The Government's pension reform

Written evidence submitted by the Investment Management Association

1. The IMA [1] welcomes the opportunity to submit its views to the Committee. We have been an active participant in the pension reform debate, and a firm supporter of the introduction of auto-enrolment and NEST. Our response focuses on these two initiatives, which we regard as potentially very significant reforms:

· Auto-enrolment has the potential to increase participation rates particularly among less actively engaged employees. It helps to decrease the complexity of the decision-making process and takes advantage of inertia to guide participants towards increased retirement saving. While we consider the existing auto-enrolment provisions a good starting point, we highlight the need for a continued focus on the issue of employee contributions, as we believe that auto-enrolment will not be able to fulfil its wider aims without sufficient participant engagement.

· We also continue to view NEST as the right model to address the particular needs and preferences of low to median-income earners. It enables its target market to benefit from an independent and accountable governance structure and the ability to utilise the competition and economies of scale present in institutional investment management. NEST’s position needs to continue to be complementary to the existing UK private pension market rather than a dominant player within it. That is why we advocate a carefully set limit on contributions and a restriction of transfers in and out of the scheme.

Auto-enrolment

2. The IMA has been a strong advocate of auto-enrolment from the early stages of reform discussions, and welcomes the progress made by Government in its incorporation into the UK pension system. As highlighted in our past submissions [2] , we believe auto-enrolment is a viable policy solution to combat inertia, which we consider to be an important underlying reason for pension under-saving in the UK today.

3. As evidenced in the US and New Zealand pension systems, auto-enrolment has great potential to improve participants’ saving behaviour. It removes the participant from a decision-making process which - due to lack of time or insufficient financial sophistication - may for many be too daunting to actively engage with. Furthermore, by requiring an active decision to be made in the case of non-participation, it takes advantage of participant inertia and procrastination to guide particularly the more passive workers towards the desired outcome.

4. Both the US and New Zealand offer compelling evidence on the impact of auto-enrolment, although the differences in its implementation make it somewhat difficult to assess precisely how it will work in other contexts:

· At the time that the Pensions Commission was issuing its original recommendations in this area, the main evidence base on auto- enrolment came from the experience in the US 401(k) system. In the US, auto-enrolment is not a national policy; rather, its provision and specific features have always been determined by the employer. Some studies suggest that, where applied, auto-enrolment increases participation rates by up to 41 percentage points. [3] To incentivise participation, the employer may also provide a dollar-for-dollar match contribution (or a fraction thereof). [4]

· The KiwiSaver scheme in New Zealand was introduced nationally in July 2007, but auto-enrolment was applied to new joiners only, with existing employees able to opt in to the scheme. The system also offers a number of benefits to incentivise members, such as an initial tax-free contribution of NZD 1,000 from the Government, compulsory employer contributions of up to 2% of the employee’s pay, an annual Government matching contribution (up to NZD 1,042.86), a first home deposit subsidy and the ability to withdraw some or all contributed assets for home purchases (both of these available after 3 years of membership). [5] While opt-out rates were around 50-60% throughout the first year after its launch, they dropped to 10-15% by 2010. [6] What is not clear, however, is the precise role that Government incentives play in the participation decision.

5. By combining an employee contribution with an employer contribution and tax relief, the UK is also using what is in effect an incentivised automatic enrolment process. However, the precise design will be very important in order to avoid sub-optimal outcomes:

· We welcome the revised earnings trigger for auto-enrolment (which now stands at £7,475 per year) as a pragmatic step aimed at excluding those workers for whom locking up funds into long-term investment vehicles may impose significant liquidity constraints in the short- to medium-term.

· We also agree with the emphasis on careful design and monitoring of the default fund. Given that most participants will be likely to invest in the default fund, rather than make an active choice, it will be very important to ensure good governance processes are in place. To that end, we welcome the work of the Investment Governance Group [7] and believe that the DWP’s proposed approach, using guidance rather than prescription, is the right way forward. Any attempt to specify investment strategies creates risk for Government, constraints for the industry and ultimately inhibits good outcomes for end investors.

· Finally, in order for the reforms to be successful, they need to guide participants towards a retirement income that would meet their pension expectations. While we consider the agreed minimum employer contribution (3%) and the tax relief provided by Government (1%) an important step to encourage participation, the aggregate minimum contribution rate of 8% is unlikely to prove sufficient to meet many people’s aspirations for retirement income. It will be important to ensure that individuals understand that the 8% is only a starting point and that some may need to make far higher contributions.

6. Indeed, a potential consideration in this regard might eventually be the combination of auto-enrolment with automatic escalation (ie an automatically administered gradual increase in employee contributions in line with wage increases). [8] This is being implemented by an increasing number of employer-sponsored schemes in the US and has, particularly during the recent years, been seen as a useful tool to counter the effects of inertia. We do, however, realise the need for a gradual approach towards pension reform and thus would only propose the consideration of the merits of such a step in the longer term.

NEST

7. The IMA has also been a strong supporter of NEST as a default provider. While auto-enrolment directly addresses the behavioural patterns underlying pension under-saving, NEST enables low- to middle-income earners to benefit from economies of scale and competition that exist in the institutional investment management market. [9] NEST will also greatly benefit from economies of scale in administration - by removing distribution and intermediary costs, which can have a significant impact on savings outcomes.

8. One of NEST’s additional advantages is its governance structure which promotes accountability and enables a close focus on the target market. The following features have been essential in attaining this:

· NEST has a fiduciary duty towards its participants which helps to shield it from external pressure. At the same time, we welcome the fact that NEST’s legal structure enables it to be held publicly accountable for its decision-making.

· NEST is in our view superior to the alternative that is sometimes suggested of the ‘carousel’, which would default participants into different pension schemes in the absence of a clear employer choice. A randomised allocation into different investment and charging structures might, especially given NEST’s target membership, have resulted in potentially harmful divergence in savings outcomes and political consequences for Government.

· From the point of view of the employee, NEST provides a portable pension arrangement that can provide continuity as he or she changes jobs

9. NEST should aim to complement and enhance the competitiveness of the current pensions market. While policy reform should be focused on correcting the gaps prevalent in existing retirement provision, it would be very undesirable if this translated into NEST’s assumption of a dominant position as a pension provider. Not only would this risk distorting the UK pension savings market, but it would put Government in an undesirable position from a competition perspective. A number of provisions are important in this respect, although these could be subject to review once the full impact of automatic enrolment becomes clearer:

· The contribution limit for NEST (currently set at £3,600 per year, uprated from 2005 value) should provide sufficient scope for median to low earners to make significant additional contributions beyond the 8% minimum.

· A restriction of transfers in and out of the scheme should ensure that NEST does not extend beyond its key purpose as a default provider for those who have not otherwise had access to long term saving.

February 2011