Lifetime ISA might have been useful in the past but is not necessary now

Pensions auto-enrolment and flexibility will increase pension coverage

New ‘Lifetime ISA’ product proposed, to replace pensions and ISAs:  The Centre for Policy Studies is calling for a new savings approach – the Lifetime ISA – to be introduced in the UK.  This would replace the separate ISA and pension systems we currently have.  The idea is unveiled in this paper http://www.cps.org.uk/publications/reports/introducing-the-lifetime-isa/?utm_source=Michael+Johnson+contacts&utm_campaign=1f6f756838-FTT_chown_lawson&utm_medium=email&utm_term=0_d781b4fd08-1f6f756838-303592833 by Michael Johnson, whose ideas are often worth listening to.  Michael is very well-connected in policy circles and has been working on this for several years.  The proposals are designed to increase savings levels in the UK, following the dramatic decline in long-term savings, particularly among younger workers.

Pensions coverage will start rising again:  It is true that pension coverage has plummeted to record lows in the past few years, and the flexibility of ISAs has proved more popular than inflexible pensions.  However, the policy of auto-enrolment under which every worker is joining an employer pension scheme and the new flexibility for pensions introduced in the recent Budget are likely to increase pension coverage significantly in future.  The success of auto-enrolment, which relies on behavioural economics to ‘nudge’ people into pensions, coupled with increased flexibility, mean the need to join ISAs and pensions together is significantly lower now.

Tax relief replaced by 50p in £ incentive up to £8000 a year:  The proposed Lifetime ISA policy would also mean the end of pensions tax relief, with all savings receiving a 50p in the £ boost from the Exchequer instead (this extra 50p would have to be repaid if money was withdrawn before age 60).  A proposed annual allowance of up to £8000 would benefit from this savings incentive top-up, meaning that higher earners would lose out significantly, while the rest of the population received more incentive.  In social terms, this makes sense, since one would be redistributing the savings incentives from the highest earners, who presumably need less incentive to save, towards the rest of the population, who probably need incentivising more.

Auto-enrolment offers £1 extra for each £1 contributed, funded mostly by the employer:  Tax relief on pensions costs a huge amount – somewhere around £30billion a year – and I suspect the success of auto-enrolment could enable the Treasury to reduce the Exchequer cost of savings incentives in future, while still seeing an increase in pension saving.  Indeed, auto-enrolment represents a far more powerful savings incentive than the proposed 50p in the £ for a Lifetime ISA.  The auto-enrolment minimum contribution levels offer a ‘buy one get one free’ deal, with an extra £1 going into each worker’s pension fund for every £1 they contribute themselves.  Employees put in 4% of their qualifying earnings, the employer contributes a further 3% and 1% more is added by basic rate tax relief, so a 4% contribution immediately doubles to 8%.  It is not clear, therefore, whether a 50p in the £ policy is the necessary.

Pension savings can be increased further by auto-escalation:  Further ‘nudge’ measures could also be introduced to increase pension savings in future. For example, ‘auto-escalation’ which would encourage people to increase their pension contributions beyond the minimum level, by dedicating a portion of any pay rise to increased pension contributions.

I proposed a Lifetime Savings Account (called ‘LifeSaver’) in 2001 but things have moved on now:  Over 10 years ago, I drew up plans for a Lifetime Savings Account, similar to the Lifetime ISA suggestions, which would cater for all a person’s savings needs throughout their lifetime.  This is an example from a Paper published in the Journal of Financial Services http://www.rosaltmann.com/pdf/LifetimeSavings_JournalFinServicesJan2003.pdf . I originally suggested that this should be seeded by the Child Trust Funds, which were the forerunner of Junior ISAs.  The idea was to ensure people would always have a savings account at every stage of their life.  Things have moved on now however.  With auto-enrolment, most people will have a pension account once they start work and will also receive extra money from their employer if they contribute.  Those who do not save in their workplace pension scheme will forego the employer contribution.  The need for a lifetime savings account has therefore diminished and the ability to access pensions flexibly will increase their coverage.

Consider using auto-enrolment for incentivising other types of saving, not just pensions:  However, I do think it worth considering allowing workers to use their savings for purposes other than pensions.  For example, repaying student debts or saving for a house is a socially valid form of saving, but those who cannot afford to fund debt repayments or house purchase as well as pensions will lose their employer contribution.  This seems somewhat unfair.  My suggestion is that anyone who saves will receive an employer contribution, but the worker’s own money could be used for purposes other than pensions, while their employer contribution and the basic rate tax relief stay locked until later life.

