Every spring, the UK chancellor presents the public with a red box full of tricks, setting out the government’s economic plans. While pension tax relief has often been tinkered with, this year George Osborne announced a wide-ranging reform of the defined contribution (DC) at-retirement system, the implications of which will be far-reaching.
The change in rules saw the removal of a compulsory annuitisation on DC pots valued between £18,000 (€21,737) and £310,000, with the average pot size nearing £25,000.
While pensions of this size must currently be converted into an annuity, capped drawdown or taxed at 55% for full cash withdrawal, the new proposal means pots of any size can be fully withdrawn as cash (at the marginal rate of tax), annuitised or used for drawdown products.
The policy moves the market more towards that of the US and Australia, two of the world’s largest DC industries, and potential impacts are modelled on how retirement decisions are made there. One expected reaction is for the annuity market to shrink – in the US, current estimates show that only about 10% of savers annuitise.
However, in addition to the impact on the at-retirement market, shock waves from the liberalisation of DC pots will be felt in several different segments of the UK pension industry.
Released alongside the Budget announcement, the government’s consultation highlights the concerns these proposals raise for defined benefit (DB) schemes.
Although there may be no obvious link between DC at-retirement reforms and DB investment strategies, the issue lies with a members’ right to a cash equivalent transfer value (CETV), allowing them to leave a DB scheme, transfer to DC and take the pot as cash. While few people exercise this right, a liberated DC market could incentivise DB savers to do so.
The government says this could have a significant impact on DB investments, as schemes could be forced to hold more liquidity to cover potential transfers. With more than £1.3trn in invested assets, the idea of DB schemes pulling away from equities and fixed income, including Gilts, is of great concern for the Treasury.
It has already proposed removing the transfer right for those members in unfunded public sector schemes, and is now consulting on whether to expand this to the private sector.
Jonathan Crowther, head of liability-driven investment (LDI) at AXA, says if large numbers of DB members take advantage of any enhanced flexibility, it would significantly affect the run-off profile for schemes. “This may reduce the attraction of holding index-linked Gilts and UK corporate bonds,” he says.
According to the government, UK private sector schemes hold about £200bn each in Gilts and corporate bonds. This means that transfers would have a negative impact on these markets, underfunded schemes and the economy. Completely closing transfers would prove positive for markets and investment consistency but result in less flexibility for DB members.
Other partial measures – such as allowing transfers but without flexible entitlement, capping transfer values or imposing trustee discretion – are also possible, but these would increase administration, create costs and not really benefit members in the long run.
While these provide more certainty, they would still affect the structure of DB investments and create the necessity for higher cash reserves. However, allowing full transfers would lead to an uncertain impact on how schemes can invest, particularly LDI.
“It would be negative for index-linked bonds as it introduces greater benefit payment profile uncertainty,” Crowther adds. “But transfers are deficit-reducing for DB, so funding levels could improve and allow further liability hedging.”
Although expectations are that the transfer ban will be extended to private-sector schemes, the government’s consultation runs until mid-June.
While the growth phase of DC investment strategies is unlikely to change for members, with equities and diversified growth funds remaining key, the latter end of the cycle will require an overhaul.
Traditional lifestyling methods and target-date funds (TDFs) dominate the DC default investment spectrum. Along with a spattering of outcome-oriented or DC LDI strategies, these shift investment holdings from equities to Gilts and cash on the approach to retirement. This is done to allow members to withdraw 25% of their pot and purchase an annuity with the remainder, which is no longer necessary.
Nico Aspinall, head of DC investment consulting at Towers Watson, believes investment strategies will change, and may become more conviction-led from trustees. “For the default investor it now depends on what the trustees believe members are likely to do,” he says. “Schemes with large amounts of savings per member will still believe in annuities and drawdown. Smaller ones will increasingly look at cash.”
Gary Smith, head of DC at UK consultancy Capita Employee Benefits, says the key will now be to develop strategies for an audience of one, rather than a mass movement towards annuities. He also believes the TDF market will cease. “We need to create a middle ground between the default and self-select options and create a structured flexibility for members as they approach retirement.”
This will require solutions based on four or five outcomes, once members decide how to proceed. With TDFs already providing retirement flexibility on timing, the sheer number of funds will become unpractical, says Smith.
However, unlike the US model, which has always been investment-led, Smith says the UK’s adaptation of lifestyling into more flexible arrangements will fit most schemes. “We have developed some advanced solutions to cater for the individual by donning flexible lifestyling,” he says. “This will have to be extended to more than just the larger schemes.”
The United Utilities Pension Scheme, a £60m DC trust with about 3,800 members, has already looked at options for such a scenario, pre-dating the government’s plans.
In February, the scheme told IPE of its plans to create a secondary default investment fund for members, designed entirely towards income drawdown over annuities. This would be underpinned by heavy member engagement as they enter the final stages before retirement.