Auto-enrolment will fail unless DC members receive more practical help warns Kevin LeGrand, Society of Pension Consultants
Auto-enrolment has to work. The figures showing the number of pensioners in prospect over the next few decades display a yawning chasm between their increasing life expectancies on one side of the balance sheet and the levels of monies put aside to supplement the meagre state pension on the other.
As a nation we have to make urgent progress in closing this widening gap. Given that the state is unlikely to (voluntarily) make significant additional contribution, individuals must take responsibility for their own future welfare. For employees, there is the prospect of employer help, beefed up by the introduction of auto-enrolment; employers should benefit from their employees being able to retire at a mutually agreed time, supported by the prospect of a financially secure future.
If the arrangement underwriting that financial future is defined benefit (DB), security is easier to deliver; if it is defined contribution (DC), however, the outcome is less clear. Not only that, the path to it is strewn with hazards for the member to negotiate, with any "wrong" decision potentially having a significant impact.
Many employers welcome not having to underwrite those decisions; however, relief may be short lived if the result of the unsupported member’s poor decisions is that the hoped for financial security in retirement looks unattainable, leading to the employee resisting the employer’s overtures to "call it a day". In future, employers effectively being forced to make payments into employees’ arrangements will want to see a return to the business: how will they react if the money contributed towards employees’ future welfare has been squandered through poor management? It is time for a return to greater employer involvement.
It is in everyone’s interests that money committed to pension arrangements in an auto-enrolment world produces the best outcome for members. In a DC environment, that presents challenges where members are faced with financial decisions for which they are ill equipped and largely unsupported. If DB schemes need a bank of expensive advisers constantly on hand, should we expect a comparable outcome when a member who is not financially literate is left to fend largely for themselves?
There are encouraging signs that this conundrum is starting to be addressed; one promising development is a tentative renewed interest in scheme designs where risk (and involvement) is more balanced between employers and members, utilising ideas such as mixed DB/DC, cash balance, "collective DC" or "DB light" and Steve Webb’s new discussion subject "defined aspiration".
Meanwhile, the reality is more likely to continue as pure DC. In parallel to the development of new scheme designs, there is a need for progress in helping individual members with financial management decisions. Assuming that affordable individual member advice will continue to be scarce (especially likely given the modest contribution levels under auto-enrolment), some practical alternative is needed.
Here, too, there are developments. The Pensions Regulator is crafting a new DC regulatory regime on the premise that, if appropriately designed and enforced, it can create an environment where a "good outcome" is more likely. I have some concerns about whether that is attainable or whether, in trying to guide the process along a path (however wide) towards an outcome that satisfies one definition of "good", the result will be to deliver disappointment against most members’ individual expectations. Nevertheless, the objective is laudable and has possibilities.
A common outcome from loading risk underpinned decisions upon individual financially illiterate members is that those members simply refuse to engage in the process. To address that, the "default" investment was introduced. This can only ever be a second best solution, since it cannot be bespoke (it would then be individual advice).
Default funds are now being designed more imaginatively and the use of tools such as white labelling and multiple default options offer the prospect of more targeted solutions for the army of newly automatically enrolled members who are expected to drift along the default route at every turn.
That may satisfy most people, but I suspect that many currently in the workforce – whatever they may say in response to survey questions – believe subconsciously that their retirement income will somehow "come good" by itself. Many will have seen parents and older colleagues retire with a respectable occupational pension, having had little involvement along the way and not appreciating the amount of work that had been done by the trustees and advisers to deliver that outcome.
Which brings me back to scheme design. DC can currently be provided through either the trust or the contract route. In either case the member is likely to be offered a choice of contribution levels, investment funds and annuity or drawdown options. In each case there will be a default for those not willing or able to take a decision.
Where the underlying scheme basis is a trust, the perception is that a degree of paternalistic assistance will be provided, even if that necessarily falls short of actual advice. With a single employer or group scheme, there is likely to be some truth in that. Trustees will, for example, select a range of investment funds to offer to members. They will only do so after having taken investment advice and, in accordance with their liabilities under s33 of the Pensions Act 1995, they will have been mindful of the characteristics of their scheme’s membership. However, that is where they will generally stop; DC trust deeds are commonly drafted to exclude trustees’ liability as far as possible.
Where the scheme is a master trust, tailoring and intimate knowledge is even less likely. The investment options will have been selected to cater for a less well defined membership; the risk of a poor outcome for an unassisted member consequently increases. That is also the case with the contract based option, where the provider offers investment choices catering for a wider spread of customers; this is usually achieved by increasing the number of funds on offer, although without necessarily increasing help with choice.
For DC to achieve anything like the predictable member outcomes of DB, members will need practical help – improved information and education alone, although important, will not suffice.
Trust based, employer related schemes are in the best position to provide that service. They can take decisions and implement design initiatives with their focus firmly on member outcomes. Recognising the reality of the high proportion of "default members", trustees may have to become more involved in investment strategies, such as through managing white label default funds so that investment changes can be made with expert professional assistance, but without member involvement or even knowledge.
But how could a more intimate focus be achieved in the context of a large master trust or a contract based arrangement? One possible option is the employer specific governance committee. There is a useful Pensions Regulator guidance in which the concept was discussed, along with other suggested ways of increasing employer support for members. Although the guidance found that a number of committees did exist, their powers were extremely limited, largely because of concerns around liability and the interaction with restrictions around advice.
In a DC future (near term at least), perhaps there is a case for the creation of a statutorily defined role of the governance committee, where duties and liabilities (including those personally of its members) are clearly set out. This detail would have to make clear how such a committee would interact with the trustees of a master trust or the parties to a contract based arrangement and represent members’ interests, but it should be possible to produce a design addressing the concerns that have hitherto limited their remit.
Auto-enrolment has the potential to alter the nightmare scenario of generations working into increasing old age, unable to retire due to poor finances. If all that we do with its opportunities is link it with pure DC and shy away from providing member support, the nightmare will remain. However, introducing pragmatic measures to help members in the key decision areas might just deliver the hoped for result from this revolutionary social experiment.
Kevin LeGrand is president of the Society of Pension Consultants;
1 Voluntary employer engagement – January 2008
Author: Kevin Le GrandKevin LeGrand is head of technical services at Buck Consultants.