This quarter's debate puts the UK's retirement reforms in their global context, and compares the adequacy of this country's defined contribution schemes with that of other developed markets.
The UK’s pensions system is moving slowly up the global rankings, but the Budget flexibilities could reduce its security. How does UK DC compare with its overseas counterparts?
Mark Futcher: The increased flexibilities effectively mean that defined contribution is no longer a pension vehicle but a later-life savings vehicle. A pension provided a secure, guaranteed, income until death, and this is no longer a necessity.
We have lost a pension generation under stakeholder regulations; this is when auto-enrolment should have been introduced. The shift from corporates sponsoring defined benefit to defined contribution has not been accompanied by greater education and engagement.
Andrew Dickson: Even when auto-enrolment contributions rise to 8 per cent this will still be inadequate for most. Will pension savings increase in future? Employers may just step up their support. But already, the new freedoms announced in the Budget herald an era of greater engagement.
Caroline Legg: This has been the year that DC has come of age in the UK. Auto-enrolment has dramatically increased the number of pension savers, and the 2014 Budget increased available options and flexibilities for pensions savers.
Together with the extensive efforts of the government and Pensions Regulator to improve quality and governance, DC has taken centre stage and we are starting to see improvements in communication, engagement and outcomes.
Alistair Byrne: Savings rates do need to rise for mid-level earners, and Australia is a good case study in terms of improving participation levels and then raising contributions thereafter.
Higher levels of member engagement in other markets tend to be overstated. Inertia is strong everywhere, and relatively few DC participants are active investors. The answer is effective, intuitive defaults reinforced with effective engagement.
Steven Charlton: It is too early to say whether the new flexibility will reduce retirement security. After all, Australia sits in the top three in the Mercer survey (see box) and they have always had the kind of flexibility we’re about to introduce in the UK.
But we can be more confident in talking about current levels of engagement. That we had to introduce auto-enrolment says all you need to know about investor engagement – it is a system that couldn’t exist without high levels of inertia. However, now auto-enrolment is up and running, engagement should gradually rise.
Ian McQuade: While auto-enrolment is improving coverage, DC contribution rates appear to be falling. A number of employers are facilitating broader savings, through Isas, save as you earn, and so on – so contributions in isolation are only part of the story.
Some employers are starting to look at the adequacy of members’ potential benefits. Their focus is on helping employees reach a point where they can afford to retire. Experience from Australia is that as members’ pot size increases, the engagement levels also grow.
Hugh Nolan: The recent improvements in the UK’s system come from excellent changes on state pensions and auto-enrolment. However, there is little or no evidence of increased engagement or adequate contributions for most people – big weaknesses relative to many other countries.
The three main risks in the UK are increased opt-outs once the AE contributions go up, consumers spending their pension savings shortly after, or even before retirement, and a failure to engage and thus save appropriately.
Tim Banks: Any global rankings system is likely to be extremely subjective. Average UK contributions are low, given that they were voluntary until recently, and compulsory contributions were small under auto-enrolment.
However, while UK companies have historically offered DC arrangements voluntarily, contributions have been good by international standards. Low engagement levels are a global phenomenon, with Australia the notable exception – possibly because Australian employees typically choose their own pension provider, which creates significant focus on individuals.
What can schemes learn from overseas structures in designing a default fund or self-select options for members?
Charlton: It is really tough to compare the UK with overseas structures. You have to factor in different macroeconomic backgrounds, savings and social security setups and also cultural variations. Trustees and employers could spend their time more profitably by considering the likely behaviours of their own workforce, and then designing a default fund or self-select options to meet those needs. They will also have to accept that workers’ needs will change over time.
Legg: We can learn from countries such as Australia, which went headlong for flexibilities and freedoms, and are now looking carefully at whether they went too far and whether to introduce an annuity requirement. The Australian experience suggests that it is important, and perhaps difficult, to get the balance right.
Banks: After April 2015 the UK will resemble the US DC landscape, where a market review shows participants generally take income. We see one default investment strategy, and that the fiduciary does not try to guess what participants will do with their retirement pot. Accumulation and decumulation strategies need to talk to each other to develop through-retirement default strategies.
Byrne: It’s interesting that in the US, where there has been flexibility in how members take their benefits at retirement, there tends to be just one default. Increasingly this is a target date fund designed on the basis that members will stay invested after retirement and draw down through time. There doesn’t tend to be much discussion about a need for multiple default routes.
Policymakers in the US and Australia are looking more favourably on annuitisation, suggesting merit in hybrid models that involve initial drawdown flexibility used in conjunction with secure income approaches later on.
Nolan: In Switzerland 80 per cent of people annuitise, but the costs are regulated and considered generous. In the US, fewer than 2 per cent buy annuities, which are typically seen as an expensive gamble.
We should design simple defaults that people can easily understand, and encourage consumers to focus on key choices such as equities versus bonds, rather than which specific manager to pick. One option we can and should import, however, is ‘save more tomorrow’ whereby members give up future pay increases in exchange for higher contributions.
Dickson: The UK DC market is nascent compared with those in Australia and US – here, DC design is just coming to terms with the recent Budget changes.
However, prior to the Budget, the UK had already forged ahead by embedding more dynamic diversified growth funds and absolute return strategies into DC default designs.
Highly diversified investment strategy characteristics look like a sensible landing place for the latter stages of DC lifestyle and target date funds.
