Cheaper pensions?

Summary

The Government wishes to ensure that the market for defined contribution workplace pension schemes provides good value, given the number of people expected to be automatically enrolled into them between 2012 and 2017, and so is considering three options for capping charges in defined contribution workplace pension schemes:

• a cap of 1% of funds under management,
• a cap of 0.75% of funds under management or
• a two-tier “comply or explain” cap, under which a cap of 0.75% of funds under management would apply for all default funds in DC qualifying schemes but a higher cap of 1% would be available to employers who could justify the higher charge to the Pensions Regulator.

Background

Following the Office of Fair Trading’s report on the market for defined contribution workplace pensions which concluded that, because smaller employers are less likely to be able to negotiate competitive charges for pension arrangements that they set up for their employees, the Department for Work and Pensions has consulted the industry about how to address this issue.

It appears that the very largest employers have been able to negotiate low charging rates for their employees.  For instance, the ABI found charges for individuals in new automatic enrolment schemes to be just 0.52%.  However, this may suggest that providers are setting charges that will result in initial losses, knowing that business from these larger employers will be profitable in the long term; it is unlikely that such deals will be available to smaller employers.

It is expected that the majority of people being automatically enrolled will join a Defined Contribution (DC) scheme – and that the majority of those will go into the default fund.  The DWP’s consultation focusses on this large group therefore, because they are unlikely to make any active choices about their pension saving and may have very little understanding of the charges they will end up paying.

The Government notes that the impact of the charges applied to people’s pensions savings over their lifetime can be significant – for instance, an annual charge of 0.5% might reduce an individual’s fund at retirement by 11%, while an annual charge of 1% might result in a reduction of 20% by retirement. ^[1]

One problem with the automatic enrolment system is that the employer is responsible for choosing the pension arrangement but employee pays the charges.  The Government finds evidence that charges have fallen in recent years, though not for all pension savers – particularly those in schemes set up prior to 2001.  The purpose of this consultation is to determine whether the pensions industry is expected to address the issues identified by the OFT, or whether the Government needs to intervene to protect people from being enrolled into schemes with high charges.

Government intervention

Proposals for intervention include:

• improved disclosure of information about charges to members, employers, trustees and Independent Governance Committees,
• a ban on active member discounts (AMDs) whereby scheme members are moved to an individual personal pension with higher charges when they leave employment and stop making contributions,
• extending the ban on consultancy charges (whereby the costs of advice to the employer on selecting and setting up a scheme for his employees is met by a charge on the employees’ funds) from automatic enrolment schemes to all qualifying defined contribution schemes,
• a ban on adviser commissions, again met by a charge on members’ funds, in qualifying schemes and
• a cap on pension scheme charges for all members (both active and deferred) of default funds in qualifying DC schemes.

The Government acknowledges that improved disclosure on its own is unlikely to solve the problem of high charges.  If employers are motivated mainly by the cost and ease of setting up a pension scheme, information which makes it easier to understand and compare the charges across schemes is unlikely to have a significant impact on their decision.

It is proposed that the charging cap would apply initially for those employers staging from April 2014.  It would then be extended, by April 2015, to all employers who have staged prior to April 2014.  However, given the timescale required to prepare for automatic enrolment, including selection of an appropriate scheme, we consider it unrealistic to expect those employers due to stage in April to review their arrangements at this late stage.

The Government is considering three options for capping charges:

• a cap of 1% of funds under management, reflecting the current stakeholder pension cap,
• a cap of 0.75% of funds under management, reflecting the charging levels already being achieved by many schemes – and the level required to achieve the NAPF’s Pension Quality Mark, or
• a two-tier “comply or explain” cap, under which a cap of 0.75% of funds under management would apply for all default funds in DC qualifying schemes but a higher cap of 1% would be available to employers who could justify the higher charge to the Pensions Regulator.  Regulations could list the acceptable quality features which might justify a higher charge, to enable the Regulator to monitor compliance.

Under each of these capping options, the DWP proposes that employers would need to pass details of their schemes charges, to the Pensions Regulator at the point of scheme registration to ensure compliance. Providers and scheme managers may then be required to provide information to the Regulator on a regular basis.

Comment

While there are, undoubtedly, some older pension arrangements with excessive charges being applied, there is a danger that, if a charging cap is set too low, it will drive all providers to offer only the cheapest of default funds – typically index-tracking equity and bond funds.  Recent innovations – aimed at improving the ultimate outcome for members – include diversified growth funds, to reduce the volatility of returns during the growth phase of membership, and more sophisticated conversion of the growth assets into annuity-matching assets as a member nears retirement.  It would be a retrograde step if costs were reduced only to see investment strategies returning to the most basic, passive strategies that lead to loss of value to members.  There might also be a negative effect on a provider’s willingness to provide additional services such as annuity broking or member communications.