House of Commons - Automatic enrolment in workplace pensions and the National Employment Savings Trust

Automatic enrolment in workplace pensions and the National Employment Savings Trust - Work and Pensions Committee Contents

6 The operation of NEST

148. The Government established the National Employment Savings Trust (NEST) to fill a gap in the pensions market by offering a "simple, low cost pension scheme to individuals on low to moderate earnings" and to support "employers that the existing pensions industry does not serve well".[164] The Pensions Commission intended that employers who did not already have an occupational pension scheme would be defaulted into NEST and did not envisage that employers would have the option to enrol into other saving schemes.[165] However, under the current arrangements, employers can either choose NEST or a private provider that has met the qualifying criteria.

149. NEST has a public service obligation to be available to all employers who wish to use the scheme to meet the auto-enrolment requirements. Unlike private providers, NEST must therefore accept businesses that the existing market may consider loss-making or not commercially viable.[166] In recognition of this its set-up costs are funded through a Government loan. NEST's latest annual report indicated that the Government's loan had reached £120 million by April 2011.[167] The repayment date for the loan will depend on a number of factors, including NEST's performance, as discussed later in this chapter.

NEST's influence on the pensions market

150. The introduction of auto-enrolment and the emergence of NEST has already started to influence the behaviour of the private pensions market, in particular in relation to how the industry communicates with employers and the public. In chapter 3 we also noted that the low charges applied by NEST are helping to increase competition and put pressure on private pension providers to lower their charges for workplace pensions. Several providers have entered the auto-enrolment market in the past year, seeking to compete with NEST for large volumes of members by charging low fees.

151. NEST described the steps it has taken to ensure that its scheme is easy to set up and administer for employers, including employers who are not large enough to have their own human resources function. In addition to establishing an employers' advisory panel, NEST has worked with the Federation of Small Businesses, the CBI, the British Chambers of Commerce and other business organisations. NEST has also conducted research into how it can communicate most effectively with members and employers, and the organisation has developed and published a NEST phrasebook of terms which have been tested and are considered appropriate for its audiences.[168] Otto Thoresen from ABI suggested that NEST had already influenced and improved the way that the pensions industry communicates with the public:

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152. Joanne Segars from the NAPF also suggested that NEST's governance structure may help improve the overall governance of DC pension schemes. She said that the industry would need to create the "right type of DC pension scheme" to cater for the new demand under auto-enrolment, and that NEST could be a model for effective governance as these schemes grow in size:

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Restrictions on NEST's operation

153. The Government has placed a number of restrictions on NEST's operation. The NAPF explained that these restrictions had been developed as part of a broad consensus following the reports of the Pensions Commission, reflecting a concern that employers might shift their existing pension schemes into NEST and reduce the level of their pension contributions.[171] The restrictions placed on NEST were also considered by some witnesses, including the ABI and Pensions Management Institute, to be a key part of obtaining European Commission (EC) approval for the Government's state aid to NEST.[172] However, the Minister confirmed that the restrictions on NEST were not integral to the EC's approval.[173]

154. We received a great deal of evidence about the problems that are starting to emerge as a result of two of the restrictions placed on NEST: the cap on contributions and the ban on transfers into NEST.

Cap on contributions to NEST schemes

155. The Government has set a limit on the annual contributions that can be paid into a NEST pension scheme. The limit was set at £3,600 in 2005 terms, subsequently uprated to £4,200 for 2011-12.[174] NEST's written evidence showed that if a scheme operated the minimum 8% contribution, an employee earning over £53,000 would breach the cap.[175] Alison-Jane Bailey from The Pensions Advisory Service suggested that the original rationale for the cap on contributions may have been lost over time:

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156. ABI acknowledged that the contribution limit would prevent employers from using NEST for higher earners, or for medium paid staff where they want to make more generous contributions than 8%. However, it argued that this simply showed that the contribution cap would be effective in keeping NEST focused on its target market of low and moderate earners.[177] This view was echoed by private pension providers including Legal & General, Prudential and Friends Life.[178]

157. However, we also heard from a succession of witnesses that the contribution limit would create complexities for many employers. Consumer Focus highlighted that employers with both lower-paid and higher-earning senior staff could be put off using NEST as they would need a separate scheme for their higher-paid workers.[179] Age UK agreed that the cap might deter employers from using NEST, even for lower-paid employees who would benefit from its low charges and specially designed systems.[180] The TUC was also concerned that the cap would put an unnecessary burden on employers, who would have to offer more than one scheme for a workforce on varying salaries.[181]

158. Witnesses also indicated that the contributions cap would create disadvantages for individuals. Which? believed that the cap would provide a disincentive for some people to save for their pension, and that the Government should not restrict people's ability to save by capping their contributions to NEST schemes.[182] The Pensions Management Institute highlighted that the cap would "frustrate the overall objective of promoting adequate levels of retirement saving" and Mercer noted that the cap would restrict individuals on higher salaries from saving into NEST schemes.[183] Age UK pointed out that employees who wished to make a lump sum additional contributions to their scheme (for example, if they received an inheritance) could not pay this into their NEST scheme if it would exceed the cap.[184] The Federation of Small Businesses also argued that, if employers decided to avoid NEST as a result of the cap on contributions, this could "expose many employees to the possibility that their money is deposited in funds that are not really suitable, thus losing a proportion of savings in higher fee charges".[185]

