The pensions lottery: nine steps to a more secure future

Over the last couple of months we have published a series of blogs showing the problems many workers have in getting enrolled in a pension scheme; the risk they bear of investment markets turning against them; and the continuation of this uncertainty into retirement.

We have suggested that there are elements of successful overseas pensions systems that provide useful pointers to UK reform. 

But it would be a mistake to think that a foreign system can be imported wholesale, or that any one change is a complete solution in itself. For example, greater collective risk pooling is of little benefit if pension contributions don’t rise. But, likewise, savers and their employers won’t put more money into pensions, unless that money is working as hard as possible.

So in this final post discussing the pensions lottery, we set out nine steps towards a better pensions system. Some are small short-term improvements. Others could take time to have an impact but would make a major difference to the lives of future retirees.

It should be noted that, while it is clear that successful pensions systems have more generous state pensions than in the UK, our focus here is on the many options available for improving the workplace set-up.

The employment lottery

We showed in our previous analysis that large numbers of people in sectors such as farming, hospitality and retail are not enrolled in pension schemes. This is despite new rules rolled out from 2012 obliging employers to enrol workers in retirement savings schemes.

Eligibility restrictions introduced at the beginning of automatic enrolment have, partly due to the impact of unrelated changes such as big increases in the income tax threshold, led to millions of people being excluded. In fact, nearly as many employees are deemed ineligible for auto-enrolment as are eligible.

1. Abolish the earnings trigger with employer contributions paid from the first pound of earnings.

One of the biggest causes of exclusion is the earnings trigger. An employer only needs to enrol someone into a workplace scheme if they earn more than £10,000 for any single job. That means that millions of low-paid workers, most of them women, are excluded. The system is particularly unfair on those doing multiple jobs that together add up to £10,000 but currently receive nothing.

Abolishing the earnings trigger would instantly bring low earners into the system and remove any incentive there is for employers to keep wages below the trigger level.

We regard this as a more effective way of bringing those with multiple jobs into the system than seeking an arrangement to determine which employers might be responsible for contributions.

2. Scrap the complicated qualifying earnings system.

Currently, pensions contributions only have to be levied on a band of earnings between £5,876 and £45,000.

If an employee earns £20,000 their qualifying earnings would be only £14,124 and the effect is even more disproportionate for people on lower incomes. So for someone on £10,000 a year, only £4,124 of their earnings are pensionable. Even when minimum pension contributions rise to 8 per cent in 2018, just 3.3 per cent of their total salary would be contributed.

Part time workers with more than one job are particularly affected because the qualifying earnings deduction applies to each job.

Levying contributions on the entirety of a worker’s pay packet would simplify administration and boost saving.

3. Reduce the starting age for contributions.

The current arrangement, which only requires workers to be enrolled into a pension scheme from age 22, risks disadvantaging those who enter the workforce rather than pursuing higher education. And starting to save earlier makes it more likely that an individual has sufficient pension for retirement. A lower starting age for auto-enrolment could simplify administration for employers. Those for whom saving is not appropriate or desirable can opt-out.

4. Set out a route map for raised contributions

There is widespread agreement that even when minimum pension contributions rise to 8 per cent from 2019, this will be inadequate for a decent retirement. Yet many employers, especially those who previously offered no pension scheme, pay in only enough to comply with the law. It is estimated estimates that two thirds of those enrolled in pensions in 2030 will be on minimum contributions.

Trade unions have long supported the stance that pension contributions should be at least 15 per cent of salary, including 10 per cent from an employer and five per cent from the wage packet of an employee.

Investment lottery

We have shown that the amount that a saver in a defined contribution pension scheme has amassed by retirement can vary enormously depending on what happens to financial markets.

What is apparent from examples overseas is that large-scale schemes are both more efficient and more able to invest in a range of assets, thus better enabling it to withstand the vagaries of investment markets.

5. Maintain open defined benefit schemes

Too many good quality pension schemes were allowed to wither away from the 1980s onwards. Those defined benefit pensions, that pay a pension based on a member’s salary and length of service, that remain are doing the job we need pension schemes to do. More than 90 per cent of people currently accruing benefits in DB schemes are likely to have a decent standard of living in retirement.

More than one in eight defined benefit schemes (13 per cent) remain open to new members, ensuring that both old and new workers can build up entitlement to good quality retirement provision. Maintaining these is a priority because they ensure that both younger and older workers have access to good quality pension entitlements.

There is a very strong case for a differentiated regulatory regime for open DB schemes. Such a regime might allow greater flexibility on valuations and greater scope for benefit changes as long as a scheme remains open to new entrants. This should be supported by adding to the Pensions Regulator’s remit an objective of seeking to maintain and promote good quality DB pension schemes.