This would mean everyone saving for their future in some form, with the help of their employer, rather than only offering employer assistance for a pension product and nothing else.

20 May 2014

• New Budget flexibilities dramatically increase appeal of pensions auto-enrolment
• Opt out rates should fall significantly
• ‘Buy-one-get-one-free’ deal too good to miss for most

The Pensions Policy Institute has today published new research highlighting that auto-enrolment is now far more attractive than previously expected.

Opting out of auto-enrolment is turning down free money:  Even for older workers, who were the group least likely to benefit from staying in their employer’s scheme, the flexibilities introduced to pension savings in the 2014 Budget will mean those who do opt out will be turning away free money.  As the PPI says, unless they are really in dire straits, it is hard to see why they would want to refuse their employer’s pension contribution and the tax relief.

Pensions are far more attractive now so opt-out rates should be much lower than expected:  The new flexibilities in the UK pension regime will dramatically increase the appeal of pension savings and employers should be prepared for much lower opt-out rates than they might previously have budgeted for.

Older workers will be first to benefit:  As workers will all be entitled to take their pension funds as cash from April 2015, if they want to, the pension savings under auto-enrolment have become significantly more attractive, especially for older workers who could be the first to benefit from the pension reforms.

Taking the funds as cash removes the previous risks to older workers:  The new rules remove the problems of pension saving for older workers, who might previously have been at risk of either just tipping over the old limits for cash withdrawals.  These ‘trivial commutation’ and ‘small pots’ limits will be swept away in 2015, so pension savers will be able to take their auto-enrolment pension fund and spend it if they wish.  In addition, there were previous concerns that older workers would find their pension income resulting in lower means-tested benefits, but now that they will be able to take their fund as cash and spend it, it will not need to count against their  means-tested benefits.  In any event, fewer pensioners will be subject to mass means-testing, as the new state pension rolls out after 2016, so the amount of money built up in an auto-enrolment pension fund will be more likely to improve people’s retirement finances.

Auto-enrolment offers a ‘buy-one-get-one-free’ deal:  Therefore, any workers who do opt out will be turning down free money from their employer.  The auto-enrolment regime offers a ‘buy one get one free’ deal on pension contributions.  For each £1 the worker puts into their workplace pension scheme, another £1 goes in (75p from their employer and 25p from the tax relief).  Unless they have huge debts, it will normally make financial sense to remain in the scheme, even at older ages – or perhaps especially at older ages – because they will be closer to the point at which they can access the money if they need to.  If they do not put that £1 into their workplace pension, they will not get the extra 75p from their employer, nor the 25p tax relief. Indeed, even non-taxpayers can benefit from the tax relief and can request to join their employer’s scheme.

Employers should be prepared for majority of workers to stay in:  The new rules will be a gamechanger for future pension contributions under auto-enrolment and employers will need to be prepared for the vast majority of their employees to decide to stay in.

27 March 2014

Charges cap is important to protect smaller firms’ workers

Will eventually need to control all charges, not just AMC

Disappointing that NEST two-tier structure will continue to prevent easy comparison

• 0.75%pa charge cap on auto-enrolment default funds from April 2015
• Banning penalty fees on leavers from April 2016
• Banning commission payments from April 2016
• As auto-enrolment spreads to smaller firms, their workers need protecting from high fees
• Pot follows member can’t work without a control on fees
• Full disclosure of all other costs, including transaction costs, by 2017
• Ultimately need cap on TER, not just AMC otherwise providers can just circumvent the cap
• NEST’s charge structure doesn’t fit with a cap – shame it will not have a single annual charge to allow customers to compare costs properly

Cap on charges from April 2015:  As the Budget measures that rocked the pensions industry begin today, another major piece of the pension reform jigsaw is put in place.  Pension providers will have to improve their practices, and while they are still reeling from the ending of captive annuities and introduction of new flexibility, the Government announces its long-awaited cap on pension charges.

0.75% charge cap is at lower end of proposals: Steve Webb has decided to introduce a cap on the charges for default funds in new auto-enrolment pension schemes.  Having consulted on a cap of 0.75%, 1.0% or no cap at all, the DWP has decided to go for the lowest figure. The cap will be introduced from April 2015.  The average Annual Management Charges (AMC) for all trust-based DC schemes are currently around 0.8%.  Pension providers will therefore have another change to cope with, in order to improve the way they treat their customers.

