HC1494 Work & Pensions CommitteeWritten evidence submitted by the Royal Society of Arts’ Tomorrow’s Investor Programme

We are pleased to submit evidence on behalf of the RSA, as part of the Tomorrow’s Investor programme. We would like to focus, in particular, on two issues of the issues you raise.

Likely impact of the limitations placed on NEST, including the contributions cap and the ban on transfers.

Whether auto-enrolment is likely to attract new providers and encourage new models of provision.

1. The RSA and Tomorrow’s Investor

The RSA combines thought leadership with social innovation to further human progress. Building on our 250 year history as a beacon for enlightenment values, we undertake influential and varied research projects and host the UK’s most ambitious free lecture series. Our work is supported by 27,000 Fellows, and an international network of influencers and innovators from every field and background.

“Tomorrow’s Investor” is a project now entering its third year, to help design and promote a pension system in Britain which meets the desires of the country’s citizens. It began with a series of “Citizen Juries”, which allowed pension holders to express their opinions on the characteristics they wished to see of the pension system. It has gone on to investigate with experts from UK and around the world how such a system can best be achieved in the UK.

2. Auto-enrolment and NEST

The passage of the Pensions Act, will introduce a new system of auto-enrolled pensions for seven to eight million people who would otherwise have no workplace pension. These are typically people who are of modest income and work for smaller employers. Overall, we endorse this policy. It is the best chance in a generation to provide comprehensive workplace pensions in Britain.

There are improvements which would be possible to the design of NEST, but they would not be possible without significant legal changes. Therefore, in concept, auto-enrolment and NEST are the best practical option for the provision of occupational pensions to those who are not otherwise covered. This is a once-in-a-generation opportunity.

However, we are very concerned that restrictions on the operations of NEST, and the abandonment of regulations which control the operations of private pension providers, will mean that the goals of this policy will not be realised. Indeed the abandonment of consumer protections invites a wave of pension mis-selling.

3. Restrictions on NEST

NEST is central to the auto-enrolment policy, since it ensures that there is a low cost pension provider even for the smallest employer. However, for reasons unrelated to public benefit, NEST has been restricted in its operations, so that its products are more costly, less competitive and offer less customer value that they are capable of doing. These restrictions will mean NEST loses revenue, costing the taxpayer many millions of pounds. After informal discussions with the DWP, we believe these to be in excess of £100 million over the next few years.

There are four key restrictions on NEST’s operations.

(1)A cap has been put on how much money Nest can receive from any individual in any given year.

(2)NEST has been forced to make an up-front charge of 1.8% on all contributions, making it look expensive compared to pensions which charge only on the outstanding balance.

(3)NEST is not allowed to make transfers in or out.

(4)It cannot return money for “short service” employees.

Taken together these restrictions hamper NEST’s competitiveness. For example, consider the effect of capping contributions. Here is how we described it in the RSA report.

The effect [of this limit] can best be understood by using an analogy. Consider a town which does not have adequate grocery shops. This is a problem for everyone, but particularly for poorer people. So the council decides it will open a new shop, which sells high quality low-cost produce. But it also restricts the amount anyone can spend in the shop. So if you have a big demand for groceries, you need to go shopping twice: once to the new store, once to another. Further, as the grocery manager doubtless points out to council officials, it is those who spend the most who help cover the costs of the grocery store. By restricting the amount people can spend, the costs and effectiveness of the new store will be undermined; its revenue will be lower, and hence its profitability reduced. We believe that is precisely the effect the limit will have on personal accounts.1

The reason for restricting NEST was to ensure that a subsidised government body offering modest pensions, did not undermine better pension provision provided through the market. We would suggest that a better solution would be to allow NEST to compete with others who were willing to offer good pension provision, subject to rigorous standards. (In our previous publications we laid out the standards which would be expected of a provider who wished to offer pensions which met the national standard). Indeed, this position is very close to the one taken by the National Association of Pension Funds, and is therefore one on which it should be possible for the Government to achieve consensus. There may be some individual critics from the industry but, given how poorly pensions are currently provided, we think that their arguments will not be difficult to counter.

Similar considerations apply to the other restrictions which have been placed on NEST.

If NEST is to be offered a subsidy, this should be because it provides a public service; that is, it is willing to provide comprehensive coverage, at modest cost, even to the smallest businesses. However, it can make little sense, in public policy terms, for it to require a taxpayer subsidy because its operations have been intentionally handicapped. Not can we foresee any difficulty with state aid regulation, since NEST provides an important public service.

4. Abandonment of Consumer Protection

But more concerning than the restrictions on NEST, is the abandonment of the consumer protection legislation which regulates the sale and conduct of workplace pensions.

From the time when the new Pensions Act is introduced, there are to be few restrictions on who can establish a pension fund, and accept deposits. There will be no restrictions on how much they can charge, and we can expect that many will be sold pensions where 50% or more of their potential pension disappears in charges. Some of these fees will be hidden from customers.

It is perhaps worth dwelling on the subject of charges. Charges are usually expressed as an “Annual Management Charge” on the outstanding balance. Thus a 1% charge, made every year will absorb about 25% of the possible pension in fees. 2% will absorb 50%. The example below makes the point.

Imagine a wise young person who decides, at the age of 25, that they will save for a pension, so that they can retire at 65 and enjoy a pension for the next 20 years. They set aside £1,000 each year, and raise that sum to cover inflation, which is 3%. They receive a 6% return on their money. That means that, by they age of 65 they will have a pension pot of £248,170. This in turn will create an inflation protected pension of £16,080 for the next 20 years.2

Now imagine that this person has to pay a fee of 1.5% per annum on their savings. Guess how much that will reduce the pension that will be earned. The answer is that it will be reduces to £9,900. In other words, someone who pays no fees gets a 60% higher pension than someone who pays 1.5%, because £16,080 is about 60% more than £9,900.

