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Actuarial Science and Insurance Series: insurance-and-pensions

The pension time bomb

Goverment attempts to help the low paid build up a pension pot could backfire spectacularly, the Cass Pensions Institutes warns. Jill Insley reports.

Millions of private sector employees could end up in poorly performing pension schemes, confounding Government attempts to boost retirement savings and possibly causing the next financial services mis-selling scandal, according to a report by the Pensions Institute at Cass.
Employees of Britain's biggest companies have been automatically enrolled in a pension scheme chosen by their employer since the beginning of October 2012, and over the next 5 ½ years all but the lowest earners will start making contributions.
Minimum contribution levels have been set at 8 per cent of qualifying earnings - 3 per cent from the employer, 4 per cent from the employee and 1 per cent tax relief. The Pensions Minister, Steve Webb, says that up to nine million people, many of whom have never saved towards their own pension, could benefit from this.
But a report sponsored by NOW: Pensions and published by the Pensions Institute warns that some employees could end up missing out if their employer selects the wrong scheme.

Sellers beware
Employers can choose one of the new pension schemes set up specifically for auto-enrolment, or use one of the existing schemes that have been runningsifor those members who don't specify where their money should be invested: between 90 per cent and 97 per cent of members are expected to use this option.
The report, Caveat Venditor (let the seller beware), found that many of the older default funds levy high charges that will greatly reduce the eventual pension for members. It estimates that there is a 100 per cent difference in the pension incomes that members achieve between the lowest- and highest-charging defined contribution funds.
However, employees do not choose the scheme their money is invested in and have no influence over the charges or quality of investment management: this is all handled by their employer. And while the employer may decide to take advice, this is unregulated.
Auto-enrolment rules stipulate that pension schemes cannot force members to make an investment choice, and that no advisor or consultant charge can be deducted from members' funds where only the minimum contribution is paid. At the same time, new rules introduced by the financial services regulator, the FSA, will ban the payment of commission on financial product sales from the beginning of 2013, and have already resulted in a mass exodus of advisors.

Unintended consequences
Dr Debbie Harrison, Senior Visiting Fellow at Cass, co-wrote the report with David Blake, Director of the Pensions Institute and Professor of Pensions Economics at Cass, and Kevin Dowd, Professor of Finance and Economics at Durham University and a Fellow of the Pensions Institute. She says: "The unintended consequence of these two new regimes is an advice gap in the smaller employer market which, unless addressed, is likely to lead to member detriment."
Of the 205,000 defined contribution schemes used in the private sector, only 10,000 have more than 100 members. The other 95 per cent account for only 40 per cent of assets, according to the market analyst Spence Johnson, and are therefore too small to be efficient. These schemes cannot compete with the lower charges of bigger schemes, yet recent research from the National Association of Pensions Funds (NAPF) and the multi-employer scheme provider B&CE revealed that many smaller employers were not even aware of the charges levied on scheme members.
Professor Blake says that employers need clear signposts to find their way to low-cost schemes. Others will have been sold a scheme in the 1990s or early 2000s, with a total charge of 2 to 3 per cent of assets under management, paid by the members out of the funds: this is up to six times the 0.5 per cent or less charged by the new multi-employer schemes.
The higher charges make a huge difference over the longer term: quantitative modelling shows that the retirement incomes of those in the high-charging schemes will be worth only about half the income achieved by members in low-charging schemes after 40 years of membership.

Disingenuous practices
"The danger is that many employers will use their existing (often high-charge) schemes for auto-enrolment. If this happens, millions of members will suffer," says Professor Blake.
In some cases employers would struggle to find out the true level of charges that their scheme provider imposes: the authors of the report encountered "disingenuous practices" in disclosing charges by some providers and advisors.
Even when employees are auto-enrolled into a low-charging scheme, their earlier pension savings will be left in high-charging funds thanks to high exit fees - ranging from 5 per cent to 25 per cent - and cumbersome transfer processes. Employees who opt out of their employer's default fund and choose their own pension scheme will almost certainly miss out on their employer's contribution.
Higher charges do not even mean better investment performance. Dr Harrison says: "While there might be a very small number of specialist fund managers who deliver above-average performance for a limited period, they are unlikely to be managing the assets of employees with lower and median incomes - the target market for auto-enrolment."

Buyers beware
The Pensions Institute's quantitative analysis showed that, in the worst-case scenarios, the highest-risk funds produced about half the retirement income produced by the lowest-risk funds.
The report's authors argue that the philosophy of caveat emptor (let the buyer beware) does not work for auto-enrolment: the onus instead should be on the seller - the scheme provider - to ensure that it delivers the desired returns.
They argue for a quality mark for schemes which meet certain standards for charges, investment of default funds and governance, so employers can identify which schemes are good quality - and shield themselves from future accusations that they did not exercise sufficient due diligence when selecting a scheme.
But the first step must be to clean up and reduce the charges on existing schemes so they can no longer erode people's savings. In October Steve Webb said he was "watching pension charges like a hawk", and that he was concerned about charges in legacy schemes. "I have the power to cap charges and will do so to protect consumers if I need to," he added.

Clear information
The pensions industry, led by the National Association of Pension Funds, has published a joint code setting out a clear, standard way to inform employers about charges. But the Government has yet to take any action against any pension scheme charges, and even the clearest information about costs is unlikely to help those employers who have little more knowledge of pensions than their staff.
Dr Harrison and Professors Blake and Dowd recommend a much tougher line: that any scheme that has high long-term charges compared with those offered by the new trust-based multi-employer schemes should be disqualified for the purposes of auto-enrolment. Failure to do this could be catastrophic for the Government, regulators and, most importantly, pensioners.
Professor Dowd says: "Unless older, high-charging schemes are abolished, their use for auto-enrolment - when up to ten million low to median earners, often with low financial literacy, join defined contribution schemes - will lead to the UK pensions market facing a mis-selling scandal on an unprecedented scale."

Jill Insley is a freelance writer. She can be contacted at jill@insleymedia.com

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