This article was originally commissioned and published in March 2013 for Investment Life & Pensions Moneyfacts publication. In his second instalment addressing Pension Reform,Tom Murray, Head of Product Strategy at Exaxe, explains why bringing the focus back to the individual to prepare for their own future is the key to increasing pension savings.
Last week I reviewed the current position of pension reforms and the whitepaper on state pension reform by the Department of Work & Pensions. I discussed the changes the government is proposing and how these still shied away from bringing the hard truth home to the population; the lifestyle they will have in their retirement will be directly proportional to the amount of money they defer spending while working in order to invest in a post-employment income. This month I want to propose further changes to the system which I believe should be introduced as soon as possible to build upon the strong foundation being laid by the current reform proposals.
The area I believe requires further reform is around the private provision of pension savings, an area that is necessary for anyone who wishes to have a decent level of income in their retirement but which governments are refusing to force the public to acknowledge as necessary. The truth is that left to themselves, the general population will continue to harken back to the days of benevolent paternalism by both government and employers instead of taking responsibility themselves for their own future. These proposals cover changes to the accumulation and decumulation areas and to the financial advice arena in order to ensure that people know they need to save, are provided with easy access to savings products and have access to advice in order to ensure that they make the right choices.
Accumulation
The arrival of auto-enrolment is expanding the amount of private pension provision in the UK. There are however a number of flaws with the system as it is currently laid out.
Some are relatively minor, such as the contribution restrictions forced upon the National Employment Savings Trust (NEST) which are bureaucratic and pointless and just serve to make life complicated for the middle range of employers i.e. low earners should be in NEST, high earners should probably not be in NEST but the restrictions make it difficult for those in the middle to be in it without sacrificing flexibility.
These restrictions are unnecessary and distort the market, two reasons that mean they should be scrapped immediately without requiring any committee of investigation to report.
A bigger issue is the sheer volume of red-tape that is inherent in the complexity of deciding who has to be auto-enrolled and who hasn’t. It appears that politicians, terrified that it would be perceived as a tax hike, decided to avoid the obvious correlation to the tax system and devise a completely separate system that would have employers constantly reviewing their staff in order to decide who they are obliged to enrol and who they aren’t. For larger firms with big HR departments this is fine. For the majority of SMEs, who employ the bulk of the population, this is a major headache and they face hours of work to constantly monitor their staff to ensure that they comply with the law.
And this workload isn’t a one-off either. It has to be done every three years for each employee. For smaller employers with a higher turnover, this could end up in a constant review situation in order to ensure compliance, a relentless nightmare to apply rules that aren’t really necessary in the first place.
The answer to this problem is very straightforward. Grasp the nettle by abandoning the opt-out system and ensure compulsion. This switches the system to be almost identical to the current national insurance system, complete with employer contributions, and will be straightforward to apply as individual circumstances no longer need to be taken into account; if people are working then they are contributing, it’s that simple.
The difference between this and taxation is that the money will be going to the private organisations providing the pension service and therefore cannot disappear into the general government spending in the way that National Insurance (NI) contributions can. Also, unlike tax and NI contributions, the worker would still have a lot of control over the money e.g. amount of contributions above the minimum, investment strategy etc. and regular reports detailing its growth.
A return to the original idea
A bigger and bolder step would be to take a look at the tri-partite approach that is currently taken for granted as being the only way that pensions should be structured. Paper after paper has been produced stating that pensions should be accrued as part of a partnership between the employee, the employer, and the government. It is generally assumed that both the government and the employer have a responsibility to the employee but it is arguable that this infantilises the employee and has led to a situation whereby workers spend what they earn and assume that somebody else is looking after the retirement aspect.
The original 1908 pension act was designed to ensure that people still saved for their own future. We need to return to that approach. What if we were to eliminate the employer contribution and the government contribution altogether? While this would be a radical tactic, it would bring home to users the need for them to save for themselves rather than constantly seeing their retirement income as somebody else’s problem.
Employers role
Does the employer have a role? Yes they do but it is not in terms of contributing so-called ‘Free’ money which does terrible damage to the whole process as it makes people feel they are getting something for nothing, which they are not. This ‘free money’ argument seems to assume that employers will somehow absorb the extra cost of pension contributions. This is unlikely and in countries such as Australia, where employers have been forced to make contributions, the salary levels stagnated until the natural rise in wages caught up with it. This makes perfect sense as labour is generally one of the biggest costs within any organisation and no financial director is going to allow the unit labour cost to rise excessively just to fund long retirements which are non-productive for the company.
