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.

We’ve written in the past about some of the positive aspects of the Chilean pension system and what the UK can learn from how it is designed. Its approach to DC decumulation is set up to drive greater value for savers when taking an income from their fund and there is a lot to learn from this aspect of the system. The Chilean pension system has, though, been seriously challenged as it has not provided adequate outcomes to the bulk of retirees. This has led to both protests and a gradual swing back to a tax funded first pillar pension.

Replacing a pay as you go pension system with DC pension saving

Chile is one of the earliest examples of a country to embrace DC pension saving. Under the Pinochet dictatorship, it abolished its pay as you go pension system, replacing it with a system of individual DC accounts. This took place in the early 1980s, as part of a much wider programme of liberalisation and privatisation. It was retained after Chile’s return to democracy following the 1988 plebiscite on the continuation of Pinochet’s rule and the subsequent 1989 elections.

The overall results from the DC system have been disappointing. Average replacement rates from the Chilean DC system lag behind the bulk of the rest of members of the Organisation for Economic Co-operation and Development (OECD), often by some margin. Also, forecast replacement rates are projected to be low. OECD analysis suggests an average replacement rate of roughly 30% in 2060. While the system is sustainable, it has arguably achieved sustainability at the expense of delivering adequate pensions.

Why has the Chilean pension system struggled?

As usual, when a system struggles over time, there is usually more than one cause.

1. The first is that Chile completely replaced its pay as you go pensions system with individual DC accounts, rather than reforming its pay as you go system and augmenting it. This effectively withdrew the welfare safety net for retirees who were not in a position to save.
2. Second, minimum contributions totalled 10% of employee earnings, without an employer contribution. This is too low to generate an adequate retirement income, especially in the absence of state backed first pillar provision.
3. The third is broken contribution histories. With a much higher level of informal working and self-employment than the UK, it was (and is) common for working Chileans not to be contributing into a DC account for large proportions of their working lives. Coupled with the impact of lower than assumed investment returns and increasing longevity, it’s not a surprise that the system has not delivered adequate incomes.

The result of this has been protests and a move back over time to a first pillar pension, funded collectively through taxation. In 2008, the Chilean government introduced a first “solidarity” pillar pension, which operates on a pay as you go basis. It is currently payable to men over the age of 65 and women over the age of 60, who have incomes in the lowest 60%. In addition to the means test, there is a residency requirement – Chileans need to have been resident for 20 years and for four out of the last five years prior to claiming in order to be eligible.

What we can learn from Chile

We can pull two main lessons out of this. First, DC can only function as a main pension entitlement if the system covers the overwhelming bulk of the population and contributions are regularly reviewed to ensure they target an adequate income. Given that this is very difficult for policymakers to achieve, some form of combination of a pay as you go first pillar that guarantees a minimum income in retirement and a DC top up seems sensible. We think that the Chilean experience broadly validates the UK’s policy mix – a split between a first pillar set around the poverty line and a quasi-compulsory DC top up.

The second lesson is that, in a democracy, pension systems have to be politically as well as economically sustainable. If a system is not producing adequate outcomes then those affected may vote themselves a more generous pension, or take to the streets. Or, as in the Chilean case, both. This should be borne in mind by countries that are further behind on the DC journey than Chile. Pensions are boring until they become interesting and when they become interesting it’s usually a sign that something is seriously awry.

If you have ever wondered why workplace pension schemes frequently offer limited investment choice and focus on the default fund, the answer is jam, and Sweden.

In setting up pension systems both policymakers and pension schemes looked extensively at both the behavioural economics literature. They tended to take in both experimental and real-world studies. Sheena Iyengar’s work on choice showed that in both a retail environment (the sale of jam) and in pension plan design, offering many choices could discourage people from making a choice. In some cases, with US 401k plans, where investment choice could be a mandatory part of plan design, having to make a choice could put people off joining a pension scheme altogether. These studies are one of the reasons why schemes frequently offer a focused range of funds, in contrast to retail platform providers. From the way newer SIPP consolidators are put together, it looks like they’ve been reading the same papers too.