Charges can significantly deplete pension funds:  It is important to cap charges on pension funds. The impact of charges on pension savings may be small in each individual year but are significant over a lifetime.  DWP figures show an auto-enrolled worker on average earnings, contributing for 46 years will pay charges that amount to 13% of their fund with a 0.5% annual charge, 19% of their total fund if charges are 0.75% pa, 24% of their fund with a 1% charge and 34% of their fund will go in charges if there is a 1.5% AMC as shown below:

Cap will not apply to all costs though:  So far the 0.75% cap only applies to the Annual Management Charges (AMC).  AMCs cover asset management costs but exclude many other ongoing charges such as legal fees, administration and accounting and do not include transaction costs.  The OFT identified 18 different charges that have been imposed on pensions.  These additional charges can add significant extra sums to the costs of workers’ pension schemes, therefore it will be vital to include other charges in any long-term cap.  Initially, the DWP will require full disclosure, then once the evidence of the level of extra charges emerges by 2017, the cap may be changed.  Capping Total Expense Ratio (TER or Ongoing Charges) would ultimately be better than AMC to prevent providers simply circumventing a cap with new charges.

Government is right not to be lulled into false sense of security by low charges for new schemes:   The OFT recently found that new auto-enrolment schemes have average AMC of just 0.51% with multi-employer schemes even less, so some say that a cap is not required.  However, it is important not to be lulled into a false sense of security.  So far only the larger employers have auto-enrolled.  These employers have the wherewithal to negotiate good terms for their workers, and more management time to devote to these issues than smaller employers starting auto-enrolment in the next few years.  Most micro employers have no experience in pensions and providers will be less keen to compete for their business so there would be a danger of much higher charges.

As auto-enrolment proceeds, workers in small employers need protection:  DWP figures confirm that members in smaller schemes, with low paid workers pay higher charges, so as smaller firms are brought into auto-enrolment, the need to protect workers from high fees is clear.  Average AMC for smaller schemes (12 to 99 members) were 0.91%, compared with only around 0.5% for larger schemes (over 1000 members).

Principal agent problem – employers choose, but workers pay :  It is important to control charges to protect workers in new auto-enrolment schemes.  Unlike traditional Defined Benefit schemes, where employers covered all the management costs, members must cover these in Defined Contribution (DC) schemes.  However, their employers choose the scheme they are auto-enrolled into, so members are in a weak position to protect their own interests.  The OFT expressed concerns about this principal-agent problem.  A charge cap will provide some protection for workers as they cannot choose or change the scheme their employer uses.

End of Active Member Discounts – about time too!: So-called ‘Active Member Discounts’ (AMD), which, in reality, are penalty charges on people who have left their employer scheme will be banned from April 2016.  These penalty charges are particularly damaging for many women who need to take career breaks for caring responsibilities.  When they leave their employer scheme they face much higher charges which the OFT estimated could be almost an extra 0.5%. 94% of pension schemes that have AMDs are still open for auto-enrolment so it is important to ensure they are ended.  The industry is being given an extra year to make the changes.  The Government’s current proposals for ‘pot follows member’ will not work unless there is a clear minimum standard for all auto-enrolment schemes.

Ban on commission-based fees : From April 2016, the DWP will ban all commission based schemes.  This will help reduce pension fees for many schemes, since where employers use a commission-based advisor, charges were on average 0.4% higher.  The industry will, however, have to retrospectively change those schemes that have already been set up on this basis.

NEST charge structure undermines effectiveness of any charge cap:  The charge structure of the taxpayer-backed NEST scheme does not properly fit with the aims of a simple charge cap.  For a charge cap to work most effectively, customers must be able to easily compare schemes with each other.  Two-tier charge models make this difficult.  NEST has an initial contribution charge of 1.8% plus a 0.3% AMC annual fee, while NOWpensions charges an £18 initial fee, plus 0.3% AMC – these cannot easily be compared with schemes that have a TER of 0.5%.  The Pensions Policy Institute calculates that older workers in NEST are particularly disadvantaged.  Those who are auto-enrolled at age 60 and contribute until their state pension age will pay far more in charges with NEST than with a 0.75% cap.  As it is older workers who will retire first under auto-enrolment, it is disappointing that reform of NEST’s charges has not been included.

Need for a measured approach:  Introducing an immediate cap for schemes already set up could interfere with roll-out of auto-enrolment and divert industry resources away when they will be vitally required to service the coming capacity crunch in the industry.  Therefore, allowing some time for the cap to fully develop makes some sense and will give providers time to cope with new demand while also adapting older schemes.

Overall a cap will help make our pension system more user-friendly:  The introduction of a charge cap, following on from increased flexibility and auto-enrolment, should help restore confidence in pensions as a fair long-term savings vehicle.  Labour has been calling for such a cap on TER, not just AMC, which would be even better for members and this may yet come.