Employers are always being told the expense of a defined benefit and the associated risks that go along with it are worth it as it helps to attract and retain high quality employees. This is no longer true. The cost is so enormous – 40 years’ work plus 20 years in retirement - that it has become far too expensive a way to attract talent. As for retention, a pension scheme may retain talent but it also retains the mediocre – those who do their job sufficiently but don’t contribute anything extra to move the firm forward.
From society’s point of view, pensions also restrict the amount of cross-fertilisation going on as middle managers don’t easily jump from company to company as any company they join will be most unlikely to have an open DB scheme like the one they are leaving.
The employers’ real role should be both educational and facilitative. Employers should facilitate the provision of advice, arrange for the circulation of information and organise the collection of contributions direct from the employee’s wages.
Government role
Does the government have a role? Yes they do but it is a role that they are already fulfilling by putting in a floor for pension income paid for through general taxation. Beyond that they have a regulatory role ensuring that pension funds comply with good-practice investment rules and that employers facilitate the administration of pension contributions.
Compulsory pension saving would remove the need for a government contribution which is distorting to society as it transfers money to those who can afford to save from those who can’t or won’t. If all taxpayers are automatically enrolled and not allowed to opt-out, then adding a tax contribution to each individual seems pointless as no incentives are needed. Without having to fund pension tax breaks, the government would be in a position to implement a cut in general taxation which would offset some of the pension cost borne by the individual employee.
By restricting the government to their own role, which is purely to provide the floor below which no citizen will fall, we then have a clearer message to give workers about pension savings. All savings will benefit the individual as there will be no loss of means tested benefits resulting from them. This will make it easier to encourage people to save for their own future.
Decumulation
A change is also required in the way funds are decumulated. The Open Market Option (OMO) needs to be made compulsory so it is not possible for pension funds to make an offering at retirement to the individuals whose pension they were growing. This is because there is an inertia that makes many people who are not financially aware, accept the first offer that they are given.
Each savers funds should be put in escrow until the client informs the company of the decision about the decumulation product they wish it to be transferred to, a decision in which the pension provider should have no input. This may or may not lead to the client purchasing a decumulation product from the provider themselves.
Advice
The Retail Distribution Review has brought about many significant changes to the market. By professionalising it, the standards have been raised but along with standards, the cost of advice has also risen. This is inevitable and so far all attempts to provide a cheaper version have foundered.
This is because the concept of cut-down cheap advice is a completely misguided one. Nobody wants limited advice – either in financial services, medical services or legal services. If you wanted to take a case, you wouldn’t want the lawyer to restrict his advice to a narrow list of possible laws that might be relevant just to reduce the price. Nor would you want an examination by a doctor which just checked a limited number of symptoms and made a diagnosis on that basis.
Neither does anyone want a financial review that focuses only on a limited area of your finances just to keep the cost down. The advice would naturally run the risk of being wrong because all components are not being considered.
In legal cases, if the client needs support then free legal aid is provided. The same is through for medical situations. As the financial advice sector is becoming more professional, we should learn from these approaches and adopt the same solutions.
When are the times when people have the greatest need of financial advice – the equivalent of a legal or medical emergency? Surely the two most important times that are not related to personal choice (e.g. the decision to buy a house) are before you start work and begin earning and before you retire and cease earning.
There is a case for the universal provision of financial advice at both of these times. The before-starting-earning phase could be taken care of as part of the school curriculum. Therefore what we really need to address is the retirement moment.
This can be done by issuing a voucher to all citizens entitling them a set number of hours with an IFA at standard rates. This would allow them to have a full financial health check before making the big decision as to how to provide for their final life stage, which would thus be based on a full assessment of their current provisions and needs.
This proposal might appear expensive but it would be cheaper in the long run to ensure that those who are making a big decision as to how to handle their savings make the right than to leave it to chance and have to re-introduce benefit top-up payments if their income in retirement is insufficient.
Conclusion
If the above reforms were taken on board, we would end up with a far simpler system, more readily understood by individuals. Bringing the focus back to the individual to prepare for their own future is a more reliable way to increase pension savings rather than by trying to encourage and nudge them, particularly as the taxpayer will inevitably end up taking up the slack in the event that this provision is not made.
The provision of advice vouchers would ensure that the key decisions at retirement would not be taken without full provision of expert advice, helping to make sure that the retiree makes the best decision for their own circumstances.
The proposed reforms are drastic and undoubtedly would have significant side-effects which would need to be examined and ameliorated, but it would be worth it to end up with a robust system in which people took responsibility for their own futures and laid plans accordingly.
Twitter: @TomMurrayDublin or @Exaxe
What do you think? Let us know in the comments below!
Part 1 of the Pension Reform article series is also available on our blog: http://www.exaxe.com/moneyfacts-pension-reform-part1
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