Older high-charging default funds will damage auto-enrolled members' pensions
Employees of the UK’s biggest businesses will be signed up to contribute to their employer’s pension scheme from Monday, unless they opt out. This auto-enrolment programme will cover all employees over the next few years, but there is a danger that a tunnel-vision focus on employer compliance with administration and contribution rules will divert attention away from the most important challenge for the new private sector pension system.
A forthcoming report from the Pensions Institute argues that the success of auto-enrolment depends on universal access to low-cost schemes with a strong investment governance framework – the main factors that determine the size of the retirement income relative to contributions paid. If this objective is relegated to “any other business”, employees’ retirement incomes will depend on their “choice” of employer, which, for most lower and median earners, is no choice at all.
The report will demonstrate empirically the extent and impact of member inequality through an examination of the full spectrum of defined contribution (DC) default funds – old and new – likely to be used for auto-enrolment. It models the impact of asset allocations and charges on member outcomes, in terms of the emerging annuity income, and finds that the impact of charges as they apply over the long term is by far the most significant factor.
This will raise important questions for providers and consultants, many of whom argue that asset management skill and the potential for outperformance is more important than cost. There is little academic evidence to support this argument and in reality UK pension funds have achieved near-zero returns since the turn of the century.* Specialist asset managers might achieve outperformance over the short term, but these firms are unlikely to run the large-scale funds used to accommodate lower to median earners – the primary target for auto-enrolment.
Competition in the auto-enrolment market has triggered a fierce price war, which is driving down costs for new schemes, but unfortunately not for the tens of thousands of older schemes introduced in the 1990s and early 2000s and still in use. The latter are characterised by total expense ratios (TERs) of up to 3 per cent, as compared with the modern TERs of about 0.5 per cent (or even less over the longer term), established by trust-based multi-employer schemes from B&CE, the National Employment Savings Trust (Nest), and Now Pensions, among others. Exit penalties on older schemes prevent members from transferring assets, even if they join a new scheme for future service.
Moreover, the research reveals a significant advice gap in the employer market where membership profiles – characterised by lower earners and high staff turnover – are considered uneconomic by most providers and advisers.
Under the original blueprint for auto-enrolment, the default scheme for these employers would have been Nest, but this feature was dropped due to industry lobbying.
Without advice, employers are likely to use their current high-charging scheme for auto-enrolment and there does not appear to be a mechanism in place to prevent them from so doing.
The report argues that a low TER should be a priority for scheme compliance, but the Pensions Regulator (TPR), which supervises auto-enrolment and is responsible for trust-based DC schemes, does not regulate pricing; nor does the Financial Services Authority (FSA), which is responsible for contract-based DC.
In an efficiently functioning market, buyers make informed choices that drive sell-side conduct and pricing. Therefore the question of who is the customer in the contract-based DC market is pertinent because the contract is between the member and the provider.
Yet the member has no influence over the charges of the scheme into which he or she is auto-enrolled, on a passive basis, because this decision is made by the employer.
Advice to employers – which usually is incorporated into the member charge – is not regulated by the FSA and unlike trustees employers have no legal or regulatory responsibility for member outcomes.
It is hard to justify caveat emptor in the above scenario. The success of auto-enrolment is predicated on member inertia, yet FSA regulation will treat millions of new financially unsophisticated members, passively auto-enrolled into their employer’s pension scheme, as though they are active purchases of complex and risky financial services products.
The report presents a workable solution to inequality in member outcomes, which would ensure that employers with no scheme at present, and those with existing schemes with high-charging default funds, are directed towards trust-based multi-employer schemes, among other low-cost models. Under the proposed solution employers would also be encouraged to facilitate transfers of any existing member funds to new schemes, but this will not be easy unless provider conduct and pricing changes.
The pensions minister Steve Webb has said that at present the government cannot force providers to waive exit charges on older schemes.
He also said it would be very much in providers’ reputational interests to do so voluntarily.
*Organisation of Economic Co-operation and Development Pensions Outlook 2012
Debbie Harrison is a senior visiting fellow of the Pensions Institute at Cass Business School.