UK: Growing pains
Gill Wadsworth surveys the UK’s growing DC pension market, whose assets look set to exceed those of DB funds by 2018
One million British workers joined the pensions savings market in the nine months between October 2012 and June 2013, allowing the coalition government a moment of triumph.
Auto-enrolment – the cornerstone of pensions reform – has been hailed a success as the UK’s largest employers revealed opt out rates of 3% to 6%, well below the Department for Work and Pensions’ (DWP) own predictions that 30% of employees would reject workplace retirement saving.
Yet all this positivity belies the many complexities and challenges that stand between the government and its grand plans for a robust pensions savings policy.
In an interim report on workplace DC saving by the Office of Fair Trading (OFT), significant problems were laid out for government and the industry: governance standards are lacking; and fees and charges may be unfair.
The DWP has since launched a consultation on quality standards in DC, which seeks to improve DC oversight and ultimately drive better member outcomes. These elements are paramount as many millions more savers are auto-enrolled into workplace schemes.
Predictions for just how significant DC assets will be in 2018 vary depending on salaries, contribution rates and investment returns. Mercer anticipates DC assets will have doubled by 2018, while Aviva predicts an increase of 75%.
In its Global Asset Survey 2013, Towers Watson calculated current DC assets to be £469bn (€545bn), which, added to Mercer’s prediction, puts the DC market at £938bn by 2018. To put it another way, roughly the same size as today’s defined benefit market.
The on-going success of auto-enrolment will determine whether DC gets anywhere near the £938bn mark, and this is where pensions reform may get knocked off course.
By 2018 all employers irrespective of size will have to comply with auto-enrolment obligations meaning companies with limited resources that have never before run a pension scheme must contribute at least 3% to their qualifying employees’ pensions.
“We have done the easy bit, in that employers with resources have delivered well. But the next bit is harder,” says Richard Wilson, policy lead for DC pensions and investments at the National Association of Pension Funds (NAPF). “Many small and micro employers will struggle with [auto-enrolment] as they haven’t run a scheme before; there are huge risks and some really big challenges coming.”
Challenges such as whether providers other than the government’s National Employment Savings Trust (NEST), which is obliged to take on any employer, will provide a competitive service to the smallest employers.
Both the DWP and OFT are considering competition in the DC market, and there has been a tremendous focus on providers’ fees and charges.
A surprise development has been the number of providers willing to challenge NEST for a share of the auto-enrolment market, with an in explosion in the number of master trusts offering an alternative to the government-backed scheme.
Some see master trusts as a likely stand-out service by 2018 since they offer a viable solution for employers unable or unwilling to put in place a trust-based DC scheme, and unhappy with the governance standards offered in a contract-based plan.
Brian Henderson, UK leader for DC savings at Mercer, says: “Master trusts will be seen as the answer to the governance question. It seems if you want a proper governed solution then employers need to go as close to trust-based as possible. Many companies don’t want to pay for that so master trusts will tick the box.”
However, the place of master trusts as the bedrock of future UK DC provision is unclear. The Pensions Regulator says it needs to investigate further and find a particular regulatory regime to govern the master trust market.
The early, ferocious competition among master trusts has also led to speculation that some will fall by the wayside.
Any consolidation in this market may see the creation of more super trusts – something long advocated by the NAPF.
Proponents of the super trust model argue that consolidating many smaller, disparate schemes into one super trust provides members with superior governance, better value and enhanced member outcomes.
In countries such as Australia, where pension saving is compulsory and the DC market is sophisticated, super trusts are seen as a suitable destination for millions of workers’ retirement savings. Wilson believes the UK is headed in the same direction. “Government and TPR are talking about scale and considering how super trusts can provide good outcomes,” Wilson says.
Irrespective of whether employers use a master or super trust, or the more traditional trust and contract-based arrangements, governance standards face scrutiny over the next five years.
Master trusts will be under pressure to sign up the NAPF’s pension quality mark, while trustees will be expected to improve their competence levels and ensure they are fit to manage DC arrangements. At the same time, contract-based schemes will need to better align the interests of those providing the benefits with those receiving them.
Alistair McQueen, head of corporate distribution at Aviva, says: “The two models [contract and trust] are fit for purpose but we can do more by bringing in independent oversight to contract-based schemes and by ensuring greater competence in the trust-based arena.”
No amount of robust governance, however, will make up for inadequate contribution rates and these remain a cause for concern in the UK DC market. Auto-enrolment currently requires contributions of just 1% from the employer and 1% from the employee, although this will rise to a total of 8% in the next five years. This is below the current 10% average contribution rate for the UK and many commentators believe members’ final pots will fall well below expectations unless people save more.
“By 2018, according to current rules, 8% will be the level,” says McQueen. “While there is a general consensus that this is better than nothing, it is not sufficient to drive the level of income that people will want in retirement.”
But government and industry are loath to demand higher contributions since they don’t want to drive savers away from the pensions market. Consequently the likelihood of contribution rates exceeding today’s 10% average by 2018 looks slim.
Investment strategies are yet another challenge for government in its quest for a robust savings policy. Default funds, into which approximately 90% of all DC savers end up, become even more important under auto-enrolment since the whole project is based on inertia and apathy. Providers and consultants have flipped accepted default fund thinking on its head, moving from a returns focused approach to one that is centred on outcomes.
Tim Horne, DC investment solutions manager at fund manager Schroders, says: “The starting point for any default should have a specific income objective in mind. We need to give a real understanding of what the [member] will get from investing in a default.”
Horne says there needs to be a greater appreciation of risk as well as return, with more emphasis on diversified investment strategies.
Such an outcome-orientated focus means providers, or possibly employers, need to pay greater attention to changes in member circumstances to ensure investment strategies and plan design remain aligned with needs.
McQueen says Aviva’s approach to default strategies is to continually monitor the savings population as well as the fund manager’s performance. “In 2012 the auto-enrolment population said they wanted low to medium risk investment options, not high risk with excessive growth,” he says. “We need to check this is still what they want in 2018 and, during those years, make sure we deliver what our customers have asked us to.”
But it is not just the accumulation phase that will be important to DC members in the future; the options at retirement are paramount in the overall success of workplace pension saving. Providers recognise the limitations of current lifestyle options, which automatically switch the member from return-seeking assets to fixed income at a specific date. The DC funds of the future will take better account of member circumstance, of economic conditions and ensure amassed pots aren’t eroded by market shocks.
Horne says: “The area that certainly should have developed by 2018 is the pre-retirement and de-risking phase. There needs to be more focus on protecting members’ pots as they approach retirement and as they either convert to annuities or consider other options.”
The UK is a long way from boasting a robust pensions saving policy and it faces many obstacles in achieving this goal over the next five years. But the challenges are not insurmountable and government and the pensions industry appear committed to workplace saving.
The trick lies in balancing affordability with adequacy and that is no mean feat. If the majority of workers are members of a scheme by 2018 that will be an achievement but the next step will be to make DC saving worthwhile.