Work & Pension Committee - Minutes of EvidenceHC1494

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Oral Evidence

Taken before the Work and Pensions Committee

on Wednesday 12 October 2011

Members present:

Dame Anne Begg, in the Chair

Debbie Abrahams

Harriett Baldwin

Andrew Bingham

Karen Bradley

Mr Oliver Heald

Glenda Jackson

Brandon Lewis

Teresa Pearce

________________

Examination of Witnesses

Witnesses: Baroness Drake CBE, former Pensions Commissioner, Paul Johnson, Director, Institute of Fiscal Studies, and David Pitt-Watson, Hermes Fund manager, and the Royal Society of Arts, gave evidence.

Q1 Chair: Can I welcome our witnesses this morning to the first evidence session of our inquiry into auto-enrolment and NEST (National Employment Savings Trust)? Could you just very quickly introduce yourselves for the record?

Paul Johnson: I am Paul Johnson; I am Director of the Institute for Fiscal Studies (IFS).

Baroness Drake: I am Jeannie Drake, Labour peer. I was on the original Turner Commission and I was involved in the creation of NEST at the early stages.

David Pitt-Watson: I am David Pitt-Watson; I am a fund manager, but I have been leading a project with the RSA, the Royal Society of Arts, on pensions futures in Britain.

Q2 Chair: Thank you very much for being here this morning. We are going to go straight into the nitty-gritty of auto-enrolment. We have had a briefing from our adviser on the mechanics of it, but we would like to get your take on some of the issues. I will start with you, Jeannie, because you are the mother-I do not know if that is the right description-of the concept of auto-enrolment and the idea that there should be a National Savings Trust, although it was called Personal Accounts in those days. It certainly came out of the work that you did as a member of the Turner Commission. Obviously, there are some things that you recommended at that stage that perhaps have not made it into the final cut of the way it has been done.

I am going to start off with some questions on incentives for individuals. Why did you decide to go for the optout model of enrolment? Why didn’t you follow the Australian example of compulsion, for instance, or why did you not recommend that kind of model? Do you think that the effects of auto-enrolment will be enough to get over the general lethargy of the individual about saving into a pension?

Baroness Drake: Thank you very much. Good morning, Dame Anne. There are two elements to the question: why we went for the route we did and whether I think it will be enough.

One starts from the premise that the Pensions Commission said the taxable capacity for pensions was finite; therefore, it should be concentrated on creating a flat-rate, as generous as possible state pension that would deal with poverty and provide a firm foundation for saving, and the earnings-related provision should be through private saving. To get that saving through private provision, what route should be taken? Should it be compulsion, with the state compelling? Should it be enrolment through the employer? Or should it be persuasion through the industry?

In considering that, we looked at both the employer and the employee separately. In terms of the worker, there are three reasons why we took the auto-enrolment route. First, we felt that if you go straight to compulsion people may see it as a tax and there could be initial political resistance to that. If it were the perception at the point of introduction-that it was a form of tax-it could put pressure on that state pension over time, so maybe compulsion should be considered if subsequently it was shown that auto-enrolment had failed. Secondly, there was recognition that people have different preference rates on how to save and when to stop working. Third, individual circumstances differ-people have housing assets and inheritances.

On the employer-the contingent compulsion-that was driven by the belief that employer engagement with occupational pensions was in irreversible decline and that it required compulsion to reverse it. The employer contribution would ensure a significant increase in workers’ participation and would also ensure a return on savings so that it could be safe to auto-enrol without all the regulated advice requirement.

Will that be sufficient to produce what is needed? In the Pensions Commission’s view, we were confident in terms of our recommendation. Of course, as you said, Dame Anne, the way in which the policy has evolved is slightly different to the Pensions Commission’s recommendation because the Pensions Commission’s view was that NEST could not be separated from auto-enrolment. There was a view that not only did you strongly encourage people to save but you had to enable them to save in a low-cost way and so that their interests were protected-that is both a governance issue and a lowcost issue.

Therefore, because we believed there was a market failure and the market could not effectively service the low to moderate-income earners, particularly in small and medium-sized employers and those with higher churn, you had to have NEST. Employers would be defaulted into it and they would have to choose to opt-out of it, subject to two conditions: that people could transfer back into NEST so their pots over time were protected and, secondly, any employer opting out had to meet an 8% contribution rate net of all charges.

What has happened, of course, is the policy, which Government are entitled to determine-now allows auto-enrolment into any qualifying savings scheme. I do have a concern that there will be lots of providers, and there are some weaknesses that I think need to be addressed. One is that I am concerned that there is a lack of quality standards being set for these providers.

Chair: We have questions on that kind of thing coming up.

Baroness Drake: Sorry. Okay, fine.

Q3 Chair: It was more: why auto-enrolment rather than compulsion? One of the things you said was that you did not want it to go to compulsion because that would be seen as an extra tax, so auto-enrolment was there, but if it failed it would be possible to move to compulsion. Does that mean you think that auto-enrolment might fail? How confident are you in the concept of auto-enrolment as a model that might succeed?

Baroness Drake: We were confident. We made the point that, if we were shown over time to be wrong on that, Government would need to re-consider. We were confident though: we had done considerable modelling; we had looked at other data sources; and the combination of the employer contribution-I have brought the figures-for the lower income groups we were assuming that there would be a participation rate of the order of about 60% and nearer 80% for moderate earners. So we were pretty confident.

Q4 Chair: So if you have a participation rate of 60%, do you think that would be 40% optout then?

Baroness Drake: Yes.

Q5 Chair: Do you think the incentives of 3% employer contribution and 1% tax relief will be enough to attract people? I understand that in New Zealand there are different incentives to get people to save into KiwiSaver.