6. Greater cost transparency

It is frequently claimed that low costs should not be pursued in pension saving at the expense of good returns. Yet the financial regulator has found quite categorically that higher charges are not a predictor of higher performance.

Yet, the cumulative effect of costs is enormous. A one per cent annual charge will consume nearly a quarter of a saver’s pension pot over their working life.

And trading excessively can cost members money. There is evidence that if managers held onto their investment more, they could save as much as 20 per cent of the costs paid by members.

There have been moves to place higher requirements on fund managers to disclose the full range of costs and charges to pension schemes. These are still in their infancy.

There is a strong need for a data standard for collecting cost data from pension funds in the UK and from their providers (asset managers, custody banks, consultants and so on), overseen by an independent body that can verify the accuracy of the information supplied.

7. Greater consolidation

But transparency is only of benefit if it leads to reduced charges.

There are upwards of 35,000 DC pension schemes in the UK. Many are too weak to negotiate a good deal from suppliers, such as fund managers. Transparency might be of little benefit to them.

A recent study of Dutch pensions found that a fund that has 10 times more assets under management, has on average 7.67 basis points lower annual investment costs. These economies of scale are solely driven by management costs.

International evidence also suggests a link between fund size and a more diversified portfolio.  Translating this into improved performance can lead to big gains for investors. An increase of 1.5 percentage points in yearly investment returns would increase their pots by 46 per cent to 62 per cent.

The establishment of large investment funds, such as is occurring in defined benefit pensions with the Local Government Pension Scheme might help improve returns and cut costs if DC pensions were given access to such .

Some consolidation in workplace pensions is likely to come with automatic enrolment. The likes of state-backed NEST and People’s Pension, while relatively small today, have the potential to become very large indeed. Almost half of those automatically enrolled have been enrolled into master trust schemes like these. This will be aided by increased regulation of schemes that could prompt some to close down.

But policy action will be required to accelerate this process.

One option is to strengthen requirements on the chairs of trust-based DC schemes. The government is currently considering moves to require the chairs of trustees of trust-based DC schemes to publish details of costs and charges in their annual statements.

Additionally, requiring them to justify whether the current size and scale of their scheme is sufficient to produce good value for members might hasten the consolidation of sub-scale schemes.

8. Move to CDC

Collective Defined Contribution pensions are like traditional defined benefit pensions without a promise and without an employer guarantee.

Instead the risks (and benefits) of investments or longevity not turning out as expected are shared between scheme members.

Like DB pensions all savings are paid into a pool, with all pensions paid from the same pool.

Unlike DB there is no pensions promise. Instead, CDC pensions have a target pension that they seek to pay, though unlike most annuities the intention is that benefits are indexed.

There is a risk that pensions will not increase or might even decrease in bad years, but in practice in Holland and in modelling based on UK conditions this is both unusual and does not result in big cuts

Studies by organisations including the RSA and Aon have found considerable advantages:

• On a like-for-like comparison, a collective pension would on average have outperformed an individual pension by 33%
• That in 37 of the past 57 years, a collective pension would have outperformed the individual pension.
• That the variability of the pension, and thus the risk the saver would have taken, would be lower with a collective rather than an individual pension.

Primary legislation already provides for CDC in the UK. However, the regulations to bring it into operation are yet to be completed.

We agree with the Work and Pensions Committee that there is a strong case for encouraging the provision of schemes that retain some of the best features of company schemes in an age when many employers do not want the long-term commitment of providing a DB scheme.

Retirement lottery

So-called pensions freedom has left retirees vulnerable to the corrosive impact of inflation, sharp drops in investment returns) and the hazard of living longer than they expected.

9. Retirement default pathways

The key to giving savers a better chance of good outcomes is for the establishment of default pathways. These would be well-researched, good value, securely governed solutions that would be suitable for most savers. Those who wished to pursue an alternative approach would be free to do so.

We see little appetite among most providers to be first movers in developing such products. Some will be understandably wary of setting a saver on default journeys that they might later say was not optimum for their circumstances. It is therefore the role of government and regulators to ensure that all savers have access to a default retirement pathway.

This would take the lessons from auto-enrolment in the accumulation stage - namely that inertia is a major driver of behaviour – and apply them to decumulation.

The likely shape of such pathways would match the combination of income drawdown and deferred annuities described by NEST in its retirement blueprint.  

However, there could be a role for Collective Defined Contribution schemes to provide a mixture of longevity risk pooling and continued access to real returns.

Conclusion

The aim of this series of blogs has been to set out the challenges facing today’s workers in securing a comfortable and secure retirement. And to explore ways of overcoming them.

We have shown that pension reform has not been settled. There is much more to do.

But there is not one change that will magically make the system work for all working people.

The steps set out above are our suggestions for how future progress could be made.

But we continue to be open to further engagement and ideas.