Towards the middle of the nineteenth century, the UK’s civil service brought into existence one of the country’s first defined benefit (DB) occupational pension schemes. It was, and still is, a pay-as-you-go system but it laid foundations for the occupational pensions industry we see today. Much has changed and variations of schemes, from DB to defined contribution (DC) have been created, each bringing its own set of rules and investment strategies. But 2014 is shaping up to be the most revolutionary year in pensions for a long time.
First, the industry has witnessed a complete overhaul of the way DC savings are treated and how they fit into the matrix of retirement saving. Removal of the need to annuitise means the concept of guaranteed retirement income, which has become the bedrock of the UK pensions industry in both DB and DC, has been superseded. While this causes little impact on the way DC assets are invested for younger members, it questions the appropriateness of lifestyle strategies and annuity matching assets.
In addition, the coalition government is introducing defined ambition (DA) pensions. These were first touted as a half-way house between DB and DC by the Liberal Democrat pensions minister Steve Webb, and later surfaced as collective DC (CDC), with parallels to the Danish and Dutch systems. Little changes for traditional DB. The future remains clear, and is one of closures, wind downs, and bulk annuities. But with the introduction of a flat-rate state pension in 2016, the UK will soon experience comprehensive social security reform of a scale not seen in more than a generation. The state pension has hitherto been two-tiered, with some private sector DB schemes contracting out from making additional contributions, in return for providing state second pension benefits themselves. However, contracting out has been abolished; this means increased costs for these schemes.
The state pension reform was a key plank of reform for Webb, and an ideal springboard for defined ambition. The 2016 introduction of the flat-rate pension is a year earlier than was originally planned, leaving Webb’s team under pressure to deliver sooner.
At a glance
• A raft of pension reforms is transforming the UK pensions system.
• Auto-enrolment will be implemented
by 2018, with £11bn (€14bn) in additional annual contributions.
• State pension reforms, including a flat rate pension, are slated for 2016.
• Liberalisation is forecast to slash the annuity market by 75% but there will be innovation in at-retirement products, like drawdown.
• Tax relief for pensions is at risk. • Legislation to introduce collective defined contribution (CDC) pensions will be introduced in the current Parliamentary session.
With fewer than nine months until a general election, both coalition partners are attempting to drive through last minute policies as they seek to differentiate themselves. Conservative plans to liberalise DC savings come into force in April 2015, a month before the election but the Liberal Democrat defined ambition project is still a work in progress. It remains to be seen exactly how both reforms mould themselves into the pensions landscape, potentially leaving it different in the future.
The ‘death’ of annuities
The DC market has been growing since auto enrolment began in 2012 and will continue on this path. The roll-out of auto enrolment continues until 2018 and, according to government calculations, will see an additional £11bn (€14bn) in annual contributions. The development of DC investment strategies continues, with more and more funds looking to a variety of asset classes, with forays into infrastructure and real estate expected.
The key issue is default investment strategies, which is where a majority of the contributions will end up, and both lifestyle strategies and target-date funds have gained traction. These invest in growth assets until around 15 years before retirement, slowly shifting into cash protection and annuity-matching assets, mainly Gilts.
But since annuities are no longer a requirement, demand may decrease. In an immediate reaction to the 2014 Budget, Legal & General, one of the UK’s largest annuity providers, said it expected the £12bn a year annuity market to fall by 75%. However, Towers Watson predicts that demand for stable incomes will keep the market “substantial”.
Irrespective of predictions, DC providers will have to innovate in terms of at-retirement options. But the current average DC pot size hovers around £25,000, which would only provide a monthly income of around £65 at prevalent annuity rates at the end of July 2014, so DC members with small pots will probably withdraw all their assets as cash, albeit tax efficiently. Auto enrolment will increase the aver- age pot size, however, leaving room for options and opening up income drawdown to a wider audience.
Nico Aspinall, head of DC investment consulting at Towers Watson, says annuities will exist but be shaped differently. Traditional products will remain, but savers will extract better value by initially using drawdown prod- ucts and purchasing annuities later in life.
This would mean a shift in asset allocation for DC funds, with greater equity exposure for longer, particularly as drawdown products become more accessible. Further possibilities include ‘U-shaped’ annuities, where income falls to match slowing lifestyles and increases in older age to meet potential care needs. It remains unclear which assets would back such annuity products.
Defined contribution: the liberalisation of pension savings
• The chancellor of the exchequer, George Osborne, announced reforms to
the way DC pot members can access their savings at retirement in the 2014 Budget.
• In the past, DC savings of between £18,000 and £310,000 had to undergo compulsory annuitisation via the insurance market. This covered the major ity of savers since average at-retirement DC savings are around £25,000. From April 2015, all savers will be able to use their savings as they see fit.
• Subject to marginal tax charges, savings can be withdrawn as cash, or through other retirement income products. Savings can be accessed at 55, which is 10 years before state pension age.
Aspinall says: “It is hard to anticipate which direction the insurance world will go. We can see a huge proliferation of products such as variable annuities and with-profits annuities, with these products relatively simple to import.”
