Putting the genie back in the DC bottle

I like Steve Webb. He has a difficult brief as pensions minister, but he has done a good job, mainly down to the fact he knows what he’s talking about and, more importantly, he actually cares about pensions. This puts him clearly into a different bracket than the majority of his predecessors who only saw pensions minister as a stepping stone to a ‘bigger and better job’ in the Treasury. (This appears to be a Labour career path!)

And I like his optimism that company pension schemes can be saved. Or rather company pension schemes can be saved where the employer takes on some ‘guarantees’ (or promises as we must call them).

But I am not sure I completely agree with him.

Final salary schemes were great for employees. But we have to be realistic, those days have gone. The vast majority of private final salary schemes are not only closed to new members, but are rapidly shutting up shop for existing members too. And most of these companies have put a defined contribution scheme of some type in their place.

Defined contribution schemes aren't a completely free ride, they come with some employer responsibility. There’s the promise to pay the right contributions at the right rate at the right time. And there are corporate governance responsibilities, to one degree or another depending on the scheme chosen. No doubt these will increase over the next few years as automatic enrolment begins to really bite. But these are not the cripplingly financial responsibilities of the final salary scheme.

So, is there really an employer demand for the ‘defined ambition’ schemes Mr Webb is planning? These schemes aim to share the risk more evenly between employer and employee. And whilst every employee would be crying out for these, will employers really go for them? They – in all probability – already have the defined contribution scheme in place, even if just for new employees (at the moment). So, we are asking them to forget this cheaper more controllable pension, and set up something which is better for their employees, but has repercussions for their balance sheet?

Maybe this is just a way of easing the path for public sector schemes to change from defined benefit. But I would love to think that some private employers will also sign up. And I am sure there will be a few who are finally closing their defined benefit scheme to all who will. But for the rest, with the hand of automatic enrolment on our shoulder, I just can’t see them signing up to defined ambition schemes, and dispensing with the arguably cheaper and more controllable defined contribution scheme.

It will be just too difficult to put the genie back into the DC bottle.

Phew! (I think!)

After a pensions rumour mill that went into overdrive in the build-up, the 2012 Budget has been almost (whisper it) quiet for pensions. We were all on guard against a further cut in pensions tax relief down to £30,000 annual allowance, which, thankfully, didn’t materialise. To raid that particular piggy bank just at the dawn of automatic enrolment would have been a mistake. It would have just robbed employers of any lasting faith in pensions, meaning they introduce for their workers the lowest contribution rate in the safest fund possible. Meaning no-one achieves their pension hopes.

But there were some changes for pensions. After some considerable hard work, Steve Webb saw his dream of a single tier pension of £140 a week based on contributions get the official go-ahead. All we need to do now is figure out exactly how this will work in practice, and especially its interaction with contracting out. And presumably the White Paper to be published over the next few months will help us do that.

State pension age is to be reviewed automatically so that keeps pace with increases in longevity. This sounds like the thorny subject of SPA is going to be taken out of political hands and placed under a neutral watch. This is especially interesting for public-sector schemes whose retirement ages are now linked to SPA – they won’t have the government to blame, just a faceless actuarial/statistical entity. But with longevity still on the rise, it could mean that 30-somethings today are going to have to work until they are in their 70s. Not a pleasant thought.

Finally, there was also an announcement for pensioners. The age-related income tax personal allowances are to be removed and instead there will be just one personal allowance for everyone. True it will be a much more generous one, thanks to the Coalition Government’s aims to boost it up to £10,000, but the current system of age allowances really helps out moderate-income pensioners. In 2011/12, those between 65 and 75 were able to receive £2,465 more income before being taxed, and those over 75 £2,615 more income. These full age allowances however are only available to those earning less than £24,000.

These allowances will be frozen in cash terms at £10,500 and £10,660 respectively until the universal personal allowance catches up. And that action will raise a staggering total of £3.3bn of revenue for the Government over the next four years. Making it clear that moderate-earning pensioners are helping foot the tax cut bills.

Over the next couple of years, these changes could be a further blow to drawdown clients, who may see their incomes fall in their drawdown reviews because of the triple whammy of falling fund values, lower GAD limits, and revised GAD tables. Now, on top of that they will be effectively paying more tax. Consequently, they may be looking out for ways of increasing their net incomes, and that might mean transfers to investment-linked annuities to take advantage of the 120% income limit.

What can KiwiSaver teach the UK?

Automatic enrolment into pensions – due to kick off in the UK from October this year – is one huge social experiment. The sad truth is that despite spending the last eight years planning it, no-one really knows what will happen. Will employers know what to do? How many will simply ignore it? Will people stay in or opt out? How much will they save? And will it all be worth it in the long run - or will many walk away in 30 years’ time with a pittance and still have to rely on the State for the vast majority of their retirement income?

Some of these questions can be answered by looking at the economic environment. The unemployment rate, recent pay rises (if any), interest rates, the housing market. And some can be answered by looking at how automatic enrolment is being portrayed. What your employer says, what the media says, what the government says, and most important, what your mate Bill says down the pub on a Saturday night.

However, we can get an insight by looking at what has happened in other countries – and the Pensions Policy Institute (PPI) has produced an impressive paper that examines the lessons we can learn from New Zealand. NZ is one of only a few countries so far to dabble with automatic enrolment; KiwiSaver was launched in 2007.