18 February 2014

• DWP report on pension charges shows importance of introducing a cap
• Workers in small firms need protecting from rising charges as small funds pay higher fees
• Labour TER cap for new schemes makes sense but don’t set too low initially
• NEST reforms needed – and AMDs should be banned

Summary

• DWP report on pension charges shows large schemes have lowest charges
• As auto-enrolment spreads to smaller firms, their workers need protecting from high fees
• Labour is right that we need a cap on charges in new auto-enrolment default funds
• OFT Report showed new auto-enrolment schemes average charges are 0.5% or less but don’t be lulled into a false sense of security as charges will drift up for smaller employers
• Cap TER (not AMC, nor dealing costs)
• TER cap of 0.75% (possibly 1%) from 2015 for new schemes, with existing schemes capped after 2017 to avoid capacity issues for providers and cap falling in future as assets rise
• Active Member Discounts should be banned as they penalise too many members and pot follows member can’t help
• NEST’s charge structure doesn’t fit with a cap – should be a single annual charge to allow customers to compare costs properly.

The DWP has just released a Survey of pension scheme charges which shows that members in smaller schemes pay higher charges.  The Survey highlights that larger schemes pay lower fees and those with commission based advisers and lower paid workers pay more.  The case for controls is clear.

Findings of DWP Survey: The Survey shows average Annual Management Charge (AMC) for trust-based schemes was 0.75% in 2013, slightly higher than the 0.71% in 2011. Among contract-based schemes, average AMC fell from 0.95% in 2011 to 0.84% in 2013. Members of smaller schemes (12 to 99 members) paid higher AMCs in both trust-based and contract-based schemes – 0.91% and larger schemes (over 1000 members) paid significantly less –  0.42% in trust-based and 0.51% in contract-based schemes.  Schemes with higher-paid workers also have lower charges as their contributions were larger. Where employers use a commission-based adviser, trust-based schemes paid on average 0.4% higher charges, and 0.2% higher in contract-based schemes.  Older scheme charges were higher, with trust-based pre-1991 schemes charging on average 0.81% but 0.71% for schemes started after 2001. Average charges for contract-based schemes set up before 1991 were 1.0%, but fell to 0.80% after 2001.

Charge cap in the long grass?:  However, despite its recent consultation proposing to cap auto-enrolment pension Annual Management Charges (AMC) at 1% or 0.75% perhaps from April 2014, the DWP subsequently announced there would be no cap before April 2015 and there are now rumours that nothing will happen at all before the next Election.

Workers do need protection:  April 2014 was certainly too soon, as it could have meant employers who had prepared early for auto-enrolment (as urged to do by Government) might have to start again if their chosen scheme did not fit with the cap.  But, as millions of workers in smaller firms will be enrolling into employer pension schemes, they do need protection.  A charge cap would be helpful for such new schemes.

Principal agent problem – employers choose, but workers pay – so just requiring disclosure of charges is not enough protection:  Unlike traditional Defined Benefit schemes, where employers covered all the management costs, members must cover these in Defined Contribution (DC) schemes.  However, members are in a weak position to protect their own interests because their employers choose the scheme they are auto-enrolled into.  The OFT report expressed concerns about this principal-agent problem.  Merely requiring full disclosure of charges is not sufficient to protect workers, since they cannot choose or change the scheme their employer uses.

Dangers of being lulled into false sense of security by recent improvements:   Recent evidence of lower charges may be encouraging (the OFT reported that new auto-enrolment schemes have average AMC of just 0.51% with multi-employer schemes even less), but it is important not to be lulled into a false sense of security.  So far only the larger employers have auto-enrolled.  These employers have HR or finance departments to negotiate good terms for their workers, and more management time to devote to these issues than smaller employers who will start auto-enrolment next.  Most micro employers have no experience in pensions and providers will be less keen to compete for their business.  Industry moves such as the Investment Management Association’s ‘Enhanced disclosure of fund charges and costs’ or the ABIs agreed standards for charges and a ‘joint industry code of conduct’ cannot be relied on as they are only voluntary.

However, don’t set cap too low initially:  The danger of being too draconian on charges is that innovation and new investment approaches will be stifled.  There needs to be a balance between protecting customers and damaging their longer term interests. Sometimes, slightly higher charges may be justified and it is inevitable that smaller schemes will have higher charges due to problems of economies of scale.  If paying a little more in charges delivers better or less volatile returns or pays for more effective information and engagement with members, they might be justified. But controls are still needed to avoid unfair practices and the DWP research suggests charges are still high in some areas.