Baroness Drake: We did believe that, but of course that rested on a set of assumptions, and that set of assumptions included having very low charges. We were making the assumption that you would do this on charges of around 0.3%. The more that charges rise, the less you actually get from your savings. Taking the tax relief and the employer contribution would provide the incentive to save, and the DWP did do a lot of modelling on this in terms of payback and how many people would get a return on their savings on this base load of contributions. We can go through the detail of that modelling and Paul will be very familiar with it. I think their modelling showed that 95%-plus would get a positive payback on their savings.

Q6 Chair: The Commission thought the expectation that people would have on retirement would be that their net income would be about twothirds of their net income when they were in work. Auto-enrolment does not give them twothirds; it gives them around 45%. With the state pension and auto-enrolment combined, that is getting closer, but it is still not going to get to the level that the Turner Commission thought would be an adequate income in retirement. Are you disappointed that that is the route the Government has gone down?

Baroness Drake: What we said when we looked at the evidence was that people aspired to 60% or so replacement income in retirement. However, in terms of public policy what it should seek to achieve through auto-enrolment and contingent employer compulsion, we took the view that the Government should try to achieve a 45% replacement rate gross, and that it should try to facilitate, through voluntary means and incentivised saving, getting people up to 60%. But the design of the base load and the auto-enrolment was targeted at 45% replacement rate gross; 30% of that had to come from the state reforms, so you have to hold to the state reforms to get the 30%, with 15% to come from the auto-enrolment and contingent compulsion. The additional saving above that would come from incentivised voluntary saving.

Q7 Chair: So you see very much the combination of the state and this second pillar as just being a base that people can then add on to, rather than being the complete income that they should have in retirement?

Baroness Drake: Yes, to get to the 45% replacement rate aspiration, the state reform and the auto-enrolment are inseparable. That was the big political argument we had at the time, if you recall-that we had to look at both. To get above the 45% requires voluntary incentivised saving and facilitating that taking place.

Q8 Karen Bradley: My questions, directed at you, Mr Johnson, are specifically on the reports that the IFS has published and work you have been involved in. The first question is: comparing the economic climate today with 2006, when the scheme was being developed, do you think that the scheme is workable in today’s economic environment?

Paul Johnson: Yes, I think it is still workable. Clearly, as you say, several things have changed since 2006. There are two big issues that one might want to think about. Firstly, of course, the economy is in a much more difficult state, and the extent to which auto-enrolment is successful in increasing savings rates in the short run will take money out of the economy. It is worth saying that it is still a year before that starts in 2012, it is still only big firms that will be coming in and it is still only at an initial rate. I am not a macroeconomist, but the scale of that is not going to be enormous in the sense of the impact it might have on the economy. Where the economy will be in two or three years’ time is anyone’s guess.

The second issue is about household incomes though, where the levels of household incomes and real earnings are falling and falling quite fast. That must, I would have thought, increase the probability that there will be more people who will opt-out, because even the additional 1% or 2% is going to feel like more of a cost in a climate in which their real earnings are falling. We have seen falling real earnings this year. The Office for Budget Responsibility expects to see falling real earnings next year. Even since 2001 we have had really very small increases in earnings. The people this is aimed at as well, at median incomes, have been doing less well than those further up the distribution. Their choice will be a harder one than I think was initially expected in terms of putting initially that extra 1% and then 3% into a scheme.

Q9 Karen Bradley: Do you think the assumptions that were made about level of enrolment and optout are still realistic, given falling household incomes?

Paul Johnson: There is huge uncertainty about what that level will be. The sorts of numbers that Jeannie talked about seemed to me still to be plausible, but there were significant confidence intervals around those at the time. The risk must be on the downside, given what we know has happened to household incomes. I guess if you were to redo the same exercise today you might come up with a smaller number, but it would be surprising if it were a massively smaller number.

Q10 Karen Bradley: Could I just ask for clarity? Did your report that was issued yesterday about falling household incomes in future build in auto-enrolment as one of the costs that was going to be levied on households?

Paul Johnson: No, it did not because, obviously, people have the option not to do that. No, it was not building that in at all.

Q11 Karen Bradley: In 2010, you recommended raising the minimum earnings threshold. What are the implications of doing that for employees on lower incomes if they are not automatically enrolled? Are there any groups in society or any demographics that would be particularly affected by that?

Paul Johnson: As you can imagine, it was one of the more complex things that we looked at-at what level of earnings you want to start auto-enrolling people. There are strong arguments in both directions. The argument against auto-enrolling people on relatively low earnings is that the state system anyway will be providing a single person on £10,000 a year every year of their life 100% replacement. In that very simple world you might think there is a case for a significantly higher point at which you start auto-enrolling people.

Of course, the world is much more complicated than that. People move up and down the earnings distribution. Most of the people on the sort of earnings we are talking about are either very young, are married to people earning more or are lone parents who are entitled to tax credits, which gives them a big incentive to put money in. That is why we ended up proposing that the threshold remained low-essentially at the tax threshold-and it was a balance of issues around not wanting people who are on very low incomes over their life to be able to enrol because they would not be better off as a result, and ensuring participation was as wide as possible. It struck us that the point at which people start to pay tax seemed a reasonable thing to tie that to.

The groups below that tax threshold are all working part-time; a majority of them are women working part-time. There is clearly a risk that some of those women will end up with less time in the pension system than they otherwise would have. As I said, I think it is a balance between that risk and the risk that you are auto-enrolling significant numbers who really would not be made better off by being in that process. I think you could make a sensible argument for a much higher number; you could also make a sensible argument for a lower number and that is where we ended up.

Q12 Karen Bradley: Are you comfortable with it staying in line with the tax limit if the taxfree personal allowance goes up to £10,000 as is in the Coalition Agreement?