Investment choice for pension savers was initially encouraged

Sweden, meanwhile, is one of the only countries that has deliberately encouraged investment choice in DC. The experiment went badly but did so in a very informative manner. The bulk of Swedish state pension entitlement is a notional DC scheme, run on a pay as you go basis, funded out of taxation. There is a smaller top up scheme, called PPM, which is a funded DC.

At its launch in 2000, the Swedish government not only allowed but encouraged investment choice in the scheme through a nationwide advertising campaign. 456 funds were offered through PPM and 66.8% of those who started saving into PPM in 2000 made an elective investment choice and chose not to use AP7, the default fund.

Outcomes for this group of self-selectors was materially worse. They tended to overweight Swedish stocks and tech stocks (during the end of the dotcom bubble) and critically, tended not to rebalance their portfolios over time. Investors in the AP7 default fund, meanwhile, received better outcomes.

Self-selection of funds was not a success

This case study has been so impactful that it is hard to think of another national DC system that has followed the Swedish route. Indeed, Sweden no longer encourages choice in the same way and has progressively shrunk the number of funds available to PPM savers.

Henrik Cronqvist and Richard Thaler, who wrote the best-known evaluation of PPM in 2004 were implicitly critical of its initial design. But their more recent work also looks at the permanence of nudges in the Swedish system. Essentially, under some circumstances, once people have been “nudged” by a pension system to do something – or not do it – that decision is quite often very long lasting.

Their more recent work shows how PPM investors tend not to react when major events happen that might affect their investments. In 2011 AP7, the PPM default fund, started using leverage in the form of total return swaps. This resulted in much higher returns but also meant that investors were taking much greater risks. This massive change in the risk profile of the fund people had been nudged into, had very little impact on investor behaviour.

Why nudging savers has its limits

They observed something similar with the Allra fraud, which unfolded in Sweden in 2017. Allra, operated a fund in the PPM system. It routed transactions through Malta, where it skimmed the transactions in the process. From a mechanical perspective, there is nothing particularly interesting about this. But from a human perspective, what’s interesting is the under-reaction by Allra’s investors. In the week after the fraud allegations came to light, only 1.4% of the fund’s investors divested. This rose to 16.5% when the fund’s auditor resigned.

PPM continues to provide actionable insights about the risks of encouraging choice and information about how to structure choices when thinking about the design of DC pension funds. Increasingly, it also provides insights about the strengths and weaknesses of policies based on “nudging” people and the responsibilities that attach to policymakers, providers and regulators once someone has been “nudged”. It remains a system to watch for anyone interested in the future of UK DC.

Like many things we take for granted, automatic enrolment was popularised in the USA.

Auto-enrolment’s origins across the Atlantic stems from attempts by large, paternalistic employers to drive up participation in their retirement savings plans. These attempts were studied by behavioural economists like Richard Thaler and David Laibson. In the UK, the Department for Work and Pensions and the Pensions Commission picked up on their research on automatic enrolment and saw in it a mid-way between compelling people to save and more laissez-faire approaches to workplace pension reform.

While the US devised and popularised automatic enrolment, it is not actually that commonplace as an enrolment technique. This reflects one of the stranger aspects of the UK’s Magpie relationship with US politics and policy. Not all of the things that we borrow are as successful or widespread in the country of origin, as they turn out to be in the UK.

Half of Americans over 55 don’t have pension savings

There are many factors at play here; as with the UK, a worrying number of Americans have nothing saved for retirement. According to a 2019 study by the US Government Accountability Office, roughly half of Americans over the age of 55 have nothing saved for retirement. But, they are in a better position than Britons.

The US first pillar pension, commonly known as social security, is much more generous than state pension arrangements in the UK.

Social security is earnings related and the average amount paid to individuals in 2022 was $1,657 per month or $19,884 per annum with a theoretical maximum for high earners of just over $40,000. Notwithstanding the fact that there is now more being paid out from the notional social security trust funds in benefits than there is coming in in payroll taxes, social security has been remarkably resistant to reform.

This means that while the first pillar will not afford American retirees a luxurious retirement, support given to almost all retired American workers is, for the most part, well in excess of that provided by the UK’s state pension. Second pillar savings are, obviously, highly desirable but the base level of support provided by social security is much greater.

