One of the main consequences of the shift from defined benefit (DB) to defined contribution (DC) pensions in the UK has been a general reduction in contributions made into pensions saving vehicles. There is of course no inherent reason why employers would be prepared to invest less in an employee’s DC pension than in a DB pension. What they gain from the transition to DC, in principle, is the alleviation of risks around investment and longevity. That employers, in general, have taken the opportunity to reduce contributions at the same time is unfortunate, and can be seen therefore as part of a general abdication by employers of their responsibility for employees’ welfare in retirement.
Several developments last week brought the issue of contributions to the fore. As part of its Pensions Outlook 2012, the Organisation for Economic Co-operation and Development (OECD) published a ‘roadmap for the good design of DC pension plans’.
The roadmap stated that:
Making sure people contribute for long periods with sufficiently high contribution rates is the most effective way to improve their chances of obtaining an adequate replacement rate from DC pension plans.
The Association of British Insurers’ (ABI’s) report, published last week, Time to Act, also outlined the decisive impact that contribution rates (and duration) can have on pension outcomes. One of the report’s main aims was to defend the insurance industry against the criticism that charges in DC provision have a detrimental impact on outcomes – they do to some extent, so the argument goes, but not as much as low contribution rates, and in any case charges are a necessary evil.
But the vital question being dodged is how contribution rates can be increased. For employer contributions, we are relying to some extent on generosity, but also on their own calculations of what contribution levels are required to recruit and/or retain staff.
New rules around automatic enrolment will establish (after a long phasing in period) a contributions floor, that is, minimum employer contribution of 3% on a band of earnings (£5,564-£42,475) into employees’ pension pots, on the basis that the employee contributes 4% of the same band (an additional 1% is contributed by the government in the form of tax relief).
Yet achieving contribution rates significantly above this level – Scottish Widows’ annual UK pensions report suggests a benchmark of 12% – may be difficult.
The Pensions Regulator (TPR) acknowledges the importance of raising contributions. Its draft checklist for the pension scheme features that will help to deliver good member outcomes includes the ambition that:
Products offer flexible contribution schemes to members and/or employers (over and above minimum scheme qualifying thresholds).
TPR’s willingness to advise providers and employers in this regard is welcome, but the regulator of course has no authority to bring such arrangements about. Furthermore, TPR is responsible only for trust-based DC schemes; contract-based schemes, which look a lot more like individual savings accounts than traditional pension schemes, are regulated by the Financial Services Authority, whose main objective is the probity of individual financial transactions not the adequacy of pensions saving.
The underlying message of much of the industry and government’s communications on contributions is that individuals themselves must commit to higher levels of saving. This is not necessarily incorrect, but the message is disingenuous for several reasons.
Most obviously, it relies on the assumption that individuals can choose to save more in a straightforward sense. At a time when the squeeze on low-to-median income continues – we know that real wages have been falling since mid-2010, and the government’s own forecasts point to a three-year real earnings drop – this assumption is highly questionable.
The argument that charges matter far less than contributions, although ostensibly true, overlooks the vital point that high charges undermine people’s trust in the pensions industry in general, and their trust in the value of saving.
The OCED points to three additional ways that higher contributions from individuals could be encouraged. Firstly, the Pensions Outlook assesses saving incentives provided by the tax system. The current system of pensions tax relief benefit higher income households most, because they are subject to the highest tax rates. Rather than linking tax relief to marginal tax rates, countries such as Germany and New Zealand have a flatter system of tax-based subsidies, and Chile (for young people) and Australia (for low-income households) offer matching contributions rather than tax relief.
Secondly, the DC roadmap advocates that accumulation (saving) and decumulation (pay-out) phases in DC schemes are properly aligned. Essentially, if the accumulation phase is going to be restrictive, then the decumulation phase needs to be restrictive too. Compelling individuals to save then leaving them to fend for themselves in the annuities market won’t do.
And finally, the Outlook suggests that guaranteed investment returns in DC schemes may be necessary. The report acknowledges that while some forms of guarantees may be prohibitively expensive, the absence of guarantees creates ‘substantial risks… for low income individuals, as even small declines in retirement income [from DC saving] can lead to severe hardship’.
As such, guarantees ‘increase the attractiveness of saving for retirement in DC accounts’. The OECD argues that investment guarantees will be especially important in countries where most of individuals’ retirement income comes from DC saving; that is, the direction in which the UK is heading. Steve Webb’s advocacy of ‘defined ambition’ pensions suggests a willingness to consider these kinds of reforms, but concrete changes may be a long way off.