Clarify what charges are capped – not just AMC, need TER cap:  Just imposing a cap on AMCs is inadequate protection.  AMCs cover asset management costs but exclude many other ongoing charges such as legal fees, administration and accounting – indeed the OFT identified 18 different charges that have been imposed on pensions.  Capping Total Expense Ratio (TER or Ongoing Charges) is better than AMC to prevent providers simply circumventing a cap with new charges.  It may be better to have no cap at all, than to lead members to believe charges are controlled while providers can increase costs in other ways.

Start with 0.75% (or 1%) cap on TER ongoing charge basis and signal a reduction in future:  Labour suggests a 0.75% TER cap which seems reasonable for new schemes (although 1% initially might also be considered) but it is important to signal that the cap will be reduced in future years. As assets under management in auto-enrolment schemes increase, economies of scale should enable lower charges.

Don’t cap dealing costs but ensure full disclosure:  I think capping dealing costs is a step too far.  One would not want to hamper the ability of fund managers to actively trade their holdings if considered necessary.  However the costs of dealing do need to be properly reported in a clear, comprehensible fashion, so members can see what they have paid.

Removing Active Member Discounts is even more urgent than charge caps as ‘pot follows member’ can’t help those with career breaks:  Another urgent reform is to clamp down on so-called ‘Active Member Discounts’ (AMD) which are basically penalty charges on people who have left their employer scheme.  Approximately 94% of pension schemes with AMDs are still open for auto-enrolment.  The OFT says workers who leave their employer can be hit with extra charges of around 0.5% a year.  This will particularly affect women who take career breaks for caring responsibilities.  The Government’s current proposals for ‘pot follows member’ will not solve this problem because people taking career breaks have no new scheme to transfer to, so banning AMDs is important.

NEST charge structure undermines effectiveness of any charge cap:  The charge structure of the taxpayer-backed NEST scheme does not fit with the aims of a simple charge cap.  For a charge cap to work properly, customers must be able to easily compare schemes with each other.  Two-tier charge models make this too difficult.  NEST has an initial contribution charge of 1.8% plus a 0.3% AMC annual fee, while NOWpensions charges an £18 initial fee, plus 0.3% AMC – these cannot easily be compared with schemes that have a TER of 0.5%.  The Pensions Policy Institute calculates that older workers in NEST are particularly disadvantaged.  Those who are auto-enrolled at age 60 and contribute until their state pension age will pay far more in charges with NEST than with a 0.75% cap.  As it is older workers who will retire first under auto-enrolment, reform of NEST’s charges would seem desirable.  Without standardisation of reporting and fee structures (including NEST reform), capping auto-enrolment charges will be less effective.

11 November 2013

There are no controls on charges people forced to pay when buying their actual pension

Far more money can be lost on annuitisation than saving 0.25% in fees

0.25% charge on £30,000 fund is £75pa but customers lose £600-£1000 when buying their annuity at retirement with no advice

Auto-enrolment needs to ensure pensions are good value:  There has been significant debate about capping fees and charges on auto-enrolment pension funds and estimates that people are losing chunks of their pension fund in extra fees.  It is clearly in the interests of customers to ensure fees are reasonable and, of course, paying lower fees will help ensure a larger future pension fund.  However this debate is missing a most essential piece of the pensions puzzle.  When people buy a pension income, they are often losing far more of their fund than the savings they make from the current proposed charge caps.

A 0.25% lower annual charge for a £30,000 pension fund equates to £75 saved each year, but when buying an annuity they often lose over £1,000:  A 0.25% charge on a £30,000 pension fund is just £75.  The smaller the fund, the less the 0.25% charge will be but that is where all the focus on controlling pension charges has been.  However, when they come to buy an annuity with a £30,000 fund, they will often have to pay over £1000 as companies commonly charge between 2% and 3.5% of the fund to sell them an annuity and there are no controls on those costs at all.  It seems the charges debate has lost sight of the wood for the trees.

Auto-enrolment is underway but has failed to focus on the actual pensions:  It is astonishing that we are well into the process of pension auto-enrolment and yet the reform agenda has not really looked at the value for money of the actual pension that people will receive in retirement.  Focussing on lowering charges while building up the pension fund is clearly important, but even if people have a larger pension fund at retirement, they could lose much more if they do the wrong thing when deciding how and when to buy their pension income. It is the annuity that is the pension, yet auto-enrolment has failed to take account of ensuring customer value at the vital stage of pension saving.

