UK: Questions remain
With auto-enrolment just a few months away, Pádraig Floyd assesses the future shape of DC pensions
Pension provision in the UK is about to enter a new era with the introduction of auto enrolment this October.
The regulation compels employers to place all employees in a compliant pension scheme and make contributions of 3% of salary. Though individuals retain the right to opt out of this arrangement, it is hoped that inertia, which has prevented people from joining occupational schemes in the past, will also prevent them from leaving.
The previous government, in response to the Pensions Commission report by Lord Adair Turner, initiated NEST (the National Employment Savings Trust) to be the de facto default provider to employers. However, since that time, the market has changed considerably and a number of others have entered the market, including Now Pensions and The People's Pension.
These three providers all operate multi-employer trust-based structures, which have become uncommon in the defined contribution (DC) market as they have been seen as an unnecessary complication and even cited as a reason for the move from defined benefit (DB) arrangements.
However, it has also become clear that many of the traditional pension providers are ready to go toe-to-toe with the new arrivals to protect their business.
"We've already started to see some divergence in the positioning of providers," says Paul Macro DC retirement consulting leader, UK at Mercer. "Some are lining themselves up as direct competitors to NEST, while others are pitching themselves as offering ‘much more than the minimum'.
"We'll see this for some time yet - at least until phasing is complete - but after this, I expect the more basic offerings to become more sophisticated as they learn from their experiences and look to increase profits, which will be hard on low-contribution schemes."
Concerns about levels of governance around contract based schemes from those employing a ‘set and forget' strategy looks likely to result in the regulator increasing compliance requirements for these arrangements. This may make them less attractive to larger employers who wish to have greater input in how their scheme is run, though they will be de rigeur among smaller employers who simply need a compliant scheme.
Traditional providers can see the writing on the wall. Legal & General and Standard Life have already launched trust-based offerings, with others expected to follow.
"We anticipate the strong trend from trust-based schemes towards contract based schemes such as group personal pensions we have seen over the last decade will slow as master trust options proliferate," says Mark Pemberthy, director at JLT Benefit Solutions. "We also expect a continuing swing from unbundled to bundled schemes as employers consider sharing administration costs with members in the face of rising pension costs and a difficult trading environment."
As to whether auto enrolment will be a success, there is little agreement and a good deal of cynicism.
There are 13.5m employees in the UK who are not active members of pension schemes, but only nine million will be auto-enrolled, points out Andrew Cheseldine, principal, Lane Clark & Peacock, as the remaining 4.5m do not earn enough. Of those, there are 2.2 million who earn less than £5,564 a year and are therefore "entitled workers". They will not be enrolled but must be offered the option of joining. The other 2.2 million or so are too young, too old, do not earn over the trigger of £8,105 or have less than 3 months' service if employers use the postponement period (which most commentators believe they will). With opt out rates of 15% to 20% overall, says Cheseldine, that's another 1.8 million who won't be included.
"Overall, there will probably be just over seven million new members by 2017 out of a possible 13.5 million. If you are a ‘glass-half-full-person', that's a lot better than we have at the moment and most of those excluded wouldn't benefit from inclusion and couldn't afford the contributions anyway."
But the risks lie in how those who are auto-enrolled, and stay in, experience the ride, he says.
"There are lots of things that could go wrong and its important the industry doesn't take short cuts or lose focus on the essentials - good administration, sensible investment and good value charges."
The anticipated level of opt-outs varies widely, but NEST expects around one-third, with research from the Institute of Directors suggesting it may be higher among small businesses.
However, in larger organisations with a strong benefits culture and extensive communications programmes, opt out is expected to be far lower. There, the message will be concentrated on investment choice and contribution levels.
"Opt outs are likely to be higher from the industries and individuals that have traditionally ignored pensions savings, such as blue collar, low paid and/or transitory workers," says Steve Herbert, head of benefits strategy at Jelf Employee Benefits. "This is unfortunate as these were the primary target of the legislation, but even within these groupings more are likely to remain in than opt out."
Neverthless, engagement on investment choices is unlikely for the vast majority of those auto-enrolled in the early years, he says, so default structures will be crucial to the success of a scheme.
"[Engagement on investment] is something that is likely to only come with time, as those enrolled start appreciating that they are building a sizable pot of money."
The greatest change we are likely to see in investment is the way funds are used, says Malcolm Delahaye, a director of Supertrust UK, a pensions provider, as providers and employers realise their responsibility to the individual member.
"Current ideas on investment choice will change as strategies focus on asset allocation to manage risk rather than pretend any single fund choice strategy delivers predictable outcomes," Delahaye says. "Like DB trustees, DC savers will eventually realise that risks around funding for an income are not the same as the risks surrounding saving to maximise capital value. The regulator wouldn't be happy if a DB scheme was funding to maximise growth regardless of downside risk and I suspect the regulator will eventually see there is a connection between the risks of DB funding and DC funding and influence products and behaviour to better manage the risk of pension outcomes."
Delahaye says an aspirational income target deserves just as much respect as a defined income target, with the only difference being that the employee's own personal covenant stands behind his aspirations, rather than the employer's.
"Steve Webb [the minister for pensions] is doing no-one a service perpetuating urban myths that there are free lunches like cheap guarantees or that risk can be eliminated without impacting potential growth," adds Delahaye. "Short cuts and illusory free lunches will not fix a broken system."
Delahaye rejects what has been termed defined ambition and championed by the minister, but Magnus Spence, a director of Spence Johnson, has published a paper that claims there may be a future for insurance-backed guarantees for DC investors.
"Our view is that it is a real possibility because the market wants it," says Spence. "DC savers are fed up with uncertainty and complexity, and a product which solves these two problems will be in great demand. Of course, it must also be at the right price."
Spence accepts guarantees have had little success in the past, acknowledging the problems deferred annuities, with-profits funds and latterly variable annuities have experienced. But, he says, some providers believe 80-100% protection might be offered for as little as 50bps to 100bps and they are working the numbers to see if they can achieve that.
There is no regulatory obstacle, he adds. All that is required to make that happen is "a willingness to accept that just because guaranteed offerings have not worked in the past in the UK that they may still work in the future."