Paul Johnson: We knew that was in the Agreement when we made the recommendation. We made it with that knowledge in mind because it struck us that somewhere around £10,000 was a pretty good place to base that on. For someone working full-time, that is still an income below the minimum wage; it is still a very low level of earnings.

Q13 Karen Bradley: Do you feel that there is little point in the Government trying to give extra incentives to people on lower incomes to enrol or to stay auto-enrolled, and actually the focus should be on those at the median income to make sure that they continue enrolled in the scheme?

Paul Johnson: The difficulty for Government and anyone giving advice here is clearly you have a whole range of very different circumstances for people on these very low incomes. I do not think it would be helpful to be trying to persuade a 22-year-old student who is working part-time to auto-enrol. I think there might be some significant case for lone parents, for example, on tax credits who are working 16 hours a week; there is a very big incentive for them to auto-enrol because of the way that tax credit works. That is one of the reasons why this is a difficult balancing act and why I think a blanket message for people on those levels of income just is not possible.

Baroness Drake: Can I say I do not really agree with that? I am just anxious that the moment does not pass and I lose the opportunity to express a view. People on low incomes do not necessarily spend all their time on low incomes, and some people on low incomes live in households where the household income is not low. One of the principles for reforming the state and the private pension system is that it would produce a system that would work for women. I am concerned that, if the trigger for auto-enrolment continues to rise, and goes up to a figure in excess of £10,000 to reflect where the Government wishes to go on the tax threshold, you are going to exclude about 1.4 million people who would previously be in auto-enrolment, 76% of whom would be women. I think only 34% of women would then be covered by the targeting of the auto-enrolment.

You then begin to stretch whether this design works for women because a) if they are part of a household they should still saving for pension; and b) all the evidence shows that, increasingly, when women get to retirement they will be living on their own-their marriages will not necessarily hold up. Furthermore, if you remove the benefit of auto-enrolment from them when they are having periods of part-time working when they are caring, you break the habit of persistency of saving. If you look at the women’s labour force statistics, there is a high incidence of full-time working, and then you get into the 30s age group and there is a high incidence of part-time working. Then full-time rises again and then part-time rises again when you get caring at the other end. So many women may have periods of full-time working, and if you do not continue auto-enrolment when they are working part-time, even though they may be making modest contributions into the pot, you break the persistency.

I am not wholly disagreeing with what Paul says, but I think you have to think very carefully about whether you introduce a design feature whereby raising that earnings trigger means the private pensions system does not work for women. Certainly, when the Bill was going through the House of Lords, I did oppose that provision in the Bill because I did think it actually started to undermine whether this design would work for women.

Paul Johnson: Can I just add one more consideration around this threshold point? What we recommended and what I believe is happening is that once you go above the threshold you then start being auto-enrolled on income over the difference between the National Insurance threshold and the tax threshold, so you get a decent amount of money going in. One of the things that weighed in our mind was a lot of concern among both employers and fund managers about significant numbers of people who literally put in 50p a week or £1 a week, and the difficulty that would create both for the schemes and also for the credibility of the system.

Q14 Andrew Bingham: Mr Johnson, it is the employers that I am concerned about. Given that we are in uncertain economic times, what is your view on the desirability of adding further burdens and costs to business, particularly small businesses?

Paul Johnson: It is clearly one of the costs of auto-enrolment. In terms of the range of policies that Government could have followed towards pensions, which might be from essentially what we have at the moment to a significantly higher state pension to compulsion into private schemes, the auto-enrolment system is the one that puts the biggest burden on employers. That is central to the design of auto-enrolment; it puts the responsibility on the employer in a way that none of those other types of systems do. I think that is an important background to the judgment made about the role of auto-enrolment. You are right; that is a significant judgment.

In terms of the distribution of that burden across employers and the work that was done for our Commission, that looks pretty small for large employers, but it could be significant, particularly in the first year or two, for the very smallest employers. That particularly relates to how that relationship with The Pensions Regulator may work and the scale of the work that The Pensions Regulator will have to do to make that work. I do not think there is any getting away from the fact that this is a burden on employers, but if you are going to have auto-enrolment it is inevitable. From what we have seen of the way that NEST will work, it will minimise that; we were taken through the systems and it looked as simple and effective as it could be.

The particular issue of microemployers-those with five employees or fewer-is one that we thought about a lot. Of the 1.2 million employers in the country, 800,000 are microemployers. That is something that, if anything, lives with me from doing the report-that number is seared into my mind. That is a very small minority of employees, but a very big majority of employers. Inevitably, if you are getting the employers to do that, the costs for that group will be substantial.

Q15 Andrew Bingham: I speak as a former microemployer. Do you think that there should be an exemption for those employing fewer than five or 10 people?

Paul Johnson: There are two reasons why we did not come down in that direction. The first was that, on the basis of conversations with HMRC1 and others, it appeared practically extraordinarily difficult to put in place something that said, "Once you go above five employees, you’re in," or "Once you go above 10 employees, you’re in; once you’re below, you’re out." In a purely practical sense, tracking who those groups are is very difficult.

Secondly, there were some concerns raised-and it is hard to know how serious these are, but you can see it-that if at five employees you do not have to do this and at six you do, the actual cost of hiring the sixth employee becomes really quite big. That is a potential brake on growth. The other issue was around the purpose of auto-enrolment. We were just talking about where the threshold should sit, and we were quite concerned about having a threshold so low that it might be disadvantageous to a number of people auto-enrolled. Where it came to the status of the employer, if you are going to have auto-enrolment-which, as Jeannie was saying, is aimed across the population-to exclude a couple of million people on the basis of their employer size did not quite fit with the philosophy behind auto-enrolment.

Q16 Brandon Lewis: We are going to have some employers who already have schemes higher than 3% but also have employees who are not in those schemes because they are at different pay scales. What could the Government do to protect against employers in that situation trying to balance out their costs by reducing their upper scheme to have everybody on NEST and reducing that contribution for the other staff, so that they end up no worse off overall as a company?

