HC1494 Work & Pensions CommitteeWritten evidence submitted by the Investment Management Association (IMA)

1. The IMA is pleased to have the opportunity to contribute to this inquiry by the Work and Pension Select Committee.1 In various capacities, IMA member firms have a significant interest in the future of pension provision. They manage assets for the full range of pension schemes and funds operating both in the UK and internationally, including defined benefit (DB) and defined contribution (DC) schemes and national pension reserve funds. Some IMA members also have specific pension company subsidiaries operating bundled (ie administration and investment platform) DC schemes domestically and abroad.

Summary

2. The IMA is very supportive of both automatic enrolment and the creation of NEST and has worked extensively with both the Department of Work and Pensions (DWP) and NEST in a range of consultative processes since the publication of the Pension Commission’s Second Report in 2005. However, as with any policy initiative of this scale, there are a number of risks and issues that need to be addressed.

3. With respect to communication, there are three central challenges: the length of the automatic enrolment process; an unsupportive wider environment in terms of attitudes to pensions; and the timing of the changes in relation to other reforms.

4. It is clear that employees will need significant support at a number of levels: whether to opt-out, how much to contribute and the provision of a good default investment option.

5. Given that automatic enrolment will encompass both contract-based and trust-based schemes, one of the key regulatory issues is the existence of two regulators overseeing DC pensions. It would be appropriate to consider options to rationalise this situation.

6. The role of NEST is clearly critical in reaching the target market for these reforms. However, NEST should not become a dominant DC savings vehicle provider and we support the constraints in place to help prevent this.

7. While we believe automatic enrolment should improve pension participation levels in the UK, one should be careful to acknowledge that success is not guaranteed and inertia-based policy has limitations. This is particularly true with respect to the retirement income market.

DWP’s communication strategy and provision of advice and support to employers and employees

8. We believe that automatic enrolment will have a positive impact upon pension saving and scheme membership (see also paragraphs 17–18 below). However, the communication challenges facing the DWP are considerable:

A marathon not a sprint. Automatic enrolment is not a synchronous policy event such as a change to tax reliefs or an uprating of state pension benefits. The length of the automatic enrolment process (2012–16) means that for many workers the 2012 reforms will be an abstract concept. It may not be clear to them when and under what terms and conditions they will be automatically enrolled into a pension scheme. For employers, however, the staging process will allow time for medium and smaller-sized firms to prepare for their new duties.

Unsupportive broader climate. There is evidence of a lack of confidence about likely pension outcomes, which may incline some within the target market to scepticism about the value of pension saving, even at the low initial levels envisaged under the phase-in programme.2 The current economic conjuncture, which has already seen cuts in the real income of many employees, may further reinforce this. The key to success may lie in being able to communicate successfully the advantage of what is effectively an employer and tax relief match for the individual contribution.

Timing of wider changes. While we welcome the proposals to simplify the state pension, and establish a clear base for voluntary private savings, this message needs to be disseminated early. One of the biggest threats to the policy of automatic enrolment are the claims from some quarters that loss of benefits will mean it will not “pay to save”. While such claims were always highly questionable for most people, there is no doubt they have had an impact on perceptions. The Government’s proposals on a single state pension will help, although the Dilnot Commission recommendations and the timing of potential changes to long-term care funding still have the potential somewhat to muddy the message.

9. With respect to the provision of advice and support to employers and employees, there are two distinct sets of issues. The first primarily concerns employer choice of provider and associated administrative responsibilities (automatic enrolment of employees, payroll deduction etc). Here, we do not have detailed views other than to support the provisions under the Retail Distribution Review which will require clarity for employees as to any impact on charges resulting from the employer’s use of an adviser (consultancy charging model).

10. The second set of issues mainly encompass the employee opt-out decision, contribution levels and investment choice. Policy needs to proceed on the assumption that many employers will remain wholly disengaged other than fulfilling statutory automatic enrolment requirements. Other venues and sources of information will therefore need to be available for employees:

Employee opt-out. For some employees—for example, those with very low disposable income and/or high levels of debt—it may be appropriate to opt-out, at least until circumstances change (automatic re-enrolment will capture this). There need to be mechanisms to help employees make this decision. It is likely that there will be no single solution, but rather a combination of approaches and agencies (eg Money Advice Service, Citizens Advice Bureau).

Contribution levels. It is broadly accepted that, for many people, 8% of gross banded earnings is a contribution level that is likely to deliver very inadequate outcomes relative to expectations. However, this level of contribution is only a pragmatic starting point. One element of the communications challenge, both initially and over time, will be to ensure that employees understand that the statutory minimum is not a form of tacit advice about adequacy. We are cautious about calls to review the 8% minimum between now and 2017. While the roll-out period is slower than might be optimal, there is a need for a gradualist approach that builds both consumer and employer confidence, given the implications for both payroll costs and individuals’ net income.

