How to develop an effective default
By Farai Muronda
To initiate optimal default choices, trustees first need to understand the context of their member base, which will differ based on different industries as well as demographic profiles. Some industries have a high turnover of staff, while in other industries employees are retained for a long period, often for an entire lifetime.
Trustees also need to consider the evolution of a member through the fund and what that would look like. What investment choices should be available to the member at what time of their life or savings life-cycle?
Once a trustee has developed a robust picture of the member base and the context of that member base, they ideally want to put them into “buckets” according to a handful of categories using factors such as risk profile or desired return outcome.
SOLVING FOR BEHAVIOURAL ECONOMICS
There have been many behavioural economic studies showing that when people are faced with choice, they tend to delay decision-making for as long as possible, to their own detriment.
By introducing default portfolios, trustees are able to remove the “decision burden” from members and automatically assign them to an investment. This is not to say that a member’s choice is taken away – members still have the right to exercise their own choice. But for the majority of members who are uncertain what choice to make, default portfolios are a guide based on wellresearched parameters.
MAKING LANGUAGE EASIER
To aid members in understanding default portfolios available to them, the industry needs to start using a different language.
For example, an average person would relate to a portfolio that preserves their money rather than a “low volatility portfolio”. It’s about saying the same thing but really understanding the context of the member and ensuring you can connect with them in a way that they understand.
RISK PROFILING – PROCEED WITH CAUTION
Risk profiling plays an important role in achieving optimal default options for members. However, trustees should be careful of relying solely on this. Risk profiling looks at how much risk tolerance a member has and places them in the right bucket for that level of risk tolerance. In addition to this, trustees should give a significant amount of weight to the investment outcome that an investor is seeking.
A risk profile may indicate that a member is an aggressive investor, but nobody likes to lose money – not even aggressive investors. Similarly, a risk profile may classify a member as conservative. However, every investment needs a certain level of risk in order to earn a return. A member cannot choose to be so conservative that they don’t earn a return that keeps up with inflation.
Trustees should combine risk profiling with a mechanism that considers the return outcome that a member wants or needs.
One example of a default investment product that accommodates the need for a changing risk profile is called a “target date portfolio” (a variation on a life-stage portfolio). If a member is targeting retirement in 30 years’ time, the portfolio adjusts exposures to risky assets according to how far away from retirement the member is.
As a member gets closer to retirement, the portfolio automatically rebalances to include more conservative and less volatile assets. The idea is that a member nearing retirement doesn’t want to risk losing their base capital – they are naturally entering a period of preservation and conservatism. However, a member that is 30 or 40 years from retirement should be in a growth and accumulation phase and can, therefore, have exposure to more volatile and high earning asset classes.