Baroness Drake: This is the levelling down issue, I think, and whether you can give protections. I would start from the basis that you cannot level down from zero, and when you think that 66% of companies do not make any provision and approximately 30% of workers in the private sector are saving, there is a huge group for whom levelling down is not a debate because they are not saving anyway. The work that the DWP has done suggests that the majority of employers are not going to take the opportunity to say, "The base load is 3%; I am going to drop down to that."

A lot of schemes have low participation rates. People say, "Oh well, 33% or 34% of employers do provide schemes," but schemes can have participation rates as low as 7%, 10% or 20%, so even within a company you can have very high levels of nonparticipation even though the statistics will say they are making a provision. It tends to vary by sector. In terms of levelling down, it is the case that you may get it at the individual level, but all the evidence, and certainly the work done by DWP, is that at the aggregate level you will not get levelling down; you will get an overall increase of some significance in private saving.

In terms of the individual, then I think it all depends on employer behaviour. Employer behaviour will vary by company because some companies will have high levels of participation and simply take the view that this is a very important part of their employment package, and they will not do anything negative. Others will say, "I have a certain participation rate and I know that reflects that my managers join and my nonmanagers do not, so I am just going to run a twotier system. I will have one scheme for certain grades and one scheme for other grades," so you may get protections for some employees coming in by default because employers use two-tiered systems.

For a lot of those people who have contribution rates at a desirable level it will be part of their contract of employment, so presumably normal contract of employment law will kick in. The bottom line is that I do not think the Government can compel employers as to what the contribution rate should be other than the base load, but there is a lot they can do to encourage good practice.

Certainly, the evidence collected by the DWP on this was quite positive. Good employers are going to stay good employers; they have a reason for being good employers and these reforms are not going to change them. It is predominantly good employers that are making good provision. Finance directors may look at it and say, "Gosh, I’m suddenly going to get a 50% increase in the number of people in my company who are saving for pensions." That does not necessarily mean that they will start changing the contract of employment for those that already did, because they will have taken a view that there is a recruitment and retention value, but they might take a view, "Well, what’s the new offer I give for the section of my workforce that traditionally have not participated?"

Q17 Brandon Lewis: Thank you. My second question, which I am actually going to put in two parts, is probably best directed at Paul, because of your review in 2010.

If we have new employees where they have the threemonth waiting period, how big a risk do you think there is of there being huge optout at the end of the three months when they obviously see their pay packet being particularly hit for the first time in a new job, particularly in the current economic climate? There is a potential risk to the whole scheme if that is on too big a scale. That is the first part.

Equally, in terms of that threemonth option before taking in, what impact do you think that will have in the bigger sense? For example, the fifth or sixth biggest employment industry in this country is tourism and there is a huge amount of seasonal employment within that sector. What impact does that three-month option have on the tourism industry, particularly because it is filled mainly by SMEs2 and people who are moving from job to job on a seasonal basis or are unemployed for parts of the year? What continuity is there? Will they ever, effectively, opt-in?

Paul Johnson: Those are, again, some of the big issues that we have to take a balanced view on. Essentially, why did we end up at three months as opposed to day one for auto-enrolment? One reason was because, looking at the statistics, there are quite a lot of jobs that last for a month or two, whether it be over Christmas or over the summer. We were given quite a lot of suggestions that the cost/benefit calculations of the costs of having very large numbers of people in for very short periods of time, both in terms of the administrative burden on the companies and employees involved, and indeed on the pension schemes, would be really quite significant. Within the scheme it obviously allows companies to do this quicker; it is an optional threemonth waiting period. There is a cost of doing things on day one and there is a cost to employers and schemes, and arguably a cost to the credibility of the system if, again, you have very large numbers of people in for very short periods of time.

That will nevertheless clearly mean that those people who are in jobs for less than three months will often not be covered. We looked at the numbers of people moving jobs very frequently, and across people’s lifetimes the amount of time they spend in jobs that last for fewer than three months is quite small. However, there will clearly be groups of individuals for whom that is not true.

The first part of your question was about the risk of people opting out at the point of auto-enrolment when they see their salary fall. The truth is that we do not know the likely scale of that impact. There is not very good evidence on this from other countries. Our guess is that it will not make a significant difference, but I think the Department is going to have to accept that there is a risk there that it will make some difference.

Baroness Drake: Can I comment on those issues as well? I think starting on 1% means there will not be such a drop in income, because you have the tax relief and you may get the tax credit adjustment as well. I personally do have concerns about the waiting period, because anything that undermines turning the power of inertia into a positive will weaken the reform. You have to hold that as a central tenet-auto-enrolment works because you are turning inertia into a positive. When you are looking at making any adjustments to the system always ask what is it doing to that power of inertia? If it interrupts that power of inertia which is a positive in terms of saving, then you are going to weaken the public policy outcomes that you want. Therefore, waiting periods will weaken the power of inertia; there is absolutely no doubt about that.

It also, in my view, disadvantages people in casualised employment. They get a double hit now because there is a waiting period and they are also banned from transferring into NEST. The whole point of NEST-of being able to default your little pot-is if you happen to work in an industry, acting or something, and you regularly have casualised employment, that does not matter. You can still get the benefit because wherever you go for little periods, you capture all your little periods, and if the employer had a different arrangement they need not be bothered with you when you left, because it would all be transferred into NEST. You could sleep at night because it would only have an AMC3 at 0.3% and first-class governance.

That was a brilliant solution-a simple and brilliant solution for people working in casualised employment. Even if employers chose alternative contract routes, when they left it could all just default simply into NEST, and the ban on transfers into NEST is serious in its consequence to everyone, but particularly for those in casualised employment. The combination of the waiting period plus the ban on transfers means that, if you are in casualised employment, public policy is not going to work too well for you.

