Debbie Harrison Visiting professor The Pensions Institute, Cass Business School, UK
The fierce debate in the UK over what constitutes a ‘good’ defined contribution (DC) workplace pension scheme focuses on total members’ costs relative to the ‘value for money’ (VfM) delivered. While member costs can be quantified – albeit based on a very flawed disclosure measure – member VfM has never been defined clearly.
In January 2014, the Pensions Institute at Cass Business School published VfM: Assessing Value for Money in Defined Contribution Default Funds(1). This sets out the results of a 12-month qualitative and quantitative investigation into the auto-enrolment market, which it predicts will reach £1.7trn (€2trn) in assets under management by 2030.
The main impact of auto-enrolment – the new system for pension scheme provision for UK employers – will be felt in the private sector. Employers must introduce auto-enrolment between October 2012 and 2018; the actual ‘staging date’ depends on the employer’s payroll schedule.
The most important feature of auto-enrolment schemes is the default fund, which is the multi-asset investment strategy designed for the majority of members – between 90% and 97% in aggregate – who do not wish to make investment decisions. The key determinants of the level of income in retirement secured by the member’s fund are the total contributions and member charges, the fund’s full costs, the asset allocation, and the glide path (the changing asset allocation over the period of membership). Currently in the UK, most DC members buy a lifetime annuity at retirement, which is a long-term insurance product that guarantees a lifetime income in return for the DC fund.
The report argues that the best measure of the member outcome – and therefore, VfM – is the replacement ratio (RR), the ratio of first year of retrement pension to final salary. To evaluate potential RR, the research captured data from a representative sample of 25 contract- and trust-based schemes sold between 1990 and 2013 and modelled the after-charge investment performance of the relevant default funds.
Conventional wisdom in the DC market suggests that you get what you pay for; that higher charges are rewarded in the form of a better outcome. The research finds this is not the case. While cheapest is not necessarily best, for a given level of contributions, the differences in explicit and undisclosed member charges, and in asset allocations and de-risking glide paths, give rise to very different outcomes. The most important factor that determines the outcome is the member charge, not the investment strategy.
The main findings of the research are as follows:
• Market size: The value of the DC market is predicted to grow more than six-fold by 2030, from £276bn assets under management (AUM) pre-auto-enrolment (2012) to about £1.7trn.
• Impact of consolidation: Competition will result in five or six major trust-based multi-employer schemes by 2020. Consolidation among providers could lead to instability and the sale of pension books to uncompetitive consolidators. Many employee benefit consultants and corporate advisers face an uncertain future.
• Wholesale shift to multi-employer schemes: Employers with a single trust-based DC scheme are likely to transfer to multi-employer arrangements once they remove their defined benefit (DB) liabilities from the corporate balance sheet, at which point they will be able to dismantle their DB trustee infrastructure.
• ‘Cherry-picking’ undermines employer trust: The practice of ‘cherry-picking’, whereby providers take on only the profitable section of a workforce, scuppers many smaller employers’ plans to use an existing scheme provider for the whole workforce.
• Contract law prohibits good outcomes: At present, it is difficult to facilitate the mass migration of member assets from old high-charge schemes to new low-charge schemes, yet this is essential to ensure member VfM for the remainder of the accumulation period. Modelling of a representative range of old and new funds indicates that pensions secured by the best funds are 55% higher than in the worst over a 40-year working life. This was largely due to charge differences. As a guide, each percentage point increase in the member charge leads to a fall in the expected pension of about 20%.
• Members are at end of the supply chain: Member VfM is distorted by supply-side imperatives that are poorly-aligned with members’ interests. The research raises questions about providers that offer ‘free’ services to employers and to corporate advisers, where the cost is incorporated in the total expense ratio (TER). A good example is the provision of free ‘middleware’ – the IT systems that integrate the employers’ payroll system with their auto-enrolment duties to ensure they enrol the right employees and pay the correct level of contributions.(2)
About 35,000 employers, with 50-249 employees, will reach their staging date for auto-enrolment between April 2014 and April 2015. During this period many providers will prioritise their services as follows:
• First, to the corporate adviser (formerly commission-based, now fee-based), which sells schemes to employers and whose advice in this market is unregulated;
• Second, to the employer, which chooses the scheme, its default fund and its charges, and which acts as the provider’s unregulated agent;
• And last to members, who pay for schemes, but have no choice in the design or charges.
Based on these findings, the report makes recommendations to the government and its regulators:
• Define member VfM: VfM for members means delivering the optimal combination of scheme cost and design, sustainable over both the accumulation and decumulation periods. This includes a TER in the region of 0.5% for the accumulation period, a well-designed multi-asset default fund with a glide path that is subject to regular scrutiny, independent governance, and a low-cost decumulation service.
• Define the member’s target outcome in terms of an income replacement ratio: The only meaningful expression of the member outcome is the income replacement ratio; the ratio of the pension in the first year of retirement to the final salary before retirement. An outcome expressed in terms of fund size does not take account of the annuity-conversion risks (eg, interest rate volatility and longevity risk).
• Define and require all costs and charges to be reported in full: All costs extracted by the default fund and the scheme should be reported in full to governance boards and regulators, so that component parts of the member charge, as well as the total, can be evaluated in relation to member VfM. Full disclosure data should be published on a central website available for independent public scrutiny.
• Migrate assets in older sub-standard schemes to new schemes: Revision to DC contract law would enable government and regulators to instigate a mass migration of assets from older schemes with poor investment strategies and excessive charges to modern schemes. The process must include all personal pension plans created when members of contract-based schemes leave employment.
• Reform regulation: The auto-enrolment market requires clear and consistent legal and regulatory regime across contract- and trust-based schemes. Without this, regulatory arbitrage will make a mockery of the new pension system.
(2) Following publication of the report, this practice is now under review by the Department of Work and Pensions (DWP)