Pensions News Bulletin October 2014
‘Freedom and Choice’ bigger than Auto Enrolment
The pension bill 2014 started its legislative journey in mid-October. After all the announcements, industry analysis, conferences and published papers, it’s hard to believe that it could all still come to naught, or at least be significantly altered before the many elements become law.
These changes, specifically the tax rules to allow individuals aged 55 plus to access their defined contribution pension as they wish, are arguably a bigger deal than Auto Enrolment. Auto Enrolment is undoubtedly huge by volume and is still going to be high profile as it bulldozes into the millions of SMEs yet to feel it. However, ‘Freedom and Choice’ is a bigger strategic change.
The most significant elements to consider are:
- The ability to take all your DC pension as a cash sum in one go,
- Or in smaller cash sums over time.
- Buy an annuity.
- Let your pension remain invested,
- But invest for growth or invest to protect?
- Buy a drawdown product.
- Or combine a number of these choices.
All these would require a different investment strategy if we were to truly optimise the outcome for the individual.
Clearly the guidance guarantee given near the point of retirement (another new pension policy), is informative and introduces the options to people, but that’s too late to allow people to choose the best investment strategy for their personal intention or expectation.
Assuming the bill passes into legislation, how will a pension scheme deal with these choices? It will be difficult without the relevant expertise, and that is something most companies don’t have. If these options are not treated seriously with regards to empowering the workforce to understand and use them, will the employer have failed their legislative governance requirements and be liable?
As with all freedoms, there is room to make serious and costly mistakes, and these freedoms are about the affordability to retire properly. They will contribute to inadvertent choices which decide who will live poorly and who will live well. In older age there is no time to rectify mistakes which have been years in the making.
When concerns have been raised the chancellor has said:
people who have worked hard and saved all their lives should be free to choose what they do with their money.
It is hard to disagree with such platitudes and it sounds reactionary to do so, but practitioners operating this regime must identify how that principle can be translated into good governance and good results for employees, and then provide that service to employers to create great HR policy.
Many people already make poor decisions within the existing pension regime, so there should be no doubt that this will be multiplied in the new one. Employers are in the best position to improve engagement with their workers, and put in place a culture of understanding and planning, so pensions and other benefits are properly integrated into people’s lives. Otherwise scheme members will be making the critical decisions about how to use their pension assets on the edge of the precipice just before retirement. Then it’s too late to benefit from all the help available and the right investment strategy that could have made a great difference to their pension scheme outcome.
Death of the Default Fund
Qualifying Auto Enrolment pension schemes must have a default fund, as did stakeholder schemes before them. With Auto Enrolment, the purpose of the default fund is to allow the ability to enrol employees into the scheme without them needing to choose the fund. In practice this means there is no reason employees need to know anything about it. There are rules about providing appropriate information, but you can’t force people to read it, let alone consider the meaning of it.
Not to worry, pre-April 2015 it was expected that almost everybody wanted the same thing. For 99% of defined contribution pension schemes, the default fund is designed to target the maximum tax free cash and an annuity purchased with the balance.
Designing the default fund to target a particular outcome is critical because the type of assets, and in what proportion, and how managed, make a huge difference to the outcome the investor receives. The easiest example to illustrate this is a default fund targeting 25% cash and an annuity, which most default funds are. Apart from the cash element, held in cash or near cash assets, the cost of the annuity portion is based on interest rates, so the rest of the fund will be invested in government bonds or the nearest corporate equivalent. The price of these may go up or down but as they travel in line with annuity prices, it doesn’t matter very much. However, if the fund was targeting growth, say, with high risk equities, it may have been doing well in growing capital, but as it has no characteristics in common with the price of annuities, the ability to buy a certain value of annuity can be going down even as the fund is increasing in value.
With all the choices each individual could have from April 2015 (see top article) there needs to be a new approach to planning a scheme’s default fund.