Despite innovation in the at-retirement market, annuity liberalisation means there may be less distinction between pensions and retail savings in the future.
Without a requirement to convert pensions savings to retirement income, politicians may be tempted to reduce tax-relief.
Kevin Wesbroom, senior partner at Aon Hewitt, says it would not take much of an economic disaster for tax incentives to be clipped. The current government has already reduced the tax relief for higher earners since 2010.
The opposition Labour Party has said it would reduce the rate of pensions tax-relief for higher earners. Webb has also suggested equalising rates for all earners.
In a note published this May, the Institute for Public Policy Research, a centre-left think tank, said that despite earlier cuts to tax relief motivated by the budget deficit, the ability of savers to withdraw 25% of their savings as tax-free cash remains an anomaly in the new DC landscape.
According to estimates by the Pensions Policy Institute, an independent think tank, abolishing the 25% lump sum could increase tax revenues by around £4bn a year, and removing tax relief for higher earners could raise £13bn.
Reform to tax relief could well affect member contributions and a sizeable decrease in annual contributions would affect the models that funds, managers and consultants currently have under development. Annual charges would have to be competitive with traditional savings vehicles in an environment of higher interest rates.
However, DC will remain strong, thanks to auto enrolment and the marketing power of annuity reforms. UBS Global Asset Management predicts that assets will rise by 8.8% a year and the boutique advisory firm Spence Johnson predicts DC assets will outweigh DB by the late 2020s.
Webb’s ambitious dream for defined ambition pensions in the United Kingdom
The current Parliamentary session, which runs until the May 2015 election, will see the implementation of innovative pension scheme designs in the form of collective defined contribution (CDC) pen- sions through an entirely new legal framework outside of DB and DC, which the government says will encourage innovation in risk- sharing models.
There is little clarity about how CDC schemes might be structured. Many have anticipated introduction of the Dutch risk-sharing and target benefits model, but the government has left room for other retirement income protection mechanisms such as deferred annuities, akin to the approach of Denmark’s ATP.
Demand for CDC exists, accord- ing to the government, but there are no concrete figures.
Con Keating, head of research at the consultancy Brighton Rock, ambitiously predicts that CDC schemes could account for 10-15% of coverage within the next 15 years, should the legislation be suitable for employers. But he notes that employer flexibility in DB pensions was successively reduced over the years and he remains cautious.
“Defined ambition is what we had before,” he says. “If it is successful, the government will just place additional responsibilities on it. Defined benefit did not fail; it just had more and more conditions added. Every time you blinked they put another cost on it.
“It is a mess, and it could stay a mess.”
Claire van Rees, associate director at the law firm Sackers, questions how many companies will adopt the model, given the requirement for scale.
“You cannot expect anyone to currently be thinking about how to set up a CDC scheme until the final legislation is in place,” she says. “I query whether we will see [many] of these schemes without government intervention, or industry-wide schemes. Individual employers will have already put their employees in standard DC arrangements for auto enrolment. Are they really going to switch to CDC?”
With work on-going to define the CDC legislation, key omissions, such as limiting employer liability, have already been highlighted by the law firm Slaughter & May. The 2016 deadline looms, with the Department for Work and Pen- sions’ (DWP) to-do-list lengthening as it tries to implement charge caps in DC by April 2015, a flat-rate state pension, auto enrolment, and Budget reforms – ignoring other welfare policies.
But politics is crucial, and the DC changes announced in the Budget are too big to fail says Kevin Wesbroom, senior partner at Aon Hewitt. This means the defined ambition agenda could slip out of reach before the election in May 2015 and Webb will probably not stay on as pensions minister in the new Parliament.
Although CDC has attracted cross-party consensus, Wesbroom highlights issues beyond the con- sensus. CDC has not received back- ing from some Labour members in the House of Lords and significant opposition could potentially derail or dilute it.
Van Rees says its a challenge given the involvement of different departments. The Treasury has pushed through its DC changes, while defined ambition is the responsibility of the DWP, leaving certain aspects confusing. “Making all this legislation hang together and work will be the biggest challenge for this government.”
She also thinks the annuity liberalsiation changes could under- mine the defined ambition agenda, making risk options less attractive. “A pure DC arrangement with flexibilities becomes more attractive to employees,” she comments. “Flexibility in CDC could work if guarantees are not provided, but the Budget limits any attempts to put in these guarantees.”
Wesbroom agrees: “The DWP and the Treasury are running different political agendas. For a lot of people, the Budget changes rule out a move to CDC.”
However, he says there is potential for employers to use CDC to provide a stable income, whereas employees can use their own DC pots flexibly, by splitting contributions.
Whatever else happens, the UK DC market will change in April 2015 as sponsors, trustees and members adjust to a world without compulsory annuitisation and the chances are that CDC schemes could be introduced by April 2016. Whether this runs to plan depends on politics and sponsor demand. Only time will tell whether 2014 was a revolutionary year for the UK pensions industry.