Retirement planning: when it makes sense to name the day

Baldrick was famous for having one, but based on pension scheme records it would appear that   millions of people don’t have a plan, cunning or otherwise, regarding their retirement date. Despite increases in the state pension age to 67 and 68, the vast majority of savers have stuck with their schemes default retirement age of 60, 63 or 65 which could end up costing them money.    

To understand why the lack of a planned retirement age can be costly, we need to consider what default funds are designed to do.

The opportunity to invest in a default fund could be perfect for people who don’t feel confident to make their own investment choices, or simply don’t have the time to do so. It’s easily the most popular solution for UK employees – and, for most, with good reason. 

But it relies on people deciding on a retirement age that’s right for them and communicating this to their provider. This is because of the way the de-risking element (a feature of almost all default investment solutions) operates.

The risk of de-risking without a planned retirement age

As members approach the retirement date held on scheme records, investments are automatically moved from higher risk funds to lower risk funds. This process is designed to protect people’s  pension pots from the effects of any sudden shifts in the market, but crucially this reduces the potential for higher returns.

In a pension’s early years, a high proportion of the money paid in might be invested in higher risk investments such as equities. But by the time a scheme member reaches retirement age, the proportion invested in equities typically falls to an average of 21% ^{[1]Footnote 1}.

All of this is designed to balance risk and return as retirement approaches. But if the member has changed their plans, that balance is upset – which can be costly.

If the scheme had a retirement age that’s too young, investments will be moved to less risky assets too early. This means members lose out on investment growth when their pension pot is the largest.

Our calculations suggest that an average earner in an automatic enrolment scheme could lose over £4000 ^{[2]Footnote 2} if their default fund is working on the basis of a retirement age that’s three years earlier than they actually plan to retire.

This estimated loss rises to just under £10,000 if they’ve set a retirement age of 60, but don’t actually intend retiring until they reach 68. A situation that’s more likely for women. The losses could be greater if the default investment is more aggressive at outset, or if the holdings at retirement are more cautious.     

There can also be a problem if the scheme holds a retirement age that’s too old. This means money will be invested in riskier investments for too long. If investments lose value too close to the planned retirement age there may not be time for them to recover their value. This means less money, or perhaps a last-minute delay to retirement plans.

The difference bad timing can make

Aviva’s governance reports reveal that a huge proportion of people in workplace pensions are triple defaulting. That means paying the default contribution rate, investing in the default fund and intending to retire at the default retirement age.

How much difference might this make? We should never underestimate the potential effect of taking an investment approach which isn’t appropriate to the member’s life stage. An analysis of defaults ^{[1]Footnote 1} found five-year default investment returns to be 3.62% lower at retirement than at 30 years to pension age. And 2.4% lower compared to the average investment return at 5 years to retirement age.    

The bottom line is that many employees who are invested in a default fund will need a reminder to log onto their provider’s website and update their pension records with an accurate planned retirement age.

The majority of schemes still have a default retirement age of 65 or younger, but anyone who’s aged under 41 won’t receive their state pension until they’re 68.

Some will see state pension as insignificant, many will depend on it to provide them with the additional income to allow them to leave work. People might already have a have some kind of plan in mind. But they need to log onto their providers web site and update their pension records if they’re to avoid a nasty surprise, or suffer an avoidable loss on their route to retirement.           

Dale Critchley, Policy Manager for Workplace Savings and Retirement, is an expert commentator with over 30 years’ experience in a variety of roles within the workplace benefits market. He is an Aviva spokesperson specialising in issues relating to workplace pensions and is regularly featured in the media.