Since the Chancellor announced the Government’s pension reforms in his budget on 19 March, pension industry professionals have been incessantly testing the waters to determine how the announcements have been received and what they are likely to mean for the current HM Treasury consultation on “Freedom and Choice in Pension”.
Initially we heard of the impact on the sales of annuities, followed closely by how financial guidance should be delivered and how receptive we may be to Dutch style collective defined contribution schemes. Latterly, and most intriguingly, we have seen how the reforms may affect employer support for occupational pensions and how employee contributions may be shaped by the new flexibility we are likely to see from April next year. The question is, what is driving the desire to contribute more to occupational pension schemes?
According to Towers Watson, around two-thirds of employers think that workers will be more engaged with their retirement savings, with many companies also anticipating an increase in contributions to defined contribution (DC) schemes from employees. The Towers Watson survey found that nearly three-quarters of employers are expecting employees who are close to retirement to start contributing more towards their pension and one-in-five anticipating younger workers will do the same.
With the switch from defined benefit (DB) schemes to DC schemes leaving a perceived gap in retirement provision, an increase in employee contributions to DC schemes is to be welcomed – providing it is for the right reasons. The concern is that the driver for the increase in member contributions may be more to do with the need for a tax efficient savings vehicle than it is to do with delivering long term retirement income.
The purpose of a pension scheme is to provide retirement income security. Traditionally, and exclusively for the majority of people, members of DC schemes the purchase of a lifetime annuity is the only financial instrument that provides such long term security. Whilst flexible income drawdown has been an option for some years, for those who had secured pension provision of less than £20,000, the reality has been annuity purchase as the only option. If we are to move away from the current regime, there must be a viable alternative to secure income in retirement.
The proposed changes announced in the budget include – indeed are centred around – the ability from April next year for DC scheme members to access their total accrued fund values in cash rather than by purchasing an annuity. The Pensions Minister, Steve Webb’s, comment that he is relaxed if people wish to access their retirement funds to buy a Lamborghini rather than an annuity, does little to reassure the industry that if not properly controlled the announced flexibility could lead to several challenges.
Firstly, there is the obvious issue of a DC member drawing accrued funds and using them for a purpose other than providing retirement income and then relying on the state for support in old age. That is a concerning issue, but not necessarily a priority for business.
Secondly, and of more concern for employers, is the question of why a business would make the effort to provide, and contribute to, a DC scheme if the majority of members see it as a simple vehicle whereby their, and the employees’, contributions can be utilised as a tax efficient savings pot. If a DC scheme ends up as a mechanism for employees to benefit from pooled investment risk, a 25% tax free lump sum and investment returns that result from their employer’s contributions, where is the upside for the sponsoring company? Pension schemes have long been used as a recruitment and retention tool and as a way of valuing the contribution of employees to a business. Under the proposed reforms “retirement”, ie the point at which scheme members can access their funds, becomes unclear at best and the focus switches from retirement income to a cash bonus with which that “dream holiday” or “child’s perfect wedding” can be financed. It is unlikely that those ambitions were in the mind of an employer when it decided to sponsor a pension scheme.
Thirdly, and of potentially serious financial concern to an employer, is the increased likelihood of members of a DB scheme deciding to take a cash equivalent transfer from their DB scheme to a DC scheme with the sole intent of accessing their accrued fund in cash. A recent report by the accountancy firm Deloitte said one of the DB schemes it serviced had seen the equivalent of a year’s normal transfers take place in a few weeks. The report went on to say that a greater number of members seemed to be considering transferring out “while stocks last”.
Chris Netiatis, pensions partner at Pitmans LLP is of the opinion that there is a distinct danger in private sector DB scheme members having an unfettered right to transfer to DC schemes, not least as it may result in a funding strain being placed on DB schemes. “A rush of members transferring out to DC schemes could have a knock on effect for the covenant strength for many small and medium sized businesses. DB pension schemes play a crucial role in the stability of the UK economy in general. They provide pools of capital used for investment in the wider economy and pension funds are long-term investors in key UK based assets. Mass exodus from DB schemes under these new proposals will damage the strength of these funds and therefore have an impact well beyond the pensions’ world.”
Linked fundamentally to the new flexibility is the provision of face to face financial guidance for members of DC schemes at the point of retirement. The reality is that the majority of members wishing to access the cash from their accrued DC funds is likely to comprise those who can most ill afford to use the funds for anything other than income in retirement. That is why financial guidance is of key importance to delivering the reforms, and why the Government needs to reply swiftly and definitively to the consultation exercise.
There has been significant, and partisan, debate on how and when the guidance will be provided, who will do it and how much it will cost the pensions industry. The Government has pledged £20million to help with the set-up costs of providing guidance with the remaining costs due to be met by a levy on pension providers due to start next April. The Association of British Insurers has calculated that the running cost of guidance to the industry could be up to £26million a year, though that could also rise depending on how much demand there is for the service. There is also the unanswered question of whether employers may be asked to meet any costs.
Whilst the provision of guidance is to be welcomed, the devil is in the detail. On the question of financial guidance, Chris Netiatis said “This is, in theory, a good idea and one which could add significant value to members at retirement. However, many questions remain unanswered. How does the Chancellor envisage this guidance being given: individual meetings, group sessions, on line webcam session?
With the look and characteristics of a retiree ever changing what does ‘at retirement’ mean in practice? Without more specific guidance and firm definitions given to what is meant by guidance and when this is given, Trustees will be unable to prepare for this new measure.”
Whilst a revision of the DC pension wold is long overdue, and whilst members of such schemes deserve increased flexibility and choice in how they provide for their retirement, we should not lose sight of what pension schemes are there to provide and the knock on implications of reform.