system or whether respondents can produce “some viable solutions for risk pooling in designing DC schemes over the long term”.

If you have any comments you would like to add to this or any other story, contact Nyree Stewart on + 44 (0)20 7261 4618 or email nyree.stewart@ipe.com

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