Perhaps the defining feature of the pensions sector in recent years is the shift from Defined Benefit (DB) to Defined Contribution (DC), which has significant consequences for scheme members as they assume the risk for their retirement.
The Office for National Statistics (ONS) Occupational Scheme Survey shows that from 2011 to 2017 the number of private sector DC scheme members grew from 1 million to 7.7 million while the number of DB scheme members fell. At the same time, the nature of DC schemes is also changing: Master Trusts now represent the vast majority of DC funds and have captured 80% of auto-enrolment contributions, for example.
Consolidation is likely to accelerate in the coming years as the benefits of robust Master Trusts become more evident. However, Master Trusts also need to take stock of their challenges and opportunities. Master Trusts can pool assets and therefore address the problem of fragmented capital in DC schemes. However, many do not take advantage of this opportunity because of the perceived challenges for DC of daily liquidity and pricing, together with the challenge of a low charge cap which can inhibit any significant investment in illiquid assets.
“There is a growing impetus for Master Trusts to seize the opportunity for more innovative investment strategies.”
Pensions, especially as longevity increases, might be expected to exhibit ‘patient capital’ and focus on long-term assets - in particular investments that take account of expected technological and demographic trends in the coming decades. While the structure of DC funds, and the higher cost of investing in potentially illiquid assets, has historically militated against this, there is a growing impetus for Master Trusts to seize the opportunity for more innovative investment strategies. Master Trusts are obliged to focus on low costs (often by offering passive investment strategies). They should also carefully consider how they can best incorporate long-term asset investment that address sustainability while still meeting the regulatory and operational demands of DC.
Apart from the guarantees associated with members’ benefits, perhaps the most obvious difference between DB and DC is the level of total contribution. Before automatic enrolment (AE), DC contribution levels were typically 9% to 11% (for employee and employer) compared to 22.7% of pensionable earnings for DB schemes, according to the ONS. Average contribution levels have fallen since auto enrolment began. Contributions from workers in auto-enrolment schemes increased to 3% of income in April 2018 and 2% for employers and are due to rise to 5% and 3% respectively in 2019. There is a significant way to go before AE DC contributions reach levels close to those of non-AE and especially DB schemes.
Despite the power of compound interest in making early pensions saving attractive for millennials, increased pension saving is difficult given many other financial demands, such as repaying student debt and getting on the housing ladder. One way to encourage millennials to save for their retirement might be to change Master Trust charge cap regulations so that they can invest in longer term, higher return assets such as private equity.
Some observers believe pensions savings should become more flexible so that members can borrow from their pots to meet housing, health or education needs, as is possible in Australia, the US and some other countries. Certainly, pension providers could harness digital technology and embrace new ideas, such as sweeping change from small purchases like a coffee into savings accounts. Appealing to millennials’ idealism by offering ESG funds as a default option (see ESG Investing) could also help to foster engagement.
The pensions dashboard, an initiative to allow people to see all their pensions pots in a single location, is due to be launched in 2019.
“The rationale for the pensions dashboard is sound. People are likely to have an average of 11 jobs during their careers and keeping track of multiple pension pots is difficult. There are an estimated £400 million of lost or forgotten pensions.”
However, progress on the dashboard has been slow and the Department for Work and Pensions' feasibility study on the project, scheduled for release in spring 2018, has yet to be delivered. The government recently said that the private sector should take the lead on the dashboard initiative. There is uncertainty whether the dashboard will survive and, if it does, in what form. One way to bring life back to the project could be to open it up so that developers can create apps and other solutions based on the underlying data using common standards (in a similar way to the Open Banking project).
CDC schemes, which have a long history in the Netherlands but which do not exist it the UK, offer something of a halfway house between DC and DB. For employers, they are an attractive alternative to DB as funding gaps are no longer their responsibility and returns depend on investment performance (as with DC) and longevity rather than guarantees. For members, CDC offers advantages over DC. Studies show that assuming similar investment strategies and longevity, Dutch CDC schemes generate returns 30%-50% higher than UK schemes. The additional return derives from sharing annuity risk, the ability to invest in less liquid but higher returning assets, the absence of a requirement to de-risk portfolios as members near retirement, and lower administrative costs.
It is important to note that despite these attractions CDC is not a panacea for the UK’s pension challenges. Since Pensions Freedoms were introduced in 2014, pensions behaviour has changed significantly: individuals now have greater personal responsibility for their pensions. A reversal to a more collective mind-set is unlikely. More generally, the Netherlands may have a less individualistic culture than the UK and may be more open to inter-generational risk sharing. In addition, the current consultation specifically excludes Master Trusts, public sector schemes and the use of CDC for post-retirement where annuity purchases could be pooled, which could make the introduction of CDC less appealing. Certainly no employers – already having made the move from DB to DC – are likely to switch to CDC. Nevertheless, the government has voiced its support for CDC citing the benefits to members of sharing investment risk and to employers of reducing costs compared to DB schemes.*
* UPDATE: In March 2019, the Department for Work and Pensions outlined a framework for the introduction of CDC schemes in the UK. The move has been well-received for the most part, but certain areas require further clarification. Additionally, some have questioned the scope of the initial legislation.
BNY Mellon assumes no liability for the content, including statistics, herein. All content, including statistics, was derived from discussions and presentations that took place at the BNY Mellon Pension Summit in London on 14 November 2018.
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