Paul Johnson: I agree with that point on the transfer issue; it is a very important one.

Q18 Brandon Lewis: I am conscious of time, so I will be very brief. Just as a follow-up to that, playing devil’s advocate to an extent with the three-month issue, one of the issues around the threemonths is if you have people in seasonal employment-you mentioned acting; I am mentioning tourism because in my constituency it is a huge employer, it is very seasonal and can be very short term for hundreds of thousands of people-that in itself would otherwise put a huge cost on to very small employers who rely on seasonal work. It could, in effect, be the difference between make or break economically. Equally, the second part, which I will leave more for Oliver-surely that is an argument for NEST coming out of PAYE4 rather than through employers?

Baroness Drake: I am not an operational person, but I think taking it out of PAYE without the employer interface you could get an operational implode. I think you have to distinguish between waiting periods and the time allowed before you complete the auto-enrolment process; they are not the same thing. Waiting periods are where an employer actively chooses to have that. The intent or the application of that waiting period will be different from allowing an employer a realistic period to complete the process of auto-enrolment.

Q19 Chair: But there is presumably nothing to stop an employer who wants to auto-enrol from day one. It is just that the legislation does not kick in to force them to do it until the three months.

Paul Johnson: That is right. What we are really talking about here is a balance between the costs, particularly to employers in this case, and the potential benefits to the individuals involved. To characterise it rather unfairly, we did think in looking at this scheme that all the weight was put on the individual and none on the cost to employers. This was one area where there was unanimity, in terms of the employers that we were talking about, about the difficulties that might be raised by very short-term engagement in this scheme, particularly some of the retailers, the tourism industries and so on.

We recognised that there is a cost in terms of some people having less time in the scheme than they otherwise would have done, but particularly given where we were with transfers and so on, and particularly given those costs and the importance of the scheme achieving credibility, that is a balance we thought was right to strike. However, reasonable people can and clearly do disagree about where that balance should be.

Q20 Glenda Jackson: On the issue of the startup costs of auto-enrolment for a small employer, what happens if none of his or her employees wish to be in the scheme? We are talking, as you have said, about a major reduction-is it 7%?-in people’s standard of living. Is there a cost for the employer that can be reimbursed? What are the costs for an employer coming into this scheme? Are there any other than saying, "Yes, we’re in"?

Paul Johnson: Yes, initially they do have to make it clear to The Pensions Regulator that they have a scheme available, which for a very small employer you would expect to be NEST, and there is obviously the time put in to understanding what that is and making it available to their employees. There are estimates of the number of days of effort that would be required.

Glenda Jackson: I am asking you the question in money terms. Time is money.

Paul Johnson: It can be. There are some numbers in here that are calculated precisely that way. So even if none of your employees join, there is still a cost to you in terms of making the scheme available, interacting with the regulator, finding out what NEST is and so on. It is not colossal, but it is a day or two of someone’s time.

Glenda Jackson: The point I am making is they cannot claim that back from anybody. But presumably that stays, so when employees decide, "Yes, I actually do want to be part of that," that is already covered.

Chair: Oliver has some questions you are all desperate to answer.

Q21 Oliver Heald: I would perhaps start with Mr PittWatson. Of course, the reason why more than half the population do not save properly for their retirement is partly because they do not earn very much money, they are intermittent or casual workers, or they are in a small business-I think fewer than 20% of small businesses offer a pension. The idea with NEST was that this would be the default provision and that it should be suitable. These restrictions, first of all, on transfers: Baroness Drake has made it clear how difficult it is if you have an intermittent worker with lots of little pots not to be able to transfer it all into NEST, which is the obvious thing to do, which seems a major restriction. Then the cap on contributions at £3,600, which is to stay the same until 2017, is a restriction as well.

I am just thinking of a small business. Say you are a small business with 10 or fewer employees: you have one person who earns £50,000 to £55,000; you have somebody on £30,000; you have a couple of people who want to do a transfer; and the rest earn less than £20,000. This is the very sort of business that NEST is designed for and yet there are these clunky barriers to using it. At the same time, here we are putting taxpayers’ money behind the scheme and saying, "This is the default provider." If we did not have the contribution cap, of course, there would be more money in the scheme and we might not need so much taxpayer money. I am interested in your views on this, Mr PittWatson.

David Pitt-Watson: If NEST were not to have a contributions cap, it would not need so much taxpayers’ money. As we understand it, it would need £100 million less taxpayers’ money if you were to eliminate that contribution cap. I think the questions you are asking are very fundamental and they link back to where Dame Anne started off the questioning, which was about how much pension people are going to get by saving. The design of a pension system makes a huge difference to the outcome because of the way that charges ramp up over time.

I will take a very simplified example, but I am happy to give you numerical examples that are more complicated if you would like. Let’s take a very simplified example that we have two 25-year-olds who both start saving at the same time. One pays no charges and the other one pays a 1% charge. The person who paid no charges will have a 33% higher pension than the one who paid nothing. I am using the example of zero charges because Jeannie told us that this scheme was originally designed to have an 8% net of all charges. If somebody takes 2% per year over the 60-year life of a pension, half the money will disappear in fees.

We then come to say, "What is it we are going to present to employers and employees with auto-enrolment?" If they go to NEST it is designed as a lowcost scheme. However to be attractive, it needs to be a lowcost scheme that works for employers, and there are a number of restrictions that we have put on it that really hamper what it is that NEST can do, and make it less attractive. Worse than that and a more acute problem is that in the past we have had restrictions on workplace pensions and regulations to ensure that people are not overcharged or inappropriately invested. A workplace pension is a stakeholder pension and for the first 10 years you cannot charge more than 1.5%, and thereafter you cannot charge more than 1%.

