Topic: Government Policy

On the face of it, the eye-catching stuff in Jeremy Hunt’s first Budget is the changes to allowances – big moves in how much money you can put into a pension pot.

From this April, it will be much easier for people with higher incomes to amass larger pensions pots. With the annual allowance rising from £40,000 to £60,000 and with the lifetime annual allowance effectively abolished, higher earners have had a good afternoon.

This should help ease the long-running issue with pension tax charges strongly incentivising doctors to retire early. Doctors’ comparatively high late career earnings, the generosity of their defined benefit pension arrangements and the restrictiveness of the tax thresholds combined to give senior medics five figure tax bills. Faced with this, many seem to have chosen early retirement.

Changes to allowances will benefit those with larger pensions

This creates a regime that is now very generous towards those with larger pension pots. Indeed, the tax treatment of pensions on death now looks extremely generous – perhaps unsustainably so. The government has, though, capped the maximum amount of tax-free cash that can usually be taken at the current level of £268,275 and intends to freeze it at this level.

The government has also chosen to increase the Money Purchase Annual Allowance (MPAA) from £4,000 to £10,000, with the stated intention of enabling people who have retired early to return to work and replenish their pension savings. The MPAA exists to stop people old enough to access their pensions from recycling money from a pension pot. That means taking tax-free cash from the fund and then putting it back in to claim tax relief.

This remains a breach of the tax rules but the difficulty in spotting people doing it means that it’s not just enough to forbid it and punish offenders. We’d expect the volume of illicit behaviour to rise. We’re also not sure that a change in the pension tax rules is a sufficiently big enough draw to lure former higher earners back to work. The OBR seems to agree, their central scenario is that the whole package of pension tax changes will increase employment by 15,000.

With median full-time earnings in the UK being £33,280, these changes are not relevant to the vast majority of UK workers. Indeed, all this is only really relevant to those paying higher and additional rate tax – and then those well into the higher rate band. The changes don’t really speak to the main issues in pension policy, specifically whether most people in work are saving enough to retire on.

Moves to encourage pension funds to invest more in UK infrastructure

The less eye catching but potentially more important stuff is coming in the autumn statement. For some time now, there has been a rolling concern at the top of government about the role that pension funds play in the UK economy. This has resulted in a range of initiatives, intended to help encourage pension schemes to invest in less liquid assets, such as infrastructure and private equity, and to do so in the UK.

So far, the measures we’ve seen are what we would term ‘enabling’ measures. These are broadly sensible and intended to help pension schemes invest in less liquid assets of their own volition. So far, we have seen guidance from the productive finance working group on how to manage liquidity risk as well as other matters.

We’ve seen changes to the defined contribution default fund charge cap to help accommodate performance fees and the Department for Work and Pensions is currently consulting on value for money measures. These are intended to help reshape the workplace pensions market so that competition focuses less on pension scheme charges and more on the potential of a pension scheme’s investment approaches to deliver investment outperformance.

There is potential for the government to be more directive here. Recent think tank proposals on this issue have included making the tax treatment of pension funds contingent on a given level of investment in the UK. Any move away from purely enabling pension funds to invest in less liquid assets needs to bear in mind the primary purpose of pensions – to deliver an income for savers in retirement. It’s their money not pension funds’ money or taxpayers’ money.

So, some significant changes in the Budget but the changes only really affect a minority within a minority of higher earners. Depending on the result of government’s conversations with the pension sector before the autumn, we could see more radical and impactful changes in how pension schemes invest. That may end up being the announcement that gets remembered from this Budget.

Phil Brown, director of policy at People’s Partnership

We’re yet to discover what the long-term impact of the Department for Work and Pensions’ (DWP) recent raft of announcements will mean for workplace pensions but there’s no escaping the fact that this is big news.

Significant announcements on both value for money (VfM) and small pot consolidation are paving the way for the DWP, Financial Conduct Authority (FCA) and The Pensions Regulator (TPR) to reshape the market, in the interests of savers.

The aim seems to be fewer, bigger pots in fewer and better run schemes, backed by the statutory means to consolidate both schemes and pots.

We think those headline-grabbing policy proposals are the right way forward. However, it’s incumbent on the industry to engage in this consultation process to achieve better outcomes for members. The economics literature on pension provision suggests that there are major economies of scale to be achieved, provided scheme governance is strong. Larger schemes are better placed to invest across the economy and achieve higher returns.

It’s important to see the VfM, small pots and illiquids proposals as linked to a broader view of the role pension funds should play in the UK economy.

With this in mind, the Government intends to encourage greater investment in illiquid assets through driving scale and by rebalancing the conversation about value provided by pension schemes. They intend to do this by shifting the focus away from charge levels and towards net returns.

When it comes to VfM, both the targeting and the outline measures are, broadly, sensible but, as previously stated, will need careful scrutiny during the consultation period. We think extending the VfM assessment package to non-workplace pension schemes needs to be implemented at the earliest opportunity. It’s important that policy makers set a timetable for this as soon as possible. It’s odd that value is getting measured and regulated in one part of the pensions market, which is specifically designed to protect members’ interests, and not in an area of the market that does not have such protections.