McQuade: There is an expectation that, post-Budget, members will take cash at retirement. Defaults should be established to reflect this.
However, as members retire with larger pots, Australia’s experience is that members are more likely to want to secure some level of income. This might not happen at 65, but it will happen. So there will need to be options for members looking to use drawdown, or those staying invested to buy an annuity later in life.
Futcher: Where overseas structures offer greater flexibility then they are predominantly all looking to come back from that extreme to one of greater annuitisation.
Annuities were an extreme option, as was drawdown, but all the Budget has done is widen the extremes. Better education and engagement is needed to ensure that most people do not select an extreme option.
The government is pushing forward with its charges cap and governance requirements. Are the changes necessary?
Nolan: Charges have an extremely significant impact on outcomes, particularly at a time of modest returns. It is absolutely right to drive charges down so that as much as possible of every pound invested goes towards benefits for the consumer.
Experience shows that few consumers are sufficiently engaged to understand the full impact of detailed and sometimes opaque charging structures, so it does seem necessary to cap charges for default funds. Higher charges will quite rightly still be allowed for people who actively choose to spend more for wider investment choices.
Legg: The proposed quality features and provisions in the DC code of practice on charges are welcome, provided they are proportionate and result in improved outcomes.
While measures to keep tabs on charges are important for fairness and transparency, they can lead to an over-focus on charges. It needs to be remembered that value for money is not solely governed by how high or low the charges are.
Banks: We see the need for transparency in member-borne charges. For instance, how much is spent on administration, communications and then investment? The real debate is value: what’s provided and why it is better. The key risk in a charge-cap world is the reduced spend on investment strategies, with a danger of affecting member outcomes.
Futcher: Everything should be based on value for money. Corporates, which the government has given an increasing role to play in providing workplace savings, usually have good processes for ensuring their suppliers offer good value. The market needed to change. The government intervened to drive innovations and restore public confidence. A charge cap has stifled some innovation and I would have preferred to see a soft cap for workplace savings and a comply-or-explain mentality.
Charlton: Any change that improves the position for investors has got to be welcome. If that can be achieved by mandating a charge cap or improving governance, or both, then the industry should greet those developments warmly.
McQuade: While the charge cap is a blunt tool there are many legacy arrangements where excessive charges are being levied on members. Legislation will remove these practices, but some well-run schemes have also been affected.
In terms of governance, establishing a requirement for trustees to monitor all costs – including transaction costs – sounds reasonable, but that assumes the information is available. Very few DB schemes know the total impact of all costs.
Dickson: The government’s proposals on charges and governance essentially aim to safeguard the millions of new pension savers auto-enrolled into DC-providers’ group schemes. The imposition of a charge cap does, however, create a false market and will limit scope for innovation, particularly in DC investment design – after platform fees, there is scant budget left.
Byrne: A charge cap is rather a blunt instrument. True value cannot always be equated simply with lowest cost. Most large workplace schemes already have charges below 0.75 per cent, so perhaps the answer lies in delivering increasingly sophisticated and innovative risk-managed and diversified solutions at reasonable cost, rather than just racing to the absolute bottom of the fee scale.
However, the charge cap will help in improving value for money in smaller and legacy schemes, which is to be welcomed.
Which charges should be focused on in DC? How can they be presented in an intelligible way?
Banks: We need a breakdown of member charges, so the value of each element is clear. For example, how much of the bundled charge goes on the investment strategy, as the key determinant of outcome after contributions?
Transaction fees are the missing part of the equation, but this is not a specific DC issue. For members to understand every charge element is difficult, which is why we need robust governance to evaluate pensions.
McQuade: Members need to be made aware of the explicit charges levied. But, it will be difficult to share the implicit charges, such as transaction costs, in a way that is understandable. If it was, wouldn’t all financial services products report this information? Therefore, once the cap is in place, it will be important to move the conversation on to value for money.
Dickson: All charges that are deducted from a DC member’s plan should be clearly broken down and explained – and we can do this simply. We can show the DC platform costs as a percentage of the total costs deducted, accompanied by an explanation in plain English of what services are provided. Similarly, we can outline and clarify the investment fund charges. Finally, we can disclose and explain any additional expenses.
Legg: Investment and administration charges are important. There are difficulties in comparing like-for-like charging structures at this early stage, and standardisation will be needed for the information to be easily comparable. However, even with greater transparency, members of occupational pension schemes are constrained because they may only select from the investment options made available.
Futcher: An annual management charging structure has always been inherently unfair, as the more money you have the more you pay. Arguably they cross-subsidised the smaller fund values.
I cannot see fund managers moving from this stance, but I would like to see pound note costs for administration that includes online access charges, marketing and so on.
Nolan: Default investment charges may drive restricted and passively managed fund choices, so the challenge is to explain the extra value available for those paying higher charges. Clear and simple illustrations and online modellers can help members understand and make informed decisions.
Charlton: We need to focus on all of the charges investors pay, from the investment manager to the administrator, and so on along the chain. Shining a light on all of these different elements of the total cost of investing normally places downward pressure on charges in general, which is good news for investors.
Byrne: The focus should be on the annual management charge and the other fund-operating costs that make up the total expense ratio. Some disclosure of transaction costs is important to enable trustees, providers and advisers to monitor efficiency, but it is not clear there is value in widespread distribution of these data to members.
