The UKâs National Employment Savings Trust (Nest) unveiled its investment strategy last week and in doing so revealed it had dug into the textbooks of behavioural finance.
The Nest fund – which is a sort of defined contribution ‘state’ pension run by a non-governmental department – is to employ a series of target-date funds for its default investment options.
It will put younger members’ funds initially into a lower risk fund described as a ‘foundation’ phase in order to create a savings habit.
But the foundation phase is also there to avoid negative reactions to volatility, which the scheme’s trustees expect to be prevalent.
One of those negative reactions that is noted in research produced for Nest (Understanding Reactions to Volatility and Loss) is that members may cease their contributions when they see their pension savings reduce.
The default funds are intended to provide inflation-beating returns over the longer term. The default option is considered to be particularly important as the target market for Nest – lower to middle-income earners – tends to suffer from lack of investment knowledge and inertia
But their lower wages also makes them more averse to losses. Nest acknowledges research that suggests losing a £10 note is far more unpleasant than finding a £10 note is pleasurable.
The announcement by Nest last week has been broadly welcomed, including its decision to offer an ethical component outside of the default target-date fund range for those prepared to take more risk.
However, Brian Henderson, European head of defined contribution pensions in Mercer’s Investment Consulting warned the low-risk early start to the default range could prove challenging.
"Nest's decision to start members off with a low-risk strategy is certainly different to traditional DC strategies. On the face of it this appears a sensible approach given the research undertaken on the profile of NEST's membership.
“However, the challenge will be taking care not to undercook the low-risk start, especially in light of the initial charges. Without sufficient growth to overcome the initial entry fees there is a potential risk that the early year low-risk foundation stage could linger."
Nick Fitzpatrick, editor©2011 funds europe