1 October 2013
- Employers must be warned of complexity and need to prepare at least a year ahead
- Can’t leave it till the last minute as capacity crunch looms
- Significant challenges still remain despite promising start
Aim to improve pensions for millions: One year ago today, the first and largest employers became legally obliged to automatically enrol their employees into a pension scheme and pay contributions for them too. This is a social policy which aims to improve pensions for millions of workers as state and employer pensions are being cut.
Confidence in pensions has collapsed in recent years: People are not saving enough in private pensions to provide themselves with sufficient income for a comfortable retirement. In fact, the ONS reported recently that membership of private pension schemes reached a record low in 2012 as workers’ incomes have been squeezed, employers have closed nearly all final salary schemes and confidence in pensions has collapsed.
State pension being cut and employer guarantees have gone: At the same time as most employer-guaranteed pensions are closing, the state pension is also set to be cut. From 2016, state pension reform will ensure future retirees will mostly receive lower pensions than under the current regime and the state will no longer provide an earnings-related element to future state pensions.
Auto-enrolment aims to make up for loss of future earnings-related state pensions: Therefore, auto-enrolment is designed to boost the reduced state pension and help make up for the loss of the earnings-related element to state provision. So far, around 2300 employers have automatically enrolled 1.6million workers into their pension schemes. By 2018, over 1 million employers are expected to have enrolled over 11million workers.
Based on behavioural economics – people won’t bother to opt out once they’re in: The policy of auto-enrolment is based on the theory that lack of pension saving stems from inertia among workers, who will not bother to join a pension scheme, but if they are put into one, they will not bother to opt out of it. This is using behavioural economics to try to encourage desired behaviour.
Initial contributions only 2% but will rise to 8% by 2018: The initial contributions are only 1% of salary from workers and 1% from employers, so perhaps it is not surprising that opt-out rates have been low. From September 2017 the total contributions from both workers and employers will rise to 5% (with 2% from the employer) and by end September 2018 the full auto-enrolment contributions of 8% (with 3% from the employer) will have to be paid in.
Largest employers starting first – opt-out rates are quite low: The auto-enrolment programme has started with the largest firms in the country first. Over the coming years, more employers will reach their start date for auto-enrolment, with medium sized employers, then smaller firms and finally the micro-employers having to join in. By 2018, even the smallest employers – such as working mothers who employ a nanny – will have to have set up a pension scheme, enrol their staff and pay in for them. Initial indications from the large firms suggest the policy is starting quite well, with the Government pointing to very low opt-out rates – around 90% of workers are staying in (although more recent figures suggest opt-out rates may be about 25% because the DWP figures only looked at those who opted out on day one, rather than those who chose to leave before the end of the first month).
As smaller firms start and contributions rise, opt-out rates are likely to increase: It is likely that as more small employers reach their start date (called a ‘staging date’) and the required minimum contribution levels rise, the opt-out rates will increase. The largest firms have spent significant sums on promoting their pension schemes to their staff and the 1% minimum contribution levels are not terribly onerous. However, smaller firms are unlikely to have the same enthusiasm for promoting their pension schemes to their workforce. The responsibility for pensions will probably rest with a Finance Director, rather than an HR Department and the finance department is likely to see pension contributions as an extra cost, rather than a company ‘benefit’.
Danger of lulling workers into a false sense of security: Of course, saving more and increasing the coverage of pensions is important, but the current policy of auto-enrolment is not sufficient to ensure later life income adequacy. Even when the contributions reach their maximum 8% level, this will be wholly insufficient to ensure a good pension income. There is a danger that workers will be lulled into a false sense of security, believing that their pension is ‘sorted’ because they are contributing under auto-enrolment. But the loss of earnings-related state pensions and employer-sponsored final salary pensions will not be replaced by the minimum auto-enrolment contribution levels.
Higher contributions are needed – SaveMoreTomorrow schemes: It will be important to encourage higher contributions over time. A very sensible system is one that builds further on behavioural economics. The ‘Save More Tomorrow – SMaRT’ schemes that have been used successfully in other countries, cold be far more powerful than standard auto-enrolment. Under these arrangements, people are encouraged to put some or all of any pay rise (yes, we will return to the days of pay rises I’m sure) into their pension. As they have not yet started living on the higher income, they are less likely to miss it, but putting 2-3% extra into your pension fund each year can quickly mount up to a more significant sum over time.
Auto-enrolment challenges remain – controls on charges: For example, there are no controls on the charges that workers must pay for their pension schemes. The workers themselves have no control over the scheme their company will use – the choice is entirely up to the employer – but it is the workers who actually pay the charges. The Government has so far shied away from capping the amount that can be charged, but if workers pay very high fees, then the value of their ultimate pension fund will be lower.
NEST is not a low cost scheme – 1.8% initial charge very high: In this regard, it has to be said that NEST itself – which is the pension scheme that the Government has set up as a low-cost provider of last resort to service any employers who cannot find another pension company to use – is very expensive. NEST charges 1.8% as an initial fee on all contributions – and a 0.3% annual charge. For workers who stay in NEST over many years, that fee will not be so bad, but for those who are only in it for a short time (such as older workers who are auto-enrolled and then reach retirement soon afterwards) NEST can end up being a very high charge scheme. I believe that the Government must urgently revisit NEST’s charging structure.
Options for taking income are not suitable for many: In addition, not enough consideration has been given to the ways in which people will take income from their accumulated auto-enrolment pension funds. Standard annuities have become very poor value and there are insufficient options for relatively small pension funds. A more creative and flexible approach to pension income options is urgently needed.
Mind-bogglingly complex rules mean administration costs over £15billion and firms need to prepare a year in advance: The rules of auto-enrolment are mind-bogglingly complex and the administrative challenges for small employers will be far more of a burden than the actual cost of the contributions. Auto-enrolment will take a long time to prepare for and many firms, especially if they have never been involved in pensions, will struggle to manage the processes. They will need help and they should plan well in advance of their start date. If they do not plan about a year ahead of time, they may well be too late and if they fail to comply with the rules on time, they can face very large fines. It is estimated that the costs to corporate UK of setting up all these pension schemes will be over £15billion. This is a major policy initiative, but is not yet structured well enough for the future.
Capacity crunch looming: It is also not clear whether the pensions industry and advisers actually have the capacity to serve more than one million employers who are going to have to start auto-enrolment in the next few years. For example, next summer alone, tens of thousands of employers will reach their start date and this is more than the total number of employers who have started pension schemes in the past few years put together. How the industry will cope with this capacity crunch is not clear. There are reports that pension companies are already turning employers away.
Further hurdles to overcome: As auto-enrolment reaches its first anniversary, there are clearly further hurdles to overcome. It seems to have made a promising start, but the easy part has been first. The real challenges are yet to come. Employers have no idea of the complexities they could face and need to be warned about preparing well ahead. In addition, the policy needs further development if we are really going to ensure better later life incomes for future generations. The changes include ensuring charges are reasonable, increasing contribution levels, simplifying the processes and providing better value income options.