No controls or caps on fees for annuities:  Buying an annuity is an irreversible purchase, customers usually only do it once in their lives, yet they receive no advice even though they pay hundreds of pounds in ‘commission’.   There are no controls on the amount of money that a provider can force people to pay when buying an annuity.  There are also no controls on the rate that people must be offered when buying an annuity.  Annuity rates have fallen so low as gilt yields were depressed by QE and there are no requirements to ensure fair value for the customer in annuity rates.

How do customers lose out on charges?

Buying direct without shopping around costs 2%-3.5% of the fund i.e. £600 – £1000 from a £30,000 pension fund for doing nothing:  Those who just buy an annuity from their existing provider have money taken out of their pension fund as ‘commission’ even if they receive no advice.  The money is just pocketed by the provider or broker.  Customers will often be buying the wrong type of annuity (for example single life annuities leave nothing for widows when their husbands die) at a very poor rate.  For a £30,000 pension fund, the provider will take £600 – £1000 but not have to provide any advice for this money.

Buying direct from an annuity broker also costs £600-£1000 or more out of a £30,000 pension fund for finding better rate, but may still be wrong product:  Shopping around for an annuity with an annuity broking service is clearly better for the customer than just staying with their pension company but will still cost significant sums even though it is a do-it-yourself service which is not covered by regulatory protection, may not offer annuities from the best provider at the time and will not ensure people buy the right type of annuity at the right time.

Buying from an independent whole of market adviser can cost around £700 for a £30,000 fund for full advice:  Many financial advisers will advise clients on annuities for less than the cost of non-advised or direct-purchase.  The customer will then be paying for the service they need, rather than paying without receiving the best chance of optimising the value of their pension fund.  They will be covered by regulatory protection and have access to all the providers in the market, rather than just those on a broker’s panel.

Pensions are still not working in the customer interest – advice costs less than d-i-y!:  So the cost of the independent, whole of market advice which people actually need is often less than the cost of buying the wrong annuity at the wrong time at the wrong rate.  The focus on ‘shopping around’ for the best rate is not enough to ensure good value pensions.  There need to be controls on the charges and fees that are paid when converting pension funds into pension income.  Unfortunately, the effect of the RDR means that regulatory bias is driving people towards non-advised services which can cost more than the advice which they really need.  It is time to sort out this end of the auto-enrolment pension process too.

29 October 2013

In today’s Pensions Bill debate, Steve Webb anounced his ‘full frontal assault’ on pension charges. Here are my thoughts:

It is of course right that people need good value pension schemes to save into with auto enrolment, but it is also important that we consider the losses they can sustain when buying an annuity. Buying the wrong annuity can be even more damaging to people’s pension funds than being in a higher charging scheme. There are no controls on the rates annuity providers can offer nor on those charges levied for buying the annuity either.

In addition, the Governments own NEST scheme established at taxpayers expense, also needs to reform its huge 1.8% initial fee. For older workers auto enrolled into NEST the fees can be over 2%. Reforming NESTs charges should be an important part of these charge cap reforms.

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.

23 September 2013

NEST charging structure may be responsible for failure to recommend a charge cap – NEST would not comply with a 1% cap!

The long-awaited OFT report into pension scheme charges has finally been released – but its recommendations are disappointingly weak in terms of consumer protection.

The OFT has done an excellent job in highlighting the excessive charges on older (particularly pre-2001) pension schemes but it has shied away from recommendations that would quickly bring them down.

It did not propose a widely-expected cap on pension scheme charges.  This would have sent a clear signal that rip-off fees must end, but was considered too difficult to introduce in practice.  Instead, it is leaving it to the insurance companies and pension providers themselves to ‘audit’ old schemes and check value for money and to establish independent governance committees to watch out for poor practice.  It is hardly likely that customers will be suitably reassured by this.

The failure to recommend a cap has disappointed many. However with the charging structure of NEST perhaps it was never likely that a cap could work.  Currently, NEST imposes a hefty 1.8% initial charge on all contributions, which would be way in excess of any likely cap.  For someone who is enrolled at an older age, the effect of the 1.8% charge is likely to leave them facing overall costs that are unfairly high.  Unless NEST’s charging structure is overhauled, perhaps it is never likely that a cap will be a realistic option.

The OFT says all the right things – recognising that, as auto-enrolment extends pension coverage to millions more workers ‘it is vital that they save in schemes that deliver good value for money’ and stressed the importance that ‘measures be implemented rapidly’.  However, it is not actually proposing new measures that will make much difference in practice.