It’s different from the UK’s version. Lower contribution rates, only one KiwiSaver per person (meaning you can carry it around with you), fixed tax relief that’s more beneficial for anyone earning below about £32,000 and a £500 one-off incentive when you take it out, and a lot more flexibility (you can get the money out in dire circumstances or first-time buyers can use it to fund their house purchase). This means it will always be difficult to do a direct comparison. But the paper draws out two important lessons on opt-out rates and contribution rates.

The opt-out rates for KiwiSaver started at 34% but dropped to 28% last year. Will the UK’s be higher or lower? On the one hand you could argue it will be lower. KiwiSaver only auto-enrols people taking on a new job and 18-year-olds. Everyone else has had to opt in. If we assume new jobholders are generally younger, then we might also assume fewer will stick with saving. Auto-enrolling everyone (as the UK will do) may gather up the 30-somethings and 40-somethings who have been in their job for several years. These people may be more likely to want a pension. Interestingly, 63% of the KiwiSaver total membership opted in – they actively chose to save – so current jobholders didn’t want to lose out.

But on the other hand, if a current jobholder is automatically enrolled they will see an immediate pay cut. And the UK version just isn’t as appealing as KiwiSaver. Less free money from the Government as an incentive, and your money is tied up for the next 40 years. So maybe the opt-out rate will be higher.

The other interesting find is the low contribution rates. Over 90% of employers are only contributing 2% (but there again they don’t receive tax relief on the contributions). If UK employers react in the same way, and just go for the bare minimum, then levelling down will be a certainty.

Individuals also tend to start contributing at the minimum level – which started at 4% but fell to 2% for new joiners after April 2009 – and stay there. Even out of those who started at 4%, only 33% have reduced to 2%, the rest have mainly stuck at 4%.

So, will all this talk of ‘get people in and then increase contributions beyond the 8% minimum’ simply fall on deaf ears? It appears so. Once they’ve made the decision to save, and at the lowest rate, it doesn’t look like there is much chance of budging them. And that makes the current discussions about ‘auto-escalation’ or ‘Save More Tomorrow’ or whatever you want to call it, even more important. We have to get people to sign up on Day One to the idea that they will (automatically) up the contribution at some later date, because otherwise they will be stuck at 8% of band earnings for ever more.

And that means the social experiment may go horribly wrong. And the chance that people will ‘walk away in 30 years’ time with a pittance’ becomes much more likely.

My top seven predictions for 2012

1.       Automatic enrolment will go ahead on time on 1 October 2012. Not that startlingly a prediction you may think, but right up to the last minute there is always the chance the Treasury will pull the plug on this initiative. Of course the bit we don’t know at the moment is the start dates for those firms with fewer than 3000 employees, and we should find that out from the DWP in the next few weeks. All we know at the moment is firms with fewer than 50 employees don’t face auto enrolment until May 2015 at the earliest. The fact the Government is willing to mess around with dates this close to lift off is ominous.

2.       The opt out rate for automatic enrolment will top 35%. And that’s if we are lucky. It could top 40% or even 50%. My biggest concern is that the Government is just not putting enough ‘welly’ behind this. It’s one thing to build a vast bureaucratic structure, forcing employers to do something, it’s a whole different thing to convince people that pension saving is ‘A Good Thing’. It may only mean giving up 1% of their salary to start off with, but that might be a step too far for many, when the upside is so uncertain. Of course, we are yet to see exactly how the DWP plan on advertising automatic enrolment, but my gut instinct is newspaper ads with lego men just ain’t going to cut it.

3.       Annuity rates will continue to fall. Don’t get me wrong. I don’t mean they will go down consistently throughout 2012 – there are bound to be upward movements as global economies (hopefully) recover. What I mean is that the overall trend continues downward driven by Solvency II, increasing longevity, and the gender directive. And with drawdown in the doldrums, there is going to be increased interest in how to get a decent income in retirement. That may mean putting off taking benefits, or considering other products such as investment-linked annuities.

4.       The date state pension age will increase to 68 will be brought forward (from 2046). With the most recent announcements it seems inconceivable that state pension age will go up to 68, 20 years after the increase to 67.  The question is whether the Government will be assured enough to make this announcement this year. After all, there’s no real rush.

5.       Open market option will get a ‘shot in the arm’. The ABI is currently consulting on changes to wake-up packs which should give the client a lot more hand-holding through the whole process, as well as highlighting the substantial benefits of shopping around. The $64m question is whether it goes far enough. And no doubt there will those who will be champing at the bit for OMO to become the default. But before that happens, we should at least be confident the vast majority will know what to do with that choice if it’s forced upon them. And at the moment, I believe, sadly, too few even understand the concept. There’s still a lot of work to do.

6.       Steve Webb will continue in his role of pensions minister for the whole of 2012. Just as long as Nick Clegg can ‘work around’ his problems, disregard his principles, and cling on to power in the coalition. It would be a breath of fresh air to have the same pensions minister for more than 18 months, so I’m hoping this prediction comes true. It’s great just having someone in charge who gives a damn.

7.       Manchester City will win the Premiership. Well, a girl has to keep the faith, doesn’t she?

Happy New Year!