The arrival of auto-enrolment has brought new challenges for the DC pensions market
The pensions landscape is changing dramatically as the first wave of large employers continue to implement auto-enrolment and new regulations take effect. So far this year, a new initiative or consultation has been announced every few days, reflecting the government’s focus on pensions.
For defined contribution (DC) schemes, a critical initiative is the Office of Fair Trading’s investigation into member outcomes. This is looking into charging structures, which can be particularly high under legacy DC schemes, and the potential difficulty of small employers in accessing the pensions market.
One concern about auto-enrolment is that, because plans are individually priced depending on member numbers, contributions and staff turnover, small employers may find they have access only to auto enrolment schemes run by bulk low-cost specialists, such as the National Employment Savings Trust (Nest) and Now: Pensions.
As a result, smaller employers that have a legacy scheme in place may find it easier to carry on with that scheme post-auto enrolment.
The rules for qualification for auto-enrolment relate to the categories of staff involved and contribution levels, but there are no caps on charges.
Master trust schemes
The National Association of Pension Funds (NAPF) has been highly critical of traditional contract-based pension charges and is pushing the advantages of master trust schemes. These are also DC but offer economies of scale and the possibility of improved governance because they can afford to set up a trustee committee, possibly with a professional independent trustee.
There is another advantage of master trusts, also known as super trusts, which is that they fall outside the retail distribution review (RDR) rules on commission payments, which took effect on 1 January 2013, so remain attractive for financial advisers to sell.
Pension providers initially made a big play in the qualifying auto-enrolment scheme market, trying to pick off larger, more profitable schemes, often offering special incentives, to gain critical mass. Some have now achieved this and have stopped offering incentives. Aegon, for example, has withdrawn its offer to reimburse 50% of an employer’s first three months of contributions on its auto-enrolment platform after experiencing exceptional demand.
Less choice for small employers
Consequently, not only will small employers that auto-enrol at the end of phasing in 2016-2017 have far less choice, the pension providers that are prepared to accept them may not, in practice, be able to cope with the sheer numbers. According to The Pensions Regulator (TPR), between winter 2013 and spring 2014, about 12,500 employers a month will reach their staging date for auto-enrolment compliance. By 2016/17, that figure will have risen to 135,000 a month, almost certainly creating so much demand for guidance that independent advisers will not have the capacity to deal with it.
Pension providers have worked hard to make themselves attractive to larger employers, however. A major tactic has been to help employers determine and manage which staff are eligible for auto-enrolment and when, using middleware IT systems.
Another differentiator has been communication around the funds on offer, so that instead of being faced with more than 100 funds, a pension scheme member is presented with about 10 funds that are clearly risk-rated, so staff can match their needs more closely. Most schemes will also offer life styling funds that automatically de-risk an employee’s investment as they approach retirement, normally by selling out of more volatile equities and moving into less risky bonds.
For decades, default funds were often passive equity funds or cash funds, but greater understanding around asset class diversification and growing sophistication in using derivatives has encouraged the use of diversified growth funds, which are multi-asset funds that aim to produce steady returns in all economic climates.
Best choices at retirement
Recently, employers have also latched onto the importance of pension scheme members making the best choices at the point of retirement, and have been asking pension providers to help them set up a panel of annuity providers for members to use. Most staff will still buy an annuity, although some wealthier members may choose income drawdown instead.
Providers must ensure that retiring scheme members are told they can use the open market option, which means they can choose an annuity from any provider in the market. Most people do not appreciate the significance of this, however.
Rates vary hugely, and there is also more to an annuity than aguaranteed income plan. For example, there are options to provide a spouse’s benefit, and options to have the remaining pot paid to dependants if the member dies within five or 10 years. Without these options, the residual pension dies with the member. Equally importantly, staff that have a health condition but do not
disclose it rule themselves out of an enhanced annuity.
These issues are becoming more critical for employers as they see regulators making pension schemes take some responsibility for members’ choices. Also, for employers that might prefer employees in certain roles to make way for others, an enhanced income at retirementmay encourage them to retire.
The imminent explosion in DC take-up under auto-enrolment has also prompted TPR to be more proactive about DC governance, and it has issued various guidance documents, such as its draft paper listing six principles of good workplace DC schemes, which was published in June 2012.
7.5% average combined employer and employee contributions into contract-based DC schemes
Source: ACA 2012 smaller firms’ pension survey, Association of Consulting Actuaries, October 2012
79% the proportion of asset allocations for FTSE 100 and FTSE 250 DC schemes that are in equities
Source: DC default research, Schroders, March 2013
29% the proportion of small and medium-sized employers that are aware of their auto-enrolment staging date
Source: Auto-enrolment tracker, Jelf Employee Benefits, March 2013
What is a contract-based DC pension scheme?
Contract-based defined contribution (DC) schemes are based on contributions from employers and staff. A scheme can be a group personal pension (GPP), stakeholder scheme or group self-invested personal pension (Sipp). Schemes are often called contract-based because most involve a contract between the individual member and the pension provider.
What are the origins of contract-based DC pensions?
GPPs were introduced in 1988, followed by stakeholder pensions in April 2001, specifically for employees on low incomes. These plans were successful in driving down charges, but have since fallen out of fashion.
Where can employers get more information and advice?
- The Pensions Regulator on 0845 600 1011.
- The Society of Pension Consultants on 020 7353 1688.
- The Pensions Advisory Service on 0845 601 2923.
What are the costs involved?
An annual management charge, typically between 0.4% and 0.7%, is applied to members’ funds, with a lower charge for passive funds. Charges can also be levied when members switch funds. Under auto-enrolment, contributions will rise incrementally and the full employer contributions of 3% of banded earnings will not have to be paid until October 2018.
What are the legal implications?
Employers are obliged to put an auto-enrolment scheme in place by their staging date, although it is possible to request a delay.
What are the tax issues?
Tax breaks are available to both employers and employees. Basic-rate taxpayers get 20% tax relief for every £100 they pay into the scheme. If employees pay above the basic rate of tax, they have to claim additional tax relief. Under salary sacrifice arrangements, employees save on income tax and national insurance contributions because they are reducing their salary in exchange for pension contributions.
What is the annual spend on contract-based DC schemes?
According to the Association of British Insurers, new premiums totalled £20.2 billion in 2012, and £19.5 billion in 2011.
Which providers have the biggest market share?
Aegon, Aviva, Fidelity, Friends Life, HSBC, Legal and General, MetLife, Prudential, Scottish Life, Scottish Widows, Standard Life and Zurich Life are all big players. Prudential has announced it is working with Nest and Now: Pensions to provide a dual scheme offering to employers.
Which providers saw the biggest increase in market share in the past year?
New entrants such as The People’s Pension, Now: Pensions and the National Employment Savings Trust have gained most employers relative to their starting position, but established pension providers have also capitalised on employers’ needs for guidance and the pre-existing relationship with them.