Small pots, big problems
The pensions world is eagerly waiting the results of the government’s response to the consultation on what is known as the small pots issue.
An excellent discussion at a National Association of Pension Funds event last month revealed once again that there is no real consensus and a lot of difficult issues to be resolved.
The problem the government faces is that what looks like a relatively manageable technical issue quickly raises some profound questions about the structure of UK pension provision. If they resolve the issue to the benefit of pension providers, then many consumers face losses. If the consumer interest is paramount (as it should be) then that points in the direction of a big and politically difficult shake -up.
The origin of this issue illustrates what Dirk Gently would call the “fundamental interconnectedness of all things” – at least in the pensions world.
The small pots issue arose from the need to deal with short-service refunds. The government rightly wants to crack down on a potential abuse by pension providers. If they use a trust-based pension arrangement, employers are able to reclaim pension contributions for staff who leave after less than two year’s membership of a scheme. This was introduced many years ago as a reasonable way of ensuring that employers did not have to deal with large numbers of deferred members in DB (salary related) pension with small entitlements (even if all refunded contributions should always have gone to the member). Using it to relieve employers of the need to contribute to DC pension pots under auto-enrolment in industries with high staff turn-overs would be a clear abuse.
But once auto-enrolment starts then there is going to be a huge increase in the number of small pension pots – and the abolition of short-service refunds will increase the number. A profusion of small pots is bad news all round. Consumers will not want their pension savings scattered around in different schemes. As it costs a scheme much the same to administer a pot whatever its size, it is economically efficient to reduce the number of pots. That allows lower charges, and hence better returns. As in almost every scheme charges are levied as a percentage of funds under management each year, scheme providers get little income from small pots and cross-subsidise the costs of looking after these from the income from big pots.
Rightly therefore the government wants to reduce the number of small pots as well as end short-service refunds. Its consultation suggested three basic approaches:
- making it easier for savers to move pension pots on request
- small pots to follow the saver from their previous employer’s scheme to one provided by their new emnployer
- small pots to go to one or more aggregator schemes when a saver leaves employment
Making it easier to tranfer pots is clearly a good idea, but it is very unlikely to make a big contribution to reducing the number of small pots. Relying on people to make active choices to prevent themselves from the consequences of inertianot only goes against the grain of auto-enrolment, but also won’t work.
At first sight, ‘pot follows member’ looks attractive. But only at first sight. There are both practical and principled objections. What happens to people who do not smoothly move from one job to another? How does the former employer know where to send the small pot? Should we allow automatic transfers from a scheme to one that has higher charges or is poorer in other ways?
This last “member detriment” issue has not only been raised by consumer interests. I have heard many industry people make the same point. Some of them have therefore advocated a fourth approach, which can be best seen as a virtual aggregator. This would not move pension pots. Instead the industry would build a giant database giving members a single place where details of all their pension pots are stored and made easily visible to them. While this approach is ingenious, it only solves the member confusion issue.It would probably encourage a few more voluntary transfers to consolidate pots, but it does little to drive economic efficiency gains and deliver lower charges.
In our submission the TUC (along with other consumer groups) has therefore backed an aggregator approach. We think NEST should have a public service obligation to accept all transfers, but that other schemes – particularly those with a sectoral focus, where it is likely that employees will move between employers with the same scheme, should also be able to become aggregators if they can demonstrate low charges, good governance and appropriate investment strategies.
But we go further. Our problem with the way that this debate has been framed is that it starts from seeing small pots as a problem for employers and pension providers. The task is therefore to come up with a way of reducing the number of small pots.
If we start from the interests of the saver, then the problem looks very different. There is no consumer reason to differentiate between big, medium or small pots. It simply makes sense to have all your funds in one high quality scheme.
The “consumer detriment” issue raises another big issue. If we recognise that moving funds to an inferior scheme is a real danger in a ‘pot follows member’ model, we should ask why should anybody be saving in the poorer scheme at all.
If we recognise that a high-quality DC scheme requires scale to deliver low charges and governance that fully is aligned with the interests of scheme members, then a consumer perspective points to a very different pensions landscape.