It is early days for the UK’s new pension regime under which defined contribution (DC) savers no longer have to buy an annuity. However, perhaps there are already lessons to be learned by other countries from the reforms. The following early insights from the National Employment Savings Trust (NEST) may be of particular interest to those working in international pension regimes, either where there is an automatic DC pension saving element or where there is an accelerated shift from defined benefit (DB) to DC.
Lesson one. Understanding members’ challenges and preferences.
As NEST’s Future of Retirement consultation shows, when consumers take their money out of a pension scheme, they have similar priorities to when they are saving. Our research on members’ reactions to losses reveals that consumers are naturally conservative when it comes to retirement. People want protection against losses and volatility along the way, and have a strong desire for a predictable outcome at the end. It is unsurprising to find these preferences when it comes to accessing their savings as well.
People’s general impression is that investment risk is not good. Although there’s a perception that higher-risk funds might deliver a larger pension pot, members worry about whether they will lose money or that their income might drop.
The new pension freedoms do not appear to have changed this apparent risk aversion. All this said, it is also clear is that consumers welcome that they no longer have to buy an annuity. This is true despite the fact that a product similar to an indexed-linked annuity may meet the needs of at least some of them in terms of security of income and avoiding investment risks.
International observers may take some comfort from the fact that, overall, consumers say they will use their pension to provide themselves with a retirement income. What is more challenging is that they are unclear on how they will do this. They are also unclear about their options.
Evidence suggests that consumers will be keen to leave their pension pot invested. It is unlikely, though, that most savers really understand their risk capacity or how they might fund their retirement this way. While sales of traditional drawdown products have increased and new drawdown options have come onto the market in the UK, there are warnings from various commentators that savers may be unaware of the risks involved.
So if, broadly speaking, savers say they want a retirement income while keeping their money invested, but are concerned about taking investment risk, where does this leave responsible product design?
Lesson two. Recognising the continued importance of defaults into retirement.
Understanding members’ needs and aspirations is only one part of what UK DC scheme managers are thinking about when designing investment approaches and options for retirement. Trust-based pension schemes also face balancing this understanding with their legal responsibility to first determine and then act in the best interests of members.
This has been a real challenge in the design of default investment strategies for the accumulation phase of auto-enrolment in the UK, where members are not required to make active decisions. Increasingly, this challenge will also be felt by trustees considering how their members may want to access their DC savings at retirement.
There are likely to be times when members do not give trustees much direction about what they want or need. There will also be times when what trustees consider to be in the best interests of members will not be aligned with what people say they want. For example, while members may say they prefer a de-risking approach in the run up to retirement, this may actually create unintended negative consequences for those who are planning to keep their pots invested and use them for drawdown.
NEST has worked with its peers in the UK and overseas to establish a number of product design and development themes where there is broad agreement on meeting savers’ needs. These include the need for some form of default retirement income solution for large groups of savers, the need for flexibility, and the need to manage the risk of people outliving their savings.
We have also identified six principles to inform the design of default retirement solutions for the new generation of DC savers in the UK:
• Living longer than expected is the key risk in retirement and a critical input into retirement income solutions;
• Savers should expect to spend most or all of their pension pots during their retirement – this principle calls in particular upon insight from Australia’s QSuper;
• Income should be stable and sustainable;
• Managing investment risk is crucial as volatility can be especially harmful in income drawdown-type arrangements;
• Providers should look to offer flexibility and portability wherever possible;
• Inflation risk should be managed but not necessarily hedged.
Lesson three. Thinking carefully about de-risking strategies.
In the UK there is pressure to create de-risking strategies that are relevant not only to how most members save, but also so they may access their pot at retirement. In a world where most DC pension scheme members say they do not plan to buy an annuity, maintaining pre-freedom and choice glidepaths does not seem appropriate.
But at this stage in the game, it is not always clear what schemes should be aiming for.
NEST’s initial response has been to adapt the glidepath for NEST Retirement Date funds so they more closely match what we think members will do in future. For those funds maturing up to 2020, the de-risking phase objective is now to manage the risks associated with converting a member’s pot into a cash lump sum, rather than an annuity. This is because pots will still be small at this stage and we believe most will take their pot as cash rather than use it to deliver an income in retirement.
Funds maturing after 2020 will aim to outperform consumer price index (CPI) inflation after all charges, while progressively dampening volatility. This is because it is still unclear what savers will want to do with these larger pots, although we think taking the whole pot as cash or converting it all into an annuity seem unlikely. This is why we have thought carefully about our portfolios. Our CPI-plus portfolio at retirement for example, has characteristics that mean while it is aimed at people who are likely to invest through retirement, it is still a reasonable portfolio for people who then change their mind and decide to take cash or annuitise.
In addition to all of the above, there may be more to learn despite the UK’s new regime’s infancy. Examples include the role of choice when there are low levels of engagement from members, and the pressure on communications and guidance to support individuals in managing the impact of investment risk and their own longevity.
Like other schemes, NEST is still evolving in its response to the freedom and choice in pension reforms.
See NEST’s Future of Retirement consultation documents at www.nestpensions.org.uk