There are five main recommendations:

1.  ABI to audit old schemes: That the ABI (Association of British Insurers) has agreed to work with the Government to audit old-style schemes to single out poor-value plans, improve transparency and identify whether they offer value for money.  An audit will not stop schemes charging too much and is not going to improve the position of those stuck in such schemes who already know they have high fees.

2.  ABI to set up independent ‘governance committees’ to check value for money: The ABI is also urged to ensure that each insurance company establishes an independent ‘governance committee’ to check whether schemes offer value for money, recommend any changes and report poor practice to the Pensions Regulator.

3.  tPR to ‘assess value for money’ of small trust schemes:   The Pensions Regulator is urged to take ‘urgent action’ to ‘assess’ the value for money of small trust based schemes.  The OFT particularly highlighted the problem of excessive charges legacy contract-based or bundled-trust schemes, which have around £30bn of people’s pension savings, plus a further £10bn in small trust-based pension schemes, where nobody is ensuring charges are reasonable.  Assessing these schemes hardly constitutes ‘action’.  The customer charges will not be affected by an assessment.  The DWP is urged to consider whether it needs new enforcement powers to ensure charges can be reduced.

4.  DWP should consult on improving transparency of charges and quality: The OFT recommends that the DWP should consult on improving transparency of charges and helping customers compare information so they can assess schemes charges and quality.  Again, this is not going to ensure charges are reduced.

5.  Ban Active Member Discounts, consultancy charges and maybe adviser charges: The report recommends a ban on the practice of so-called Active Member Discounts which are really just higher charges for members who no longer contribute after leaving their employer.  It also suggests banning adviser and consultancy charges, whereby employees pay fees for advice and services given to their employer, while the employer actually chooses which scheme to use.  These measures could help improve customer value.

Even after the OFT’s damning findings of bad practice and high charges, customers will continue to lose out.  The interests of the industry have prevailed.  It is true that most schemes are better value nowadays, however companies have too often kept charges opaque and hidden the true costs of their products.

Meanwhile, millions of workers will be automatically enrolled into company pension schemes where there are inadequate controls and safeguards on the charges they will face.  Even the Government’s own taxpayer-funded scheme is failing to operate in the customer interest on this issue.

Who is protecting the customer?

OFT report into pension charges expected to propose a 1% cap

How does that square with NEST’s 1.8% initial charge?

NEST charging structure needs urgent overhaul as it can be poor value

The long-awaited report from the Office of Fair Trading, assessing the charges levied on UK pension plans, is about to be released and is expected to recommend a cap on the charges for UK pensions probably of 1%.

This recommendation would raise a number of issues.  It is vital to be clear which charges are covered by the cap.  Currently, there is a confusing array of cost measures.  The standard ‘Annual Management Charge’ or AMC only covers part of the costs, while even the ‘Total Expense Ratio’ (TER) does not actually include the total expenses.  Unless customers are clear what costs they are paying, and what the cap includes, this recommendation will not be sufficient to ensure better value.  Indeed, it is more than ten years since stakeholder pensions were originally introduced with a 1% charge cap, so little progress seems to have been made in terms of customer value, even though expected returns have fallen significantly since then.

But more importantly, a charge cap of 1% exposes just how expensive the National Employment Savings Trust (NEST) is.  The Government established NEST as a national scheme that will ensure all employers can access a pension scheme for their staff.  Taxpayers have already spent hundreds of millions of pounds setting it up.  Yet this government-sponsored scheme charges far more than 1% for many workers.

NEST takes 1.8% out of every worker’s contribution.  There is then an ongoing annual charge of 0.3%.  The Treasury apparently insisted on a high up-front charge in order to try to recoup the taxpayer loan to NEST as quickly as possible.  However, the value offered to NEST’s members has been compromised and the charging structure needs to be urgently rethought.

Any worker who does not stay in the NEST scheme for many years will be at risk of paying much higher charges in NEST than in other schemes, and possibly even more than the 1% cap that might be imposed.  NEST only works out better value if the 1.8% charge can be spread out over around ten years or more.  But older workers who are automatically enrolled may not be able to remain in the scheme long enough to overcome the initial fee.

The OFT inquiry is right to shine a spotlight on high charges and value for money for pension savers.  But the Government itself must re-examine its own practices and urgently consider changing the charging structure for NEST.  A flat fee of 0.5% would be much fairer and could even result in more revenue for taxpayers by increasing its attractiveness and bringing in more members.