The best evidence we have about the average charges for small pension funds, such as those most immediately affected by auto-enrolment is that they are already in excess of 1.5%; many charge much more.3

But in addition to the problem with charges, there will be no restrictions on how the money will be invested. And there will be few requirements on the skill or probity of those offering to provide advice to employers on establishing a workplace personal pension.4

5. The Government’s Position

We have raised these questions with the Pensions Minister, but he has declined to act, saying that he has asked the Pension Regulator”, (who has as yet no powers to stop inappropriate selling), to “monitor the market”. If problems are seen to arise he may take powers to reinstate consumer protection, but only after problems become apparent.

This seems to us a peculiar position of intentionally deciding to close the door only after the horse has bolted. If we know what a good pension looks like, (and the National Association of Pension Funds has developed such a standard), then it should be established before, not after legislation is implemented. We note the recent commission on pensions lead by John McFall reached a similar conclusion.

Further, we do not believe that the Pension Regulator itself, believes it has the sort of resource needed to regulate the one million plus companies affected by auto-enrolment.

These issues have been raised in the press, in particular the Daily Telegraph, and, in response, the Government has laid out why it thinks mis-selling will not occur. We believe its position to be out of touch with the evidence about how, based on past experience, the new auto-enrolled pensions are likely to work, particularly since they are targeted at small, unsophisticated employers. And if people are sold poor pensions, this threatens to create a “market for lemons” which will undermine what is otherwise a good policy, one which has been many years in development, and one on which there is broad consensus.

The Government position is defended in the Financial Secretary’s response to a parliamentary question. The letter argues:

(1)That there is little change, either to the regulatory regime or to the nature of pension purchasers envisioned by auto-enrolment.

(2)That trustee structures, or FSA oversight will prevent poor pensions being sold.

(3)That we know what the current cost of pension provision is, and that it is low.

We take issue with all these positions, as will most people who have studied the pensions industry, and the reforms which are contemplated. We would reiterate that the danger is not simply that some people will be sold poor pensions. It is that, if mis-selling comes to light, it will encourage people to withdraw from auto-enrolled pensions. Thus undermining the opportunity to provide funded pensions for most of the population, and indeed undo the very policy which the Government itself is seeking to promote.

Taking each of the Government’s arguments in turn:

(1)Auto enrolment will take place in a very different regulatory environment, without adequate consumer protection. Historically all personal pensions where the purchaser was not given individual advice have been sold with “stakeholder” pension protections. These, (inter alia), limited the charge which could be made and restricted transfer penalties. These protections were introduced to stop the selling of expensive and inappropriate pensions. Under auto-enrolment, these protections will be withdrawn. Further, even in the stakeholder environment, it was the employer who voluntarily set up the pension plan; these were typically large, better motivated and more sophisticated employers. The typical new workforce pension will be involve responding to government legislation, it will be sold to the smallest, least sophisticated employers who have not voluntarily offered pensions in the past. They are therefore more likely to purchase a poor pension for their employees.

(2)Legal Protection: In certain structures trust law can work well; in others it does not provide adequate (or any) protection. However, It is likely that in workplace personal pensions in which millions of consumers will be automatically-enrolled there will be no one with a fiduciary duty to ensure good value for members. Regarding the FSA and charging, while charges may, in theory be disclosed, the evidence suggests that few understand that, over the lifetime of their pension, a 1% charge will reduce the potential pension payout by 25%. A 2% charge will reduce it by c 50%. Furthermore, there are hidden charges, beyond those declared, which even sophisticated purchasers find it difficult to untangle. There are many possibilities for abuse. One is the practice of raising charges on pensions after a worker leaves employment, and the employer has no incentive to ensure good terms for their ex-employees.

(3)Regarding costs, we know of no reliable source to back up the Government’s statement that a majority of defined contribution (DC) pension schemes have charges of less than 1% per annum on the outstanding balance (paob). They also claim default funds typically have charges of 0.4-0.6% (paob). These figures are unreliable and not relevant to the discussion. They have been provided to the DWP by pension providers in qualitative studies, they have not been evidenced, and in any case refer to current large employers, not to those small employers who will typically be affected by auto-enrolment. The most comprehensive attempt to work out pensions costs, amongst smaller funds, such as those to whom auto-enrolment will apply, is a quantitative study for the DWP, which reveals an average cost of 1.53% (paob). This means that, over a pension lifetime, an average saver is losing 40% of their possible pension on fees. Many are losing much more. The study also reveals that existing employers do not understand pension charges. Many for example do not realise that the costs are charged on the outstanding balance, rather than the contribution made. As we noted above, that increases costs by 25 times over the whole lifetime of the pension.

We are not alone in voicing concerns. Which? and the TUC have also raised these questions. They, like us, are fully in favour of auto-enrolment and NEST.

In summary, the view that current consumer protections should be abandoned, is deeply dangerous for the success of pension auto-enrolment. Furthermore, the view that action can be taken if it seems pensions are mis-sold, forgets that if these pensions are found to have been mis-sold, this will result in individuals withdrawing from pension provision. But much of the mis-selling may not come to light, because, as with endowments, it can take many years, if ever, for such mis-selling to become apparent. If we know what constitutes an inappropriate pension, this should be regulated against before it is sold, not after the mischief has taken place.

6. Solutions

We believe the solution is clear. The Government should ensure similar consumer protection applies to auto-enrolled as to current workplace pensions. This is a matter of great importance.

In addition, the Government should lift the restrictions on NEST. It should not delay in doing so. Firms rarely switch pension provider. We cannot rely on the lifting of restrictions in the future to ensure that the benefits of NEST can be enjoyed by all who would benefit from them.

19 August 2011