The proposal as it stands right now with auto-enrolment and NEST, which by the way I fully support-I think it is extraordinarily important that we push this forward-is one that is proposing to remove all those consumer protections. In so doing, the risk of people thinking they have a good pension scheme, like a NEST scheme that is low cost and will give you a decent pension, to people getting a bad deal-or rather their employers auto-enrolling them into something that will not give them a decent pension-is very high indeed.

Sorry; I have given a very long answer to your question, but it would seem to me that there are two things that we do need to pay attention to. One is that anyone who is competing with NEST is offering broadly the same terms as NEST. Second, if it were me, I would not restrict NEST, not least because as a good Aberdonian, I do not see why the taxpayer should be paying £100 million-plus for a worse service from NEST than would be possible if those restrictions were withdrawn.

Q22 Oliver Heald: Let me just challenge you as some in the industry would, because, of course, you probably know I basically agree with you. Many people will say, "Look, this is a statebacked provider competing with the private sector. How could it be right that there is even any state backing?" Of course, that is almost the opposite of what you are saying.

David Pitt-Watson: Because what NEST is doing is being the default provider. Nobody is out there in the City saying, "I’m more than happy to take the business at low cost from every fish and chip shop in Britain." That is what NEST is doing and that is why we are willing, it seems to me, to give it a loan, actually, rather than a subsidy. It is loan money that is going to NEST. It seems to me that is a service in the general economic interest.

In Britain, I think we have the second lowest replacement rate by state pensions of the final salary of the retiree, of any country in the whole OECD5. Our state pension provision is really minimalist. That is why we need to promote private pension savings. By the way, I think that auto enrolment should be available to poor people as well as to wealthy people, but certainly we do need something that is going to add to the state pension. It seems to me clearly in the general economic interest that people have a low-cost, effective route for their savings. NEST and auto-enrolment provide that and they allow the optout for people who decide they do not want to save. That is good, but the architecture of the rest of the system is very illdesigned to provide what Baroness Drake was saying was the objective of the reform, which was a lowcost system that is run in savers’ interests.

Q23 Oliver Heald: Another thing that is said, Mr PittWatson, is that, "You would never get it through state aid rules if you didn’t have those restrictions because you’re making an unfair advantage in the market place." What would you say to that?

David Pitt-Watson: The lawyers that we have working on the RSA project do not understand that objection at all. They say that, if it is a service for general economic interest, as long as it does not distort competition so as to be against the public interest it is not affected by state aid rules. State aid rules, in any case, are designed for things that affect trade between member states and, of course, this is a purely domestic UK matter that we are talking about. I don’t, and I think our lawyers don’t, understand that objection.

Q24 Oliver Heald: I don’t know whether Baroness Drake or Mr Johnson would want to come in on this restrictions issue.

Paul Johnson: I broadly agree with what David has said. The restriction on the amount that you can put in has three consequences: one, it adds complexity; secondly, it adds cost; and thirdly it sends out a very odd message to the populace that that is as much as you would ever possibly need to save for a pension, which is clearly not the case.

Oliver Heald: Yes, and there are some inflation upside risks at the moment.

Paul Johnson: Yes.

Baroness Drake: I agree with the three headings. It adds cost and complexity and disadvantages the employee in terms of what you are trying to achieve for them. On state backing and state aid, there is no state backing on the return on the fund, so there is no "if you put it into NEST, you are guaranteed to get X". This is not National Savings, so there is no state backing of the return. The custodial arrangements of the monies are not with the state. The state backing comes in a loan to create NEST, which will be repaid at proper interest rates.

Where the state aid element comes in, there is a public service obligation that NEST cannot turn any business away. A contract provider can say, "I don’t want to provide to you," and it will. A contract provider will go for those parts of the market it wants to go for to get a return and to lower its costs. NEST cannot. Any employer who knocks at its door, even those that are just not cost-effective to service, has to be provided for. It is on that narrow issue of the public service obligation.

The primary driver for NEST is if you are going to auto-enrol people and compel employers to contribute, you have to deal, as we saw it, with a market failure-supply side failure; the market cannot provide to a significant chunk of the market, either at the cost and so the charges levelled act as a disincentive to save. Also, there are governance issues here, such as how you manage these people’s savings over their lifetime. State backing or state aid gets a bit muddled, so I was trying to strip it back.

David Pitt-Watson: I would say, just in conclusion, that there are two things here. One is the restrictions on NEST, which I think we all agree we would like to see removed. The other one, which really is an acute issue, is the failure to regulate the rest of the industry. "Which", the consumers’ association has said "responsibility for ensuring pension charges are low in workplace personal pensions is falling through a massive black hole".

Robert Peston has said that the: "scope for misselling is enormous". This is a real and present problem, so that should be the first priority. If you sort that one out, in a way it helps you with the second one, because at least you know, if there is a private provider, that they are giving at least as good terms as NEST. But it seems to me very difficult to justify why you would wish any restriction on NEST. You would want it to be competing hard and doing the best it could to make sure that the private sector did the same.

Q25 Teresa Pearce: Baroness Drake, just in what has been said there it is quite clear that the original idea for NEST was to solve a problem, but in the negotiations between the Government and other vested interests-large, small, micro-employers, the industry-there have been a number of compromises. Would you say, could you say or do you think that those compromises are in the best interests of the employees who would not have been around that table negotiating?

Baroness Drake: The big difference between the Turner recommendations and what Government decided is that NEST is not a default fund; it is one of many providers, so that was the big policy difference-but that is the policy, so we are where we are. I do have a real concern that there have been some arrangements allowed as a result of the response to various representations that I do not think serve the employee well. I have no hesitation in saying that. One of those is the ban on transfers into NEST. I cannot see any gain for the employee of a ban on transfers into NEST. I cannot see it. I struggle to have any suggestion. It can only support the industry; it cannot support the employee.