Investment choice. All experience internationally from DC schemes suggests that the vast majority (80–90%) of members do not exercise an active investment choice. Instead they use a default strategy. This is broadly true regardless of the scheme demographic. One of the implications for employee support is therefore that the pensions industry will have to intensify efforts to develop default strategies that deliver good outcomes (ie. outcomes that meet the reasonable expectations of an individual given a particular level of contribution). Here, there is a significant tension likely to emerge between communication and investment. Providing individuals with the ideal scenario of high returns without some level of risk is not possible. The question then becomes whether it is possible to communicate better to assuage concerns that might arise during the accumulation phase, or whether it is necessary to adopt an investment strategy that itself limits the possibility for such concerns to arise (ie low volatility or guaranteed funds). There are significant trade-offs here that need to be assessed by scheme decision-makers: eg protecting against extreme events may limit overall returns through a combination of higher costs and/or different underlying asset class exposure.

Arrangements for phasing and staging the introduction of auto-enrolment

11. The challenge of automatically enrolling millions of employees into the National Employment Savings Trust (NEST) and other schemes resulted in the conclusion by NEST and the authorities that a long staging process was necessary. The risks created by teething difficulties in a rapid enrolment process were felt to outweigh the communication and planning risks that will inevitably arise between 2012 and 2016. As we point out in our answers above, there is no riskless route to success and many millions of workers may experience a relatively long period without clarity as to their pension arrangements.

Role of the Pensions Regulator

12. The regulatory environment for UK pensions is complicated by the co-existence of two regulators overseeing pensions provision - The Pensions Regulator and the Financial Services Authority (FSA). While the two organisations have signed memoranda of understanding, their relative roles are not totally clear. It would be helpful to consider further what steps may be taken to rationalise this However, given that a contact-based pension is, in many ways, only just another form of tax wrapper for long-term investment, it is difficult to argue that a wholly separate regulatory regime from that of an ISA (Individual Savings Account), for example, is merited.

NEST’s potential market share and possible effects on other providers

13. There are groups of employees and types of firm which it is challenging for the pensions industry to serve in a commercially viable manner. A number of reasons for this can be identified, primarily firm size, level of employer engagement, earnings levels and the likely persistency characteristics of scheme members. In this context, the creation of NEST will help the Government to implement the automatic enrolment reforms. Its governance structures will also service to protect the interests of scheme members.3

14. The challenge for Government has been how to introduce NEST without distorting the wider private savings market, which serves millions of customers across the UK. It would be a negative outcome for Government, industry and consumers if NEST turned into a dominant or quasi-monopoly pension provider. For now, a number of constraints are in place to prevent such an outcome. There will be no transfers in or out, and an annual limit on total contributions. The IMA has supported both measures, and believe that these should be maintained until the impact of the 2012 reforms becomes clear. As the Johnson review pointed out, there is a high degree of uncertainty about behaviours arising from the introduction of automatic enrolment and the default fund.

15. With respect to whether automatic enrolment is likely to attract new providers and encourage new models of provision, we believe that higher pension participation and savings levels should result in greater competition and innovation. However, some of that innovation will also be driven by changing needs. Splitting pension saving into separate accumulation and decumulation phases is not optimal in a number of respects. Helped in part by the greater flexibility afforded by the recent reforms to annuity regulation, we believe the industry is likely to intensify its efforts to develop solutions that meet the evolving and often very different requirements of retirees.

NEST’s investment strategy

16. The UK and international DC markets are characterised by strong levels of debate about appropriate approaches to default fund design. This debate is in part driven by perceptions of varying needs in different parts of the market. It is also driven, inevitably, by different opinions about the investment process itself. NEST has taken the view that encouraging persistency among its target membership group is a key priority and has therefore chosen an innovative default approach that includes a “foundation” phase with the aim of preserving member contributions. Other providers may mimic such an approach or choose to compete against it on the basis that they can offer other strategies that suit their target membership.

The extent to which auto-enrolment is likely to achieve the desired behavioural change in terms of encouraging people to make provision for retirement

17. The UK automatic enrolment initiative will be the largest ever undertaken and all the available evidence internationally suggests that automatic enrolment is a helpful mechanism for improving participation rates. We support its introduction, offering a way to steer individuals in a direction desired by decision-makers without full compulsion: so-called “libertarian paternalism”.4

18. However, there are two important caveats that we would draw to the attention of the Select Committee. The first is that context matters and that care should be taken about generalising from international experience.

New Zealand is the only other country to have attempted a nationwide roll-out, and differs in two key respects. Automatic enrolment applies only to new employees and has a range of incentives attached, including early withdrawal provisions. While automatic enrolment has generally been hailed as a success, opt-out rates were initially high (50% on a monthly basis) and have taken some time to fall (to below 20% by 2010).5 We should be cautious in the UK about rushing to premature judgement in 2012–13.

Where automatic enrolment has been widely used (and studied) at firm level in the US, it was implemented on a voluntary not a legislative basis and therefore implies a reasonably engaged attitude on the part of employers. This cannot be assumed for the UK.

19. The second caveat is that inertia-based consumer behaviour has limitations. We believe that it is possible, even desirable, to improve long-term savings levels by using behavioural strategies such as automatic enrolment. This could even be complemented over time by automatic escalation, a technique successfully used in the US to link increases in contribution levels to pay increases. However, more will be needed to create sustainable changes in behaviour and to empower individuals with respect to the difficult choices they will face in making retirement decisions. In particular, the decumulation decision—ie how to take a retirement income—is critical and cannot easily be engineered through default (ie inertia-based) options.

25 August 2011