159. Lawrence Churchill, Chair of NEST, explained that the cap on contributions would be an impediment to women over 40 who were looking to save for an adequate retirement. Women in these circumstances may wish to make higher contributions if they had not contributed to a pension during a career break, but the cap on contributions would prevent them from investing higher amounts.[186]

160. The RSA's Tomorrow's Investor Programme believed that the cap on contributions would hinder NEST's competitiveness and result in it offering less value for money to customers.[187] NEST confirmed that it would experience some administrative difficulties and costs as a result of the cap on contributions. It explained that, in cases where the contribution cap is exceeded, there would be difficulties in identifying which contributions fell within and outside the cap, as well as in subsequent calculations relating to refunds and tax relief. It also noted that, if an individual has more than one employer, it would be costly to administer cases where the cap was breached.[188]

Ban on transfers and the consolidation of small pension pots

161. The UK currently has a significant problem with the number of small "stranded" pension pots accrued by employees in occupational schemes. An individual who changes jobs several times in their working life, possibly joining a new scheme on each occasion, can easily end up with many stranded pots.

162. According to HMRC, 2.4 million people have combined personal and stakeholder pension pots of less than £5,000; and four million have less than £10,000.[189]^{In theory,}employees can transfer small pension pots into other (non-NEST) schemes upon leaving a job. However, the NAPF describes the rules around transfers as "extremely bureaucratic and off-putting". It described the build-up of small pots as a "perennial problem" for its members and indicated that the problem is likely to grow after the introduction of auto-enrolment, with the cost of administering small pots becoming larger than the value of the pots themselves in many cases.[190]

163. ABI highlighted this problem and emphasised how complicated and expensive it can be to try to combine multiple pots. It indicated that it would be beneficial to consumers if their small pots could be transferred into their pension pot in their new employer's scheme.[191]

164. Nevertheless, the Government has decided that pension pots accrued in other schemes cannot be transferred into a NEST scheme, despite the conclusion of the 2010 Johnson review that the restriction on transfers into NEST would exacerbate the problem of employees accumulating numerous small pension pots, particularly for those on low incomes or for people who change jobs frequently.[192]

165. The Pensions Management Institute believed that banning transfers into NEST was a "missed opportunity" to deal with the issue of small pension pots: NEST could have been used as a default vehicle for accepting all pots which fall below a set monetary value.[193] Consumer Focus argued that holders of small pension pots face "on-going detriment" as the management and administration costs are often high compared to the annual growth. It believed that qualifying employees should have the opportunity to transfer existing pension pots into a new employer's qualifying scheme, including NEST.[194]

166. The Government has itself acknowledged the problem created by small pension pots. In December 2011, DWP published a consultation seeking evidence on how the Government could reduce the number of small pension pots and improve the process for transfers between pension schemes. It put forward several solutions, including an automatic transfer system where pension pots could be collected in one or more "aggregator" schemes or could follow people from job to job. The consultation paper asks whether NEST might play an "aggregator role", as it has already been designed to have many of the characteristics that would be needed for an aggregator scheme. For example, the aggregator would need to be willing to accept the small pots.[195] However, NEST could of course only play this aggregator role if the Government lifted the ban on transfers.

State aid

167. We considered the impact that these two restrictions might have on the level of Government financial support needed for NEST. NEST received a loan from the Government to cover the costs of its establishment and the initial years of its operation. NEST receives interest relief on the loan and is therefore not paying a full commercial rate of interest. This form of Government support for NEST is therefore considered as state aid under European Commission rules. The Government's intention is that NEST will repay its loan and become self-financing.

168. NEST's repayment terms for the Government's loan are based on forecasts of its costs and revenues, and these in turn will be based on the NEST scheme's expected size and membership profile.[196] Figures published by the EC indicated that if NEST experiences low volumes of members, state aid could reach £379 million, whereas if membership is high, only £200 million may be required.[197]

169. The Minister explained that it was not possible to provide a precise figure for the impact the restrictions would have on the level of state aid. However, he accepted that the amount of state aid was likely to be greater than it might otherwise have been as a result of the restrictions being in place: "Clearly, there is a benefit to the Exchequer; you lift the constraints on NEST and presumably it gets more contributions and more business, so it can borrow less and repay the loan quicker."[198]

Removing the restrictions on NEST

170. NEST was set up to address an existing market failure which meant that many employers and employees were unable to access low-cost, good quality pension provision. It has been given a public service obligation to accept all employers and employees, including those that private providers may consider to be unprofitable business. If NEST is to deliver on its public service obligation, it needs both to achieve economies of scale and for the Government loan to be available at a non-commercial rate for its set-up costs.

171. The Government has determined that NEST should offer the same charges to all, so that lower-paid people in small businesses can benefit from low charges that might otherwise only be available in larger or better-paid workplaces. To keep NEST focused on its core business it has also been agreed that, unlike other providers, it cannot cross-sell other financial products or operate outside the workplace, in addition to the contribution limit and ban on transfers.

