By Tom McPhail, Head of Pensions Research at Hargreaves Lansdown
Auto-enrolment is the keystone policy response to the retirement savings crisis, yet the very nature of auto-enrolment means that it also risks undermining the next stage of the process in rebuilding the UK’s savings culture.
Once auto-enrolment is up and running, the next big challenge facing the government, the pensions industry and individual investors is to achieve widespread recognition of personal responsibility for retirement provision. Without this recognition and the willingness to actively engage in retirement planning, the majority of savers are still doomed to disappointment in retirement. The solution to this challenge lies, at least in part in usingworkplace wrap account solutions.
The political (and industry) consensus around auto-enrolment has remained solid, in spite of a general election, a faltering economy, public sector pension strikes and a radical overhaul of the state pension. Even when the hastily formed coalition government had to call on Steve Webb to fill the role of Pensions Minister after Nigel Waterson failed to hold onto his Eastbourne seat, the subsequent review of auto-enrolment confirmed that the new government would be making only minor tweaks to the auto-enrolment rules. The concept of Nudge – of using behavioural economics to get people to act in positive ways which they would not otherwise pursue – is now accepted as mainstream orthodoxy. People will not choose to save for retirement if left to their own devices but if they are put into a pension, then inertia (apathy?) will ensure that the majority stay there.
The first step in the solution to the pensions crisis therefore lies in putting people into pensions without asking their permission first. In order to enrol people into pensions, it is necessary to make certain assumptions around the terms of engagement. For this reason, all auto-enrolment pensions will have a default contribution rate, a default investment fund and a default retirement age. Individuals will be able to make the entire journey from being auto-enrolled at the age of 22 through to retirement in their late 60s, without ever once actively engaging with their pension. This is to some extent an echo of the old days of paternalism. Back in the 60s and 70s when we had a state pension worth more than a tin of beans and employers gave employees a final salary pension as a matter of course, it was possible for employees to take retirement for granted. Many millions of people could and did build up an at least half decent pension without ever having to get directly involved.
Now, with just 11% of private sector employees accruing rights in a final salary pension, the world is turning defined contribution. Whether we like it or not, that’s the way it is and there is no sign that employers will be embracing longevity and investment risk again anytime soon. What’s more, we haven’t just moved away from paternalism, we have also moved away from collectivism. The bulk of defined contribution pensions (NEST included) are structured around an individual account rather than a pooled fund.
The problem with auto-enrolment though is that whilst it may deliver pensions, in many cases it won’t deliver good pensions. As the attached table shows, even allowing for the introduction of a new universal state pension, an 8% pension contribution rate – the default auto-enrolment contribution – doesn’t deliver an adequate pension in replacement rate terms for anyone at any earnings level, not even if they start at age 22. Anyone starting a pension in their 30s or 40s is likely to still be working and saving into their 70s because they’re not going to be able to afford to retire in their 60s.
The essential basic formula is to start young and save lots. For many people, starting young is no longer an option, which only leaves saving lots and retiring later. Good investment growth can help to bridge the gap but is far from guaranteed. The problem with many default funds, including NEST’s is that they are designed to be more conservative than is appropriate for many younger investors. By their nature they have to be lowest common denominator investment solutions; investors who choose to engage and to select pension investment strategies and risk profiles more suited to their own personal needs are likely to do better.
If not before, then there is always going to be a need for investors to engage with their retirement savings at the point of retirement. When they come to convert their money purchase pot into an income, investors will need to make a series of decisions around the type of income they want. They’ll need to look at death benefits, inflation proofing and investment risk; they’ll need to consider whether they are eligible for an enhanced annuity and whether they want to take their retirement income all in one go or in a series of transactions. It is widely recognised that this engagement works best if investors aren’t presented with such questions from scratch in last few months before retirement. It is far better for these questions to come as the culmination of an on-going interaction between the investor and their savings.
Alongside all this pension upheaval comes the Retail Distribution Review (RDR). Due to start in 2013, this regulatory change to the financial advice industry is likely to raise advisory standards but will also have the effect of disenfranchising vast swathes of the population from accessing regulated financial advice. The banning of up-front commission will mean that charges will fall but it will also mean most people are not going to be told what to do with their medium and long term financial planning needs. They are going to have to avail themselves of self-service and non-advised solutions.
This is where Wrap accounts are likely to come into their own. Unlike traditional pensions, they provide employees with the means to manage their pension and non-pension savings and investments in one place, through one secure website. Employees can elect to have money deducted from their pay and invested into an ISA account alongside their pension. They can move money from their ISA into their pension (and back again at the point of retirement). They can research investments and take advantage of financial planning calculators to try and plan their savings more efficiently. Workplace wrap accounts are designed to make financial planning easy for employees. As such they appear to offer a ready-made solution to the challenges of promoting individual responsibility and engagement.
Talking to employers in recent months it is apparent that they are only just starting to get to grips with auto-enrolment and what it will mean for their business and their employees’ pensions. Every business in the UK will have to reconsider how it deals with pensions and workplace saving and how much support it is willing to give to its employees. There is a great deal of work to be done over the next few years.
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