20 million workers will soon be reliant on a defined contribution (DC) pension for all or some of their retirement provision. For many, this will be a first foray into pension saving. Others, a reducing number, will have a defined benefit (DB) legacy pension and a hard core, around five to seven million, will be able to rely on DB as their major pension source. In other words, the retirement expectations of a significant proportion of people are going to be reliant on the success of DC.Worryingly, DC tends not to be as generous as DB. This is for a couple of reasons: generally lower contributions are paid and DC has operated inefficiently. This inefficiency cannot be allowed to continue.
Six levers control whether a DC scheme can produce a good member outcome. The investment, contribution and point of payment decisions, the efficiency and effectiveness of administration systems, the value for money (VFM) of the charges and the adequately protection of scheme assets. All of these need to improve, as explained below.
Investments are complex, arguably the most complex part of the pension process and yet, as with the contribution decision, the investment decision is often made based on the wrong criteria: inputs not outputs.
There is little point trying to educate 20 million people to understand the differences between diversified growth and target date funds. It’s admirable to aim that high, but impractical to believe it can be done, in the short term at least.
Default funds should be designed to please all, be appropriate and have intent. Fiduciaries must understand the risk profile of their members at as granular a level as is possible.
Value for money is probably the most contentious of the controls if only because the government is threatening to cap charges at some point.
VFM is a comparison: costs verses return derived as a consequence. If this is accepted, then it also has to be accepted that a cap on charges is the wrong tool to influence value for money. A cap treats the symptom not the disease.
What really needs fixing is fiduciary responsibility, there needs to be an effective champion for the member in the delivery chain. DC trustees exist but are not commonly effective – the regulators must change this. Independent Governance Committees (IGCs) for contract based schemes, as proposed by the Office of Fair Trading, do not yet exist.
The key test on contributions is that appropriate decisions are made. The evidence they are not is most people contribute too little – we estimate UK DC is only 17 per cent funded.
The contribution decision is usually based on perceived affordability; but as most people don’t know the cost of a pension, their analysis is ill informed. A more informed approach is to focus members on outcomes; how much and when they want a pension and their acceptable margin for error. This will produce a contribution rate. They can then decide whether the rate is affordable or to reset their goals.
There are many flaws in the payment part of the process: the cost and consequent frequent absence of advice, the underuse of enhanced annuities, the inaccessibility and risks of drawdown and the poor value and volatility of annuity costs.
It’s not practical to insist all employers pay for the cost of providing advice but that does not mean that we should accept the status quo. We need a new model for advice and new retirement products that sit somewhere between annuities and draw down. The payment phase is the DC process ripest for innovation.
Although administration has greatly improved recently this shouldn’t lead to complacency. It’s still common to have multi day delays between two ends of a process. DC should be simple: almost instantaneous money movements.
There are various protections that exist at the contribution and payment phases. What is missing is a reliable mechanism during the savings phase.
The Financial Services Compensation Scheme (FSCS) is the principle DC protection. It, however, is fundamentally flawed. There is no guarantee that it will be able or willing to bail out a DC scheme.
This is a problem with only unpalatable solutions: do we accept unreliable protection or do we accept, for example, a PPF style scheme for DC?
The process of improving DC has begun, but the regulators and legislators came to the party rather too late, much remains to be done. As a generation of workers approach retirement and discover that they have too little money saved, they will want to blame someone.