19 May 2014

We are smack bang in the middle of a pension revolution. Auto-enrolment will result in millions of new pension members and Steve Webb is on track to introduce minimum quality standards for workplace pensions and a radical degree of freedom and choice in retirement before the next election.

Combined with the reforms to the State Pension, these measures will have a lasting impact on how employees and employers outside of the public sector provide for retirement. 

The acceleration in the pace of change has been breathtaking. Auto-enrolment legislation was crystallised in the Pensions Act
2008, with implementation initially phased between October 2012 and the end of 2016. The staggered roll-out was extended to the current timetable in early 2012 to give smaller employers “additional breathing space to prepare for the reforms while operating in tough economic times”.

The timetable for the latest reforms is not so measured. The defined contribution workplace pension market study by the Office of Fair Trading was published in September 2013. The Department for Work and Pension (DWP) consultation and response followed swiftly and the minimum quality standards for qualifying workplace pension schemes will become effective in April 2015.

It looks likely that the Freedom and Choice in Pensions changes will happen even faster, progressing from the Budget bombshell on 19th March 2014 to implemented legislation in April 2015. 

The outcome of these changes is unequivocally positive. There will be more people in better governed and more efficient pension schemes, with more options to mould their benefits to their increasingly individual retirement lifestyle patterns.

Having the option of accessing their entire pension fund as cash will transform how members think about defined contribution (DC) pension plans. Having spent years talking to members about their DC pensions, I am in no doubt that the current requirement to use the majority of the pension fund to produce a sustainable income has resulted in DC pension plans being seen as an abstract form of saving for many members, with obvious implications on engagement and funding.

Notwithstanding the moral hazards of DC pensions potentially not generating a sustainable income throughout retirement, the option of accessing the whole fund will transform how members think about DC pensions. A £40,000 fund will no longer be £10,000 of real money and £30,000 of money lost in the pensions ether, generating a pitifully small annual income. It will be £40,000 of real money.

This radical change makes pensions much simpler to understand and at a stroke removes many of the reservations people have about saving meaningful amounts of money into their pension. 

In a powerful double bill, the pension charge cap will also be introduced in April 2015. After consulting on three potential options, Steve Webb has introduced the charge cap on member borne deductions at 0.75% of the member fund per year – the lowest of the three options suggested in the consultation. This was a bold move, but perhaps an inevitable one given the growing perception of “rip-off pensions”.

The OFT report, published in September 2013, voiced valid concerns about the potential risks of employers negotiating pension terms on behalf of the members. However the report also illustrated that pension charges have been falling steadily since the introduction of Stakeholder Pensions in 2001 and the removal of commission on new schemes from 2013 would have inevitably led to average charges falling further. The charge cap undoubtedly has a vital role to play in providing consumers with reassurance that their workplace pension scheme will provide good value for money and help address the widespread public
scepticism that encumbers much of the financial services sector. However, in the long run I expect that the increased governance requirements contained in the minimum quality standards will be more important in delivering better member outcomes than the charge cap itself.

The charge cap will cover all costs borne by members. In many schemes this will include the costs of administration, default investment, governance, regulatory costs and member communication. Looking ahead this may also include flexible retirement options, the cost of providing a guidance guarantee for members at retirement and pot follows member automatic transfers.

Scheme providers and trustees will need to balance spending on each of these areas within the overall charge cap and it is inevitable that at times a compromise will need to be made.

This may be on the quality, frequency or medium of communication; it may be on administration functionality (e.g. availability of free fund switches or transfers); it may be on investment strategy. 

In recent years, we have seen an increase in DC investment strategies which look to manage investment volatility without sacrificing investment growth, such as diversified growth funds. These investment strategies will not be impossible in a capped world; however future DC default funds will now be limited to those which can operate within the charge cap. This may mean funds with higher proportions of lower cost passive investments or funds with less proactive asset allocation.

Opinion is divided on whether lower cost investment is more beneficial than unconstrained investment management. However it is clear that the range of default investment options open to DC schemes will be more limited following the introduction of the cap.

The DWP Pension Landscape and Charging Survey 2013 found that the average Annual Management Charge (AMC – which is not exactly the same as member borne deductions but similar) of Trust based schemes was 0.75% and contract based schemes was 0.85%. It also found that small schemes generally have higher charges than large ones. 

These figures confirm how bold the charge cap is, with perhaps a majority of existing pension schemes being above the cap, particularly those offered by smaller employers.

All of these schemes will need to be reviewed and either renegotiated or replaced by a scheme with lower charges by the later of April 2015 or the employer’s staging date. The subsequent abolishment of commission and Active Member Discounts in April 2016 may lead to some schemes being reviewed and renegotiated again a year later.

All of these changes will require huge amounts of activity from employers, providers, administrators, trustees and consultants; discussions, communications, changes to processes, technology development. The sheer scope and pace of change will undoubtedly pose challenges to many of those involved in supporting members, sponsors and trustees of private sector pensions.

Similar concern about an auto-enrolment capacity crunch has yet to be answered. May 2014 is the first month where the number of stagers has exceeded 10,000. Therefore we are only just at the beginning of the first significant peaks of auto-enrolment demand. Indeed with many businesses leaving much of their planning to the last minute, or even using the three month postponement period for some of their preparations, it may not be until quarter four this year before we can measure how well the pension industry coped with the summer 2014 auto-enrolment activity spike.

There will be little time to reflect or draw breath before the implementation of the minimum quality standards and Freedom and Choice in Pensions reforms.

This pension revolution will leave strong framework for workplace pensions which deliver good outcomes to members who are genuinely interested in their pension pots.

This will also be good for employers if, when this legislative thrill ride stops, they can see that their time, effort and money has delivered pension solutions which support their business rather than just a reluctant spend on more red tape. No pressure.

Kathryn Rodriguez
Flex Consultant +44 (0) 161 931 4516