It is likely that, in the next few years, almost all auto enrolled pension scheme members will have no choice but to take a cash sum from their pension pot, as it won’t have accumulated enough to make any other choice worthwhile. However, even in this case, it is necessary to consider how we deal with the near-retirement and post-retirement period.
That is, post ‘retirement’ period because the mandatory retirement age was abolished in 2011, and ever increasing numbers of workers will be continuing work either in full time or part time roles. Default funds will therefore need to be extended. Decisions must be made about if, when and how they end.
So in the case of the cash default fund, should:
This example shows the importance of assessing each scheme’s needs by looking at the characteristics of each workforce and their potential retirement ambitions – and this is one of the least complex examples!
This is why, post-April 2015, the default fund as we know it will be on the way to obsolescence. Replacing it will be differentiated default strategies which have the ability to optimise different retirement outcomes.
In this new world, a pension scheme with significant pot sizes (say from £50k average) will need a ‘default’ strategy made up from a number of funds which, merged together, or used separately, cater for the most likely available choices for those scheme members. This requires much more scheme sensitive planning than previously, and is done by modelling the schemes membership, including likely pension results in the future based on various investment strategies, together with understanding what the members will most likely want to do with their pension.
Surveys, employee forums and stochastic modelling are the tools, but it is also necessary to cultivate a culture of pension engagement in the workplace if a workforce is going to truly benefit from the freedom and choice policy in years to come. Failure to engage will result in poor value from the years of pension contributions, and potential detriment to scheme members as bad as any pensions mis-selling to date.
All these changes, why here, why now?
I believe there are two major reasons for this. The first is a symptom of Auto Enrolment. If you consider someone on average earnings contributing the Auto Enrolment minimum, they will be paying about £400 a year into a pension scheme at the moment, including employer contributions. When the mandatory contribution rises to its maximum, the contribution will be about £1600 a year. Make up your own reasonable investment return assumptions, and even after a generation, the pot size is unlikely to provide an annual pension of enough to live on. If the auto enrolled population were then also forced to buy an annuity with their fund, as now, they may have been outraged to find either:
The political storm and mis-selling accusations that would follow are best avoided. Auto Enrolment for the masses will take decades to really come into its own with account values that people will appreciate.
The second reason is that it seems there is a growing appreciation, at least by the chancellor, that we do not incentivise pensions in the best way. That the £50bn a year in pension’s tax relief could be reduced and better arranged, cheaper incentives could produce better results and be better appreciated.
In my February 2014 newsletter, I profiled a paper from the Centre for Policy Studies, written by Michael Johnson, that set out how to get better pensions from less tax relief. In the February newsletter you will see that some of the recommendations appear to have informed government policy and have become reality. In his latest paper on the subject, Mr Johnson has updated his recommendations and made the following eight proposals:
- Pension contributions from employers should be treated as part of employees’ gross income, and taxed as such.
- Tax relief on pension contributions should be replaced by a Treasury contribution of 50p per £1 saved, up to an annual allowance, paid irrespective of the saver’s taxpaying status.
- ISA and pension products should share an annual combined contribution limit of £30,000 available for saving within ISA or pension products (or any combination thereof). This would replace the current ISA and pensions tax-advantaged allowances.
- The 25% tax-free lump sum should be scrapped, with accrued rights to it protected.
- The Lifetime Allowance should be scrapped. It adds considerably complexity to the pensions landscape, and with a £30,000 combined contributions limit for pensions and ISAs, it would become less relevant over time.
- The 10p tax rebate on pension assets’ dividend income should be reinstated.
- People should be able to bequeath unused pension pot assets to third parties free of inheritance Tax (perhaps limited to £100,000), provided that the assets remained within a pension framework..
- The annual allowance should be set at £8,000, with prior years’ unutilised allowances being permitted to be rolled up, perhaps over as much as ten years, all subject to modelling confirmation.
The paper is a good read for those of us passionate on the subject and can be found here:
Thank you for reading.