Secondly, I am concerned at the way in which short service refunds are being deployed, because short service refunds were a facility introduced under defined benefits, but it is now being utilised by the industry. NEST cannot give short service refunds, so it may be attractive to an employer to maybe go with a contract provider who sets up a trust arrangement that allows a short service refund, which is totally contrary to public policy. Short service refunds can go up to cover two years of employment. We are not just talking a few months here, because the rules are that for the first six months the employer can ask you to go and take your contributions. After six months you can either transfer your savings out or the employer can say, "Well, I will keep my contributions; here’s yours, net of the NI that the Government will take." So it is quite a long period for these short service refunds. That is against the public policy intent and also it is leveraging against NEST, because they cannot give short service refunds.

Those are two particular examples, and I think the third one is that the Secretary of State has power under the 2008 Act to set quality standards on any provider who wants to offer a scheme for auto-enrolment purposes. I know that the Minister, Steve Webb, has indicated he is thinking of increasing the quality standards. At the moment, it is just a requirement to have a default fund and to have the base load of contributions. I would certainly add to that quality standard list-for example, duty of care around the design of default funds, because you can have contract providers and you can have an employee leave the employer scheme, and you have these small pots foundering around that cannot transfer into NEST; you do not know what the charges will be and who is looking after the investment. What is the investment strategy for those? Those are the three areas I would identify.

David Pitt-Watson: I would comment as well-almost all the areas that Jeannie has mentioned are ones that, if they change, would also be to the advantage of the small employer as well as the employee. The changes we are suggesting would create a simple, good and easy system to which you could default. That was what the Pensions Commission wanted. What we have done is to tie NEST’s hands behind its back, and then to deregulate so that nobody knows whether anybody out there is selling them a good pension or a lemon. For a small employer, it would be much better to know, "Look, here is NEST and maybe a few other competitors. We know these are good; we can default to that; we can put in our 8%-3% for the employer, 1% and 4%-and we know that people are provided with what is a decent basic pension at low cost."

That was the original intent and somehow all these restrictions have been put in, and at the same time we have completely derestricted the protections that made sure that people were not being overcharged-and, by the way, that their money was being invested in appropriate things- It isn’t just fee levels where consumer protection is needed. It is also investment practice. As I understand it, there is nobody who would stop a pension provider which decided to invest all their clients’ money in Greek bonds. That is not a sensible outcome of an auto-enrolment policy that has been designed with crossparty support over 10 years, with Jeannie being one of its great architects. That cannot be a sensible outcome and it is a loophole that needs to be closed.

Q26 Glenda Jackson: Essentially, my question has been answered previously. Mr PittWatson, you gave the example of charges, which would be 1%, and then it is astronomical. Essentially, I was going to say to you: why would any employer opt for the extravagant charges? Is it simply that the amount of detail that is furnished to any of us when we are looking at pensions is indecipherable nine times out of 10? It is simply impossible to read all the small print, so is that part and parcel of what you would regard as beginning to reregulate the pensions industry?

David Pitt-Watson: I think it is just setting sensible rules. Even if we kept the regulation that is there today, that would be a big advance on what we are doing, because we are planning to throw the regulation out. That is the problem. Yes, it is because it is quite complicated to know what it is that you are paying for. It is what the economists would call a situation of asymmetric information, where the person who is selling you the pension knows more than you do. That is why you get so many misspelling scandals in financial markets. It is why you have endowments misselling and so on and so forth. So, for a market like this to work and work well, it needs a degree of regulation. All the studies that have been done on this market that have tried to get any quantitative sense of what the current costs are for small employers of pensions like the NEST pension suggest a) that they are extremely expensive and b) that employers do not really know how much they are paying.

Q27 Glenda Jackson: I have been quite scathing about the pensions industry, and Dame Anne said earlier they are now interested in this market. Are they going to change their ways because NEST is offering them serious competition in this area? Or do they just see it as an easy picking?

David Pitt-Watson: I am sure some will try to do the right thing, but if we abandon regulation there will be an awful lot of people-some good, some not so good-who will do the wrong thing. If they do do the wrong thing, I think two things will happen. One is that a really good system, a really good policy will be introduced and you will have headline after headline of things that have been missold. Employers will say, "My goodness, it is a jungle out there; we should withdraw from this."

The other thing is that there will be pensions that are costly and inappropriate and for years, we will never know, as with endowments; where it took years and years and years before anybody ever discovered that was a problem. We just need to get back to what Jeannie said the pension commission wanted; which was, "We have NEST, and if you go to NEST that is a sensible default option." Unfortunately, due to the four key restrictions that have been put on NEST, including the way they charge, if an employer goes to NEST it is difficult for NEST to comprehensively offer them the service they want.

Paul Johnson: Could I add something just by way of clarification? We have been talking about two things here in terms of restrictions, regulations and so on; I think they are very different. The set we have just been talking about, which is about restrictions on NEST, ensuring charges are regulated, transfers and all that kind of thing, seem to be creating problems for the whole system. Getting rid of them is not putting any burden on employers-indeed, maybe the reverse. The other set of things we have been taking about are about burdens for employers and how that relates to the tradeoff with employees. I think it is just worth being clear that one set of those things, I think we all agreed, is almost a nobrainer-it needs to be sorted out. We may get different views, but with the other set there is going to be more of a trade off.

Q28 Harriett Baldwin: You have all spoken very eloquently about charges, and I just wanted to explore another area a bit further. Another point at which providers can perhaps earn excess profits is when the pot purchases an annuity. At the moment, we rely on good will to explain to people who are purchasing an annuity that they ought to be shopping around for the best possible rate. Do any of you have any comments on that?

