Smart defaults: Determining the number of default funds in a pension scheme

We propose a new methodology for the smart design of the default investment fund(s) in occupational defined contribution pension schemes based on the observable characteristics of scheme members. Using a unique dataset of member risk attitudes and characteristics from a survey of a large UK pension scheme, we apply factor analysis to identify single factors for risk aversion, risk capacity and ethical investment preferences, and then apply cluster analysis to these factors to identify two distinct groups of members across age cohorts. We find membership of these clusters depends on a number of personal characteristics, with the principal differentiating feature being that one group had previously engaged with the pension scheme, while the other had not. These identified characteristics can be utilised in the design of smart default funds, including appropriate engagement strategies.