Lines between workplace and non-workplace pensions have been increasingly blurred for years and it’s important that both are subject to similar regulatory standards. We also see future competition between workplace and non-workplace pension providers, based on VfM metrics as being healthier than competition driven by brand, advertising and cash incentives. Thinking about this another way, members or customers will be making better informed decisions in areas such as consolidating pots.

Value for money in pensions relates to 3 areas

The civil servants and regulatory teams have made a strong start in setting out what value for money is, breaking the subject into 3 areas:

1. investment
2. charges, and
3. service quality.

While this captures the key elements of the value offered by a pension scheme, getting the nuance of each of these elements right will be difficult.

On investment, the issues relate more to presentation than substance. There’s no alternative to looking at past performance but, equally, the risks of overweighting it as a factor in decision making are well known. Poor performance tends to persist, good performance may not and funds in the top performance quartile in any given year may well not remain there. Any honest assessment will need to factor in the limitations of available metrics even though the regulators’ proposals look sensible at first glance.

We have stronger challenges to the parts of the package that focus on charging and service quality. Here, the diversity of the sector and the differences between pension schemes that provide services to the whole of the market, those targeting only higher value members or employers and those targeting non-workplace individual customers becomes very important.

The FCA uses 9 questions from its financial lives survey to measure engagement with pensions. Levels of engagement vary by age, gender, income and ethnicity – sometimes for reasons we don’t fully understand.

Here, the regulatory approach needs to be sensitive to diversity in the pensions sector and find ways to measure the value added by schemes serving the whole of the market. It’s important that the new metrics are sensitive to the nuances of pension provision across the entire market. Government and regulators are right to focus on this area but it’s up to schemes to help make this work.

We come back, time and time again to the US and Australian retirement systems, mainly because the challenges and solutions facing these countries and our own are so similar.

In this article, I am returning to the US as one of President Biden’s last acts of 2022 was to sign the SECURE 2.0 act into law. Passing with bi-partisan support, SECURE 2.0 is a substantial evolution of the US retirement system. It contains some 92 different measures, some major, some minor. I’m going to focus on three here.

While the US pioneered automatic enrolment as a joining mechanism for DC schemes, most of the evidence relating to the success of AE Stateside comes from large paternalistic employers. It took off in the corporate sector well ahead of its adoption by individual state legislatures. Previous efforts to mandate auto-enrolment at the federal level in the US had failed.

Securing the future for a generation of workers

SECURE 2.0 mandates that new 401k plans established after 31 December 2024 should automatically enrol members. Pre-existing plans are exempt from this requirement and there are exemptions for government organisations, employers with fewer than 10 workers and employers that have been in existence for less than three years. Eligible employers will be required to enrol employees with an initial 3% contribution, rising every year by 1% to at least 10%, before hitting a ceiling of 15%.

This is a robust implementation plan, and a much faster timeline for phasing in an increase to minimum contribution rates than here in the UK. While it’s not an exact comparison, it’s entirely possible that by the end of the decade early adopters of the new arrangement in the US will have higher mandatory minimum contributions than comparable AE arrangements in the UK – despite the UK having completed staging in 2018.

Is annuitisation the answer to decumulation in the US?

I then come to decumulation. In common with other countries where it isn’t mandatory, annuitisation is unpopular in the US. Much the same is also true in Australia. Annuities have also acquired a bad reputation, due to historic mis-selling scandals tarnishing the product class. The problem of converting a pot of capital into an income, though, is as acute for Americans as it is for UK savers and Australians. Industry observers expect technical challenges in SECURE 2.0 to lead to more retirement plans offering partial annuitisation inside the plan, effectively turning the product class from a retail to an institutional one.

This is strikingly like post-freedoms decumulation models that have been talked about in the UK for some years. There are key differences, deferred annuities exist in the US in a way they don’t in the UK – prudential requirements blocking the development of the product class in the UK. But it’s a similar answer to the same problem – decumulation through DC is hard and no one claims to have cracked it yet.

Tackling the problem of small pots

The third and final area of focus is the enabling of automatic transfer of plan balances below $5,000 to the new plan unless the saver chooses otherwise. This measure is strikingly similar to proposals by Steve Webb when he was pensions minister for “pot follows member” in the UK. Under the Webb plans, deferred pots under £10,000 would have automatically transferred to a worker’s active pot. The reasons for the failure of the proposals are long and complex (I should confess I served on the DWP working group), but the administrative cost and complexity was the main root of the problem.

The difference with the US approach is that clearing house services exist, which can facilitate the required transfers. Similar services just do not exist in this country and, while considerable theoretical progress has been made on small pots consolidation, the UK pensions sector is years behind the US on administration of transfers. We expect the US experience to figure large in discussions of the forthcoming DWP call for evidence on small pots consolidation.

The next item in this series will dig further into SECURE 2.0 and look at differences in the taxation of retirement accounts, the self-employed and the introduction of liquid savings accounts tied to retirement saving. The latter bears enormous similarity to the sidecar proposals being trialled by NEST Insight. There is a huge amount to learn and, potentially, apply to the UK retirement savings’ landscape.