At the moment, the NEST scheme appears expensive relative to many private pension providers.  Anecdotal evidence suggests many employers have rejected NEST for its auto-enrolment scheme.  The membership of NEST is below initial expectations and, although its restrictions are being lifted in 2017, a reformed charging structure would make NEST far more attractive to use.  This could ultimately ensure that more employers use NEST and that taxpayers recoup their loan more quickly.

Or am I missing something?

8 August 2013

• DWP delighted auto enrolment opt-outs much lower than expected
• Treasury will have to budget for higher than expected tax relief!
• Encouraging progress in improving private pension coverage, but far more is needed – including annuity reform

Auto-enrolment among largest firms has been successful in ensuring more people save in a pension: The DWP has released figures today showing that nine out of ten workers automatically enrolled into their employer’s pension scheme have decided to stay in.  It is clear that, so far, auto-enrolment is a huge success in terms of encouraging workers to belong to their employer’s pension scheme and take advantage of the employer contribution.

Initial opt-out rates likely to be a maximum though:  The DWP Survey among 50 of the largest employers (both public and private sector) shows that the vast majority of workers have overwhelmingly decided to stay in, once they have been enrolled automatically.  The opt-out rate of 9% is far lower than previously might have been expected.  There are a few reasons, however, why this figure is unlikely to exceed the proportion of workers choosing to stay in once all employees are enrolled in future.

Large employers have heavily promoted their schemes:  Firstly, the largest employers have often spent significant amounts of time and money preparing brochures and materials on auto-enrolment to promote their schemes, and their HR departments genuinely wish to ensure that as many workers as possible stay in the scheme.  Smaller firms are less likely to be quite as enthusiastic, especially those that have not offered pensions before. They are unlikely to be so willing or able to devote such resources to auto-enrolment.

Initial minimum contributions very low:  Secondly, the initial auto-enrolment minimum contributions are only 1% of salary, whereas by 2018 the employee will have to contribute 4% (and the employer 3%, with an extra 1% from tax releif.)  Therefore, workers will not see much of an effect in their pay packet from auto-enrolment deductions initially.

Markets have done well and publicity has been helpful too:  Thirdly, markets have performed well recently, which has probably encouraged people to stay in the scheme so far.  There has also been significant public promotion of auto-enrolment, which has added to its appeal.

Encouraging that younger workers have lowest opt out rates: It is certainly encouraging that the opt out rates among the younger workers are the lowest, since they will have more time to benefit from the compound growth of their savings.

Also good that the over 50s have higher opt-out rates – they are group for whom pensions more likely to be unsuitable:  I am also pleased to see the over 50s having higher opt out rates, since the oldest workers are least likely to benefit from auto-enrolment.  Indeed, they face risks if their auto-enrolment contributions result in them exceeding the amount of pension savings that can be taken out as a lump sum (called the trivial commutation limit).  For example, if they have saved in pensions in the past, they may have a pension fund of nearly £18,000 and a small extra contribution via auto-enrolment could just push them above that threshold and mean they can no longer receive the lump sum and may need to take an annuity or other income.  Those who are older will also be more at risk of losing means-tested benefits if they have a bit of extra pension income from auto enrolment when they retire.  Therefore, higher opt out rates for older workers are welcome.

Dangers of workers feeling auto-enrolment will mean their pensions are sorted:  Of course, it should also be noted that the level of contributions in auto-enrolment is currently nowhere near enough to provide anyone with a decent pension income in later life.  Far higher contribution levels will be needed, just to make up for the future reductions in state pension as the State Second Pension is phased out.  There is a danger of workers being misled into believing that the auto-enrolment level of contributions means their future pension requirements will now be taken care of.  That is certainly not the case.  More reforms and higher contribution levels will be required.

Annuity reform vital for future private pension adequacy:  Reform of the annuities market is an urgent requirement for optimising outcomes of auto-enrolment pension savings in future.  Currently, the annuity market is not working in the interests of the customer.  Most of those buying annuities in their 60s are receiving poor value and often buy the wrong type of annuity, without understanding the risks of their decision.  Most have no inflation protection and there is no automatic mechanism to ensure their partner can benefit from their pension savings too.

DWP delighted – Treasury may not be quite so pleased:  Overall, however, the DWP will be pleased to see such low opt out rates.  Whether the Treasury is quite as pleased with the higher level of tax relief than it might have previously budgeted for, of course, is another matter!

– The DWP ad hoc release can be found here: https://www.gov.uk/government/organisations/department-for-work-pensions/series/ad-hoc-statistical-analysis-2013-quarter-3

– Previous research can be found here: https://www.gov.uk/government/publications/attitudes-to-pensions-the-2012-survey-rr813