No nation-wide AE for Americans

There have been successive attempts to roll out automatic enrolment at a federal level, which have not met with success. Meanwhile a variety of states have brought in variations of automatic enrolment at the state level. Illinois was the first to bring in its programme in 2015, followed by Oregon, California, Connecticut, Maryland, New Jersey and Virginia. Pennsylvania and Hawaii are currently considering the issue. While there has been some bi-partisan support for automatic enrolment, both at a state and at a federal level, these states are predominantly wealthier than average and lean Democrat.

At the federal level, last autumn, all the proposals in the Biden administration’s flagship Build Back Better bill were removed from the bill’s framework. Those included proposals to require established employers with more than six workers to begin automatically enrolling employees into either individual retirement accounts. In some ways, this is emblematic of slow progress at the federal level.

An important year for US pension savers (possibly)

2022 could, potentially, be the year this changes. HR 2954, dubbed the SECURE Act 2.0, which is currently in front of Congress, contains provisions intended to mandate that businesses of more than 10 employees, which have been trading for more than three years automatically enrol their workers in a retirement plan. The initial contribution rate is 3% of pre-tax earnings but this escalates automatically by 1% every year to a minimum of 10% and a maximum of 15%. Individuals can select a different contribution rate if they want.

We are watching this with interest. There have been many attempts to bring in significant reform of workplace retirement saving at the federal level, but none have yet succeeded.

That alone tempers enthusiasm in the experiment. But the provisions on automatic escalation are interesting and, should they work wholesale, could provide an example for the UK to follow. It would be a pleasing development if the nation that pioneered automatic enrolment managed to extend its benefits to the bulk of its own citizens.

This Australia Day, we take learnings from Down Under and look at how UK pensions could benefit from the advancement of the country’s superannuation system.

This is highly relevant to the UK because the Australian Superannuation system is roughly 10 years ahead of the UK in its DC journey and policymakers often, but not always, look to Australia for inspiration.

The Your Future, Your Super policy package follows on from a series of inquiries into the performance of the Superannuation system. These, especially the final report of the Productivity Commission, made serious criticisms of parts of the Super system and have forced a heavyweight response from the Australian government.

The performance element of Your Future, Your Super, implemented last year, subjects funds to a pass/fail test based on investment performance. The regulator (APRA) examines 7 years (changing to 8 from 2022) of a registerable superannuation entity’s (RSE) investment performance and compares it to a benchmark portfolio. The benchmark is put together using the RSE’s asset allocation and a series of benchmark indices for each asset class.

If the RSE’s performance is more than 0.50 per cent lower than the benchmark, then it fails the performance test. If the annual test is failed more than two years in a row, then the RSE is banned from accepting new business into the product. This strongly incentivises “failing” funds to merge.

Australia’s Superannuation was already consolidating rapidly ahead of this regime coming into effect. Some analysts expect further consolidation and a dramatic shrinking of the market to far fewer funds. We see that as likely but are cautious about estimating how may funds Australians may have to choose from.

Value for money is key

There are both positives and negatives from this for the UK. We think the main lesson for the UK is that if the regulator, in this instance TPR backed by the Department for Work and Pensions (DWP), wants to increase the pace of consolidation in workplace DC then binding value for money tests are one way to achieve this. The current approach UK to driving consolidation based on value for money is focused on DC smaller schemes and allows trustees of the schemes in scope much more discretion in compliance than the Australian version.

One potential outcome of the recent TPR/FCA consultation on value for money metrics would be the strengthening of this regime and its application to more schemes. The Australian audit applies to all regulated funds, not just smaller ones.

Too much focus on past performance can be a negative

We do, though, see negatives to the Australian approach. The approach focuses only on past performance. There are two problems with this. First, past performance is not a good guide to the future. Poor past performance tends to persist while good performance may not. This limits its use as a decision-making criterion, even for regulators and professionals. The real value in a pension scheme is driven by the decision making around a scheme’s default fund, which is impossible to capture quantitatively. But it is also the key thing you would want to understand if you were trying to judge which funds are more likely to show value for money over the long term.

Second, performance next to a reference portfolio creates quirks. A conservative fund might outperform its benchmark and pass the test. A more aggressive fund might outperform the conservative fund but underperform its benchmark and find itself, effectively, out of business.

We look forward to seeing how a tougher value for money regime plays out in Australia and whether a consolidated market really delivers the benefits promised.