The UK government plans a new system of Personal Accounts to provide pensions for employees who do not have access to a good quality work-based scheme. The scheme is due in 2012 and the Personal Accounts Delivery Authority is working hard on the details. Getting the investment arrangements right is a major challenge and an issue Pada is currently consulting on.

It is clear that the target market for Personal Accounts comprises lower income individuals with little prior investment experience (“reluctant investors”). They are likely to be disinterested in pension planning and investments, easily confused, easily put off and more than averagely risk averse. This has implications for the investment arrangements. In particular, most members will end up in the default fund rather than making an active fund choice.

The trustee corporation can never be sure it knows what members want. It therefore has to take a view on what will be the best investment solution for the majority of members. However, it is impossible to do this without having a target in mind, such as a particular type of annuity on the retirement date. We believe that the objectives of Personal Accounts should be a) to deliver a pension in retirement rather than a lump sum and b) to deliver a pension that is stable in relation to the pattern of contributions made during the course of the member’s career. If two people have the same pattern of contributions, they should end up with a similar pension. These objectives are similar to those in a conventional defined benefit scheme.

Given these objectives for Personal Accounts, the overarching objectives for the default fund should be to a) maximise the income replacement ratio for a given contribution stream, and b) to minimise the variability of pension outcomes for the same contribution stream. This involves a classic risk-return trade-off, but expressed in terms of pension outcomes, rather than rates of return.

The ideal default investment strategy would be a lifestyle strategy. In the early stages of the strategy, contributions would be invested in a highly diversified portfolio with a significant equity weighting to benefit from the equity risk premium. As the selected retirement date approaches, the risk of the fund would be reduced by a systematic switch into deferred life annuities. This would help to hedge interest rate and longevity risks in the period leading up to retirement. The use of deferred annuities is a key difference from the typical lifestyle fund where the glide path involves a switch into bonds. What type of deferred annuities should they be? Given that state benefits in retirement are index-linked, there is a case for allowing the member to choose a level annuity. This would maximise income at the start of retirement when the pensioner is most active.

The lifestyle strategy could be delivered using target date funds. These are funds managed to meet the risk/return objectives of members retiring in a particular year (eg 2030). Target date funds offer benefits in terms of ease of communication to members, who should be able to relate to the concept of a fund being managed with their retirement date in mind. Target date funds also provide a degree of future proofing as it will be relatively easy for the trustee corporation to make adjustments, for example to the derisking glide path, if market developments require.

In terms of managing the default fund, it would seem unlikely that the trustee corporation would have the skills and flexibility to add value in short-term market timing. However, the strategic asset allocation could be adjusted through time to take account of changing market conditions. It would also make sense to use a wide range of asset classes to achieve maximum diversification, including so-called alternatives assets. The need for low costs and the difficulty of choosing active managers with consistent superior performance would suggest the use of passive approaches where possible.

Beyond the default fund, Personal Accounts should offer a narrow range of funds suitable for investors who want a bit more choice. There might be scope for multi-asset funds that have higher and lower levels of investment risk than the default, ie, risk-graded managed funds. Probably only two additional funds are needed, one with higher and one with lower risk than the default. The variation in risk level could be achieved by having a different overall asset mix, or by varying the length of the glide path, or by some combination of the two.

There should also be funds that cater for commonly-held religious and ethical preferences, again ideally in the form of diversified, managed funds. There is no need for asset class funds to act as building blocks for DIY asset allocation. Branded funds would also seem likely to create an unwarranted distraction from the key risk allocation issues.

Alistair Byrne is senior lecturer in finance at the University of Edinburgh Business School. David Blake is professor of pension economics at the Cass Business School