Baroness Drake: Again, looking at NEST, one of its virtues, particularly for low to moderate-income earners, is that NEST, in terms of the thought leadership as to how it manages people through their saving through lifetime, has given a lot of thought to handling the annuity stage, and how you help people exercise their choice. I cannot do it justice here; I can merely commend the work that NEST has done. It is worth reading because it is a good model of assisting people making choices and identifying what is available in the marketplace in relation to them. I would give NEST a tick because I think that is fine; if you are in NEST there is a lot of work being done to help people.

This is an issue for the Department. An ongoing policy consideration generally is how you assist people getting access to annuities that are appropriate to them. The open market option has not really worked too well because, again, it requires a degree of activity on the part of the person buying the annuity, and we know inertia always sets in. There is scope for doing work through that. It is not strictly an auto-enrolment issue; it is a standing issue that would be there anyway, with or without auto-enrolment. There need to be more efficient ways of helping people into the annuity market.

The third area, which is probably much more Paul’s area, is that the Government needs to think about what kind of instruments would support a good annuity market going forward, given the large numbers of people who would be going to the markets seeking annuity. At a macro level, there is an area to look at here as to the ways in which the Government could support the industry.

David Pitt-Watson: I agree with all that, and I think there are some really big and interesting questions about pension design. If you take my 25-year-old again and you compared a 25-year-old Briton with a 25-year-old Dutch person, both saving an equal amount of money in real terms until they are 65, retiring on the same day and with the same life expectancy, you would expect they would get the same pension, but actually the Dutch person would have a 50% higher pension than the British person. We have a very inefficient pension system in respect of which NEST and auto-enrolment are a very strong step in the right direction. Part of that expense of the UK system has to do with annuitisation.

Another thing I would say is to be careful about the idea that "education will solve this problem". As I have been writing about these issues over the past three or four years, I have gone to several conferences of pensions experts, most of whom come and tell me how they have managed to be sold the wrong pension. These are people who are really quite knowledgeable. I have been sold an endowment that was quite inappropriate and I am supposed to be good at this stuff. You need to have a system that nudges people in the right direction.

Jeannie started off by telling us we need a lowcost on a system that is run in people’s interest. We started this whole RSA work with a citizens’ jury where we asked people, "What would you like to see from the financial system?". They just said, "I want to be able to give my money away and trust the right thing happens with it." What we need to have is a system where there are defaults and there are nudges that will do the right thing for the ordinary saver. In that, NEST and auto-enrolment are, I think, moving in exactly the right direction.

Q29 Harriett Baldwin: Can I just ask about the investment strategy of NEST? We were told when we visited that for young investors, such as 22-year-olds, it would actually be invested in quite a low-risk portfolio because the behavioural implications of someone seeing a drop in the value of their portfolio early in life were very worrying. All investment theories suggest that when you are young you should be very heavily invested in high-risk investments. Would you like to express a view on that?

David Pitt-Watson: I think there is a tension between theory and practice thing here, and I think it is a very interesting choice that NEST have decided to make in that, because, as you say, traditional investment theory would say you take a bigger risk in the early stage of a pension investment. NEST are saying, "But if people see that risk on the downside, they will withdraw." There would be ways in design where you can get over that-for example, if we all invested collectively. But that is not on the table right now, so I think NEST probably has done its research on this, and I wouldn’t challenge them on that policy.

Baroness Drake: The rationale for this, in public policy terms, is that you want to get people not only saving but to persist with saving, because saving for just three years is not sufficient. You have to design something that gets them in and gets them staying in for about 30 years. What the research that NEST and its predecessor undertook showed was that low to moderate-income earners were very sensitive to absolute loss but did not understand relative loss. If they started in January with £200 and they put money in over the year, and they got to December and there was £150, they thought "What am I doing here? I don’t have very much." They were very sensitive to absolute loss.

Therefore, when you are designing an investment strategy, you have to balance a reasonable risk/return philosophy with achieving persistency of savings. When you are concentrating on that persistency of savings, what it also showed was that young people in particular were very sensitive to absolute loss, and we can all easily speculate why. When you are investing, at the beginning you do not have a lot of money in, so do you have to put it all in equities-it is only a little bit of money. The bigger thing is, if you see a loss in that first year or so, it could trigger you into nonpersistency. NEST were seeking to balance achieving persistency-not saying, "Equities are out," but managing persistency against risk/return profile.

Q30 Harriett Baldwin: I totally appreciate what is intended. It is just that the risk in a defined contribution scheme is people remain invested in the low return options, which gives a much higher probability that, like Mr PittWatson was saying, people are disappointed with their retirement incomes.

Baroness Drake: This comes back to the governance issue that, if all providers can come in and provide a scheme under auto-enrolment subject to meeting the quality standards, and it says one of those is you have to have a default investment fund, then in my view there should be some quality standards around what is expected. If you are in a trust-based scheme, The Pension Regulator is working away telling you as a trustee, which I am, what you have to think about and do in order to produce a good quality default-it is not telling you what it should be; it should tell you what to think about.

There is a deficit on the contract provision side and it is even worse when somebody has left their employer. Maybe if there is an employer engaged there is some thought on it. But when you have left your employer, you are not staying in your employer scheme and you are just defaulting to some other provision in that contract provider-who is looking after your investment interest there? There is a governance gap and that is why I was saying that the Secretary of State has the power to set the standards under the Act. They are being jolly well set for trustees; I think, if I may presume, that Steve Webb should take the opportunity to set some standards around governance in this area.

Chair: I am going to draw things to a close. We will lose the rest of the Committee because Prime Minister’s Questions are on in 10 minutes, and the House is sitting. I had another question, but we do not have time for that. Thank you very much for coming along this morning. It was lively and interesting, and I think it set the tone for the rest of our inquiry. Can I thank you very much for your contributions.

Baroness Drake: Thank you for the opportunity to be before your panel. I have enjoyed the discussion.