Forty per cent of default funds are still targeted to annuities, which could be leaving members exposed to “unintended investment risks”, according to Aon.

The introduction of the freedom and choice reforms in April 2015 has seen a huge drop in the number of people purchasing an annuity, with people choosing other options such as drawdown. However, Aon has warned that pension schemes’ default strategies, which in the past would move members about to retire into UK fixed income funds - targeting annuity purchase - are lagging behind this trend.

Commenting, Aon head of DC investment advisory Chris Inman said: “The change in preferences at retirement has introduced the need for pension schemes to re-think this approach. Traditional investment strategies that utilise passively managed funds that invest solely in UK fixed income can now be exposing members to significant unintended risks.

“Our research of capital loss of UK fixed income, relative to global equities and different types of diversified growth funds, shows that these funds have not effectively protected members against capital losses, especially over recent periods where yields have risen.”

Aon noted that fixed income funds used by DC schemes tend to be restricted to the relatively concentrated UK fixed income market and, therefore, they may not offer the same diversification opportunities and liquidity as global markets.

Aon’s Defined Contribution Scheme Survey 2017 showed that 85 per cent of members are still using the default option and that 40 per cent of these default investment strategies target the purchase of an annuity at retirement. In the wake of freedom and choice, members should be aware that investing in fixed income has become much more risky, Inman said.

“Regardless of whether members take their benefits as cash or draw them down as flexible income, how we think about risk should change. We should focus on the absolute variability of outcomes, as well as the magnitude and duration of the capital loss. For DC members nearing retirement, investment strategies need to mitigate key risks including opportunity cost, longevity and inflation.”

Aon recommends that members find out from their schemes what sort of strategies their money is invested in as they get nearer to retirement. They can then decide whether UK fixed income is an appropriate investment for them, based on their retirement intentions.

In addition, Aon DC investment consultant Adam Hayes said: “Members could explore alternatives to these funds. For example, more diversified strategies such as multi-asset credit and absolute return bonds (ARB) could be something more suitable for members. Both strategies can allocate into a number of fixed income markets, with ARB managers being much more unconstrained and investing in a much wider opportunity set.

“It is essential that members consider what their preferred option would be as they approach retirement. That way they can be in a better position to choose the type of strategy that best suits their retirement choices.”

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