172. As we have highlighted, these final two restrictions risk creating unintended complexity for employers. Many employers wish simply to have one pension scheme for auto-enrolment, and to be able to consolidate previous DC schemes into their new one. However, these restrictions make it impossible for NEST to deliver this to many employers, who may therefore find NEST less attractive. It is likely that this effect will grow as medium-sized and smaller employers are brought into auto-enrolment. For many of them, it will be even more important to be able to use a single scheme for all employees but they will not be able to use NEST as a single provider if they have employees earning more than £53,000[199]. This may force them to choose a scheme with charges higher than those offered by NEST.

173. The unintended consequence of the Government's restrictions might be that the original market failure is not addressed by NEST: many employers will still fail to access its low-cost pension scheme, and many of the employees for whom it was intended will not be reached. Instead they may be offered an alternative scheme with higher charges, and with the accompanying detrimental effects on their retirement income. If this situation is allowed to arise, a further consequence is that NEST may be unable to achieve the scale it needs to deliver the low charges which are at the heart of its public service obligation.

174. Several witnesses, including the CBI, the Investment Management Association and the ABI suggested that the Government should wait until its review of auto-enrolment in 2017 before considering whether to lift the restrictions on NEST.[200] However, if the Government waits until 2017, the overwhelming majority of employers will have already chosen their pension scheme and it will be too late to rectify the situation.

175. We understand the rationale behind the restrictions placed on NEST as part of the sensitive consensus agreed between the Government and the various stakeholders. However, we are very concerned that two restrictions will have unintended consequences: the cap on contributions will add complexity for small and medium businesses, and the ban on transfers will be disruptive for both employers and employees who would like to transfer existing pension pots into NEST. We believe that these restrictions may prevent NEST from addressing the market failure that it was designed to resolve. If state aid rules allow, we therefore recommend that the Government removes the cap on contributions and the ban on transfers as a matter of urgency.

176. The growing problem of small stranded pension pots needs to be urgently addressed, and we warmly welcome the Government's consultation on consolidating small pension pots. NEST would appear to be the obvious choice for the role of aggregating small pots into a single, larger pot. If the Government wishes to pursue this option, it will of course need to remove the ban on transfers of pension funds into NEST.

NEST's investment strategy

177. NEST plans to offer a range of investment options, with a default, the NEST Retirement Date Fund, for members who do not wish to make a choice. NEST believes that the strong likelihood is that the majority of members will invest in the default fund. Members can alternatively choose one of NEST's non-default funds, which include higher risk and lower growth funds.[201]

178. NEST's research showed that its membership would be likely to have median earnings of around £20,000. Members at this income level were considered likely to be less comfortable with investment risk and unlikely to recognise the long-term risks of inflation. NEST's research also suggested that younger members were particularly sensitive to volatility and loss. NEST's default Retirement Date Fund has therefore been designed with these members in mind.[202]

179. The default fund will take on different amounts of risk at different stages in a member's saving "career", assuming that an individual begins saving in their twenties. The Foundation phase pursues a lower risk strategy to reflect the lower appetite for risk and the adverse reaction to volatility and loss amongst people aged 29 and below. During the Growth phase, which will make up the bulk of the pension "career", NEST will seek to maximise the value of the retirement pot. Finally, during the Consolidation phase, money will gradually be taken out of higher risk assets, such as equities, and put into those that are likely to be less volatile. This should reduce the risk that a member's pot will decline suddenly in value just before they retire.[203]

180. Several witnesses suggested that the investment strategy for NEST's default fund was too cautious and might lead to members receiving lower incomes in retirement. The Centre for Retirement Reform and the Building and Civil Engineering Benefit Schemes both described NEST's investment strategy as "ultra conservative". They argued that it was "imperative" to educate members to make individual choices that will help them reach their desired retirement income.[204] Legal & General believed that NEST's approach was "very cautious" and that investment for young employees should be exposed to more risk and return as they will be less affected by volatility over the long term.[205] Friends Life said they understood the rationale for NEST's policy, but they believed that education and guidance was necessary to increase members' understanding of investments.[206] However, NEST reiterated its view that its approach was necessary to address the concerns of its potential customers:

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181. Nevertheless, the experience in the 401(k) marketplace in the United States showed that many investors suffered low returns from a cautious approach to investment. NEST should take account of this in relation to its investment strategy for younger investors with a long investment time horizon.

182. Whilst we understand the views of witnesses who considered NEST's investment strategy to be overly conservative, we believe that NEST's approach has a clearly explained behavioural rationale and will be distinctive in the marketplace. It will help to ensure that savers are not deterred by potential temporary falls in the value of their pension which might lead them to withdraw from their auto-enrolment scheme and exacerbate resistance to retirement saving.

183. However, over the longer term the Government, the pensions industry and NEST must act to increase savers' awareness and understanding around the advantages and disadvantages of investments. We recommend that the Government's communications strategy for auto-enrolment includes a strong focus on improving the public's understanding of effective retirement saving.

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167 National Employment Savings Trust (2011), Annual report and accounts 2010/11 Back

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