UK: hard at work
Written by Nick Martindale
Nick Martindale looks at what the sweeping changes in the UK pensions system could mean for the industry as a whole
The UK pensions landscape is currently undergoing a period of transition, with long-planned changes coming into force and new legislation pushed through since the change of government in 2010. Perhaps the most significant development, though, is the introduction of reforms designed to ensure all employees have access to a workplace pension, with a minimum level of employer contributions.
The move will see all staff aged over 22 and earning more than £7,500 a year automatically enrolled into existing workplace schemes unless individuals specifically opt out, while companies that do not currently offer a scheme will be able to offer access to the National Employment Savings Trust (NEST). The new setup will begin to take effect in October 2012 with larger employers, while smaller firms will need to comply by 2016.
“Auto-enrolment puts the UK at the head of the class in terms of defined contribution pensions,” says Tom Middleton, technical consultant at the Pensions Management Institute (PMI). Very few countries’ pensions systems are based on compulsory auto-enrolment; everywhere else it is a voluntary system that corporate sponsors – encouraged by governments – have adopted.
Most schemes, however, will find themselves facing higher pension contributions and this could prove the catalyst for a wider reassessment of existing provisions. “Key questions include how these costs will be absorbed, whether the contribution structures they designed in an ‘opt-in’ world are still appropriate in an ‘opt-out’ world and how they will differentiate their pension offering from the basic minimum that everyone will get so employees know they are receiving a valuable benefit,” says Paul Macro, senior consultant at Towers Watson.
NEST, meanwhile, could inject some much needed competition and innovation into the defined contribution landscape for smaller and medium-sized schemes, says Nils Johnson, co-owner of investment marketing intelligence firm Spence Johnson.
“This is the first time a defined contribution (DC) scheme has been built from a blank slate,” he says. “They got the best and brightest ideas and then went out and tendered for the most cost-effective investment solutions. The resulting target date funds may make the UK the most advanced country in the world in terms of overall scheme design. I’m willing to bet our European friends on the continent will all learn from, and possibly adopt, what NEST is doing in the UK.”
But Richard Butcher, managing director of Pitmans Trustees, says schemes will also face a greater compliance burden with the introduction of NEST. “This is going to expose the appalling low standards of governance that generally apply to DC schemes,” he says. “The regulator knows this and has started to set out guidance. The burden of compliance, however, will fall on employers. They need to wake up and smell the coffee if they are not to be sanctioned.”
NEST, on its own, will not solve the UK’s pensions shortfall, warns David Calfo, head of DC strategy at BNY Mellon. “The contribution rates, the charges and the low level of investment risk may mean widespread disappointment at the level of returns achieved,” he warns. “It takes quite a big leap of imagination to see that NEST will, in the majority of cases, generate for its members anything like the level of retirement wealth that members would want or need.”
The decision by the coalition government just weeks after it came to power in May 2010 to switch the inflation measure used for pension payments for both public and private sector schemes from the retail prices index (RPI) to the consumer prices index (CPI) is also weighing heavy on the UK pension sector.
“Having announced that the switch to CPI would apply to private sector schemes as well as in the public sector, the government took a further five months to decide what this would mean,” says Paul Kitson, senior consultant at Towers Watson. “The end result is that most schemes will now use CPI to revalue members’ benefits in deferment. Some will automatically move to CPI for increases to pensions in payment as well, but most will be prohibited from doing this in relation to benefits accrued in the past.”
Jay Shah, co-head of business origination at Pension Corporation, says the unexpected nature of this particular issue also serves to highlight the vulnerability of pension schemes in the UK to legislative or regulatory change. “Our assessment is that pension liabilities have increased by between 25% and
50% solely due to these types of changes over the last couple of decades and there will be more to come,” he says.
The change to CPI is also causing issues for funds that wish to hedge risk, suggests Phil Page, client manager at Cardano, with organisations currently only able to purchase RPI-linked bonds. “Funds have to decide between not hedging the CPI risk at all, which we advise against, or an imprecise hedge using RPI-linked instruments,” he says. “The UK government needs to help create a solution, not just a hedging problem, by issuing CPI-linked bonds.”
The abolition of the default retirement age and the system under which members had to purchase annuities by the age of 75 is also set to have an impact on the make-up of schemes.
“This will lead to a complete rethink of the most appropriate investment strategy for pension scheme members saving for retirement,” says David Hutchins, UK head of research and investment design at Alliance-Bernstein DC Investments.
“End-point-sensitive, inflexible and costly lifestyling strategies based on a default retirement age can no longer be considered the most suitable default fund for the majority. They will give way to more robust target date funds, with their inbuilt capability to evolve dynamically in a simple and efficient manner as legislation, markets and member behaviour changes.”
As well as people living and working longer, falling bond yields have also had an impact on annuity rates, says Ashish Kapur, European head of institutional solutions at wealth management company SEI, which has led to investors looking for new approaches such as partial drawdown or lifestyling strategies which don’t de-risk completely.
The end of a set retirement age and the trend to work later in life also poses issues for employers, says Ian Neale, director of Aries Pension & Insurance Systems. “At the moment there is considerable uncertainty about the impact on pension schemes,” he says. “For example, it is unclear whether an employee in this position must be permitted to continue to accrue new pension benefits. There is no suggestion that pension schemes will no longer be able to specify a normal pension age.”
Other regulatory factors are set to impact the UK pensions landscape, too. Alan Morahan, principal at Punter Southall highlights the new framework established by the Financial Services Authority’s retail distribution review, which will come into force in 2013. “This is aimed at providing clarity around the services offered by advisers, while raising professional standards and abolishing the payment of commission, which the FSA believes distorts consumer outcomes,” he concludes.
Nick Martindale is a freelance journalist