March 2011

By Nick Martindale

Nick Martindale asks what impact the current pensions landscape is having on pension scheme design

On the back of the worst economic recession in living memory, fund managers and trustees alike are having to confront some of the biggest changes to the occupational pensions landscape in decades.

Primarily, the introduction of compulsory pensions and the arrival of the national employment savings trust (NEST) scheme will see millions of people automatically enrolled into work-based schemes.

"NEST represents a real challenge to the industry," says Duncan Howorth, chief executive, UK employee benefits group, at JLT Benefit Solutions. "With low charges, a new vocabulary, good governance and the investment to offer high levels of operational performance and efficiency, the industry has a new benchmark. The response should come in the form of better employee engagement, better tools and assistance with contribution modelling and the delivery of good investment solutions and outcome for defined contribution members."

For Deborah Cooper, a partner at Mercer's UK Retirement Resource Group, the biggest challenge will be that of communication with the new breed of pension contributor. "Some will have no material amount of other savings and are likely to be risk averse in relation to any savings they do have," she says. "However, low-risk investment strategies, on average, tend to result in lower outcomes. The communication and management of the relationship between risk and return will be crucial to ensuring the likely outcomes from auto-enrolment are appreciated."

Overall, however, the move is likely to enhance the amount of money paid into schemes, says Will Aitken, senior consultant at Towers Watson. "You can't enrol 10 million people without it involving higher floats of money," he says. "That should lead to lower charges for the majority of members and some innovation in investment as things that have been too expensive or complicated to do before now start to become possible." But the move will also create some tricky logistical issues in keeping track of who has opted out and when, as well as managing the introduction of new members, he adds.

The abolition of the default retirement age is also likely to impact on scheme design. Aitken suggests employers offering defined contribution plans will have to take a more active role in retirement planning if they want to avoid a situation where employees are left with no choice but to carry on working indefinitely. "The one-size-fits-all era of defined contribution investment might be coming to an end and something that's more appropriate to the membership is going to need to come in," he says.

But defined contribution schemes in particular should continue to work to a specified end point, suggests David Hutchins, head of defined contribution investment research and design at Alliance-Bernstein. "In DC, the issues faced are threefold: insufficient contribution levels, poor value products and poor investment solutions," he says. "Target date funds go a long way to resolving all of these, reducing investment complexity for members, allowing communication to focus on the need to save sufficiently for retirement, reducing long-term costs and, critically, improving investment outcomes."

Nick Atkin, director at Atkin & Co, says that as long as schemes do not require members to take their benefits at a certain age it should be possible to retain the current normal retirement age within the schemes themselves. But he warns that existing provisions to allow early and late retirement could cause problems.

"For some schemes, these adjustments have left the member worse off on the basis that they are optional and by taking a prudent approach to setting the adjustment factors so the scheme is not selected against," he says. "However, this may also be seen as discriminatory and schemes could potentially be leaving themselves open to litigation."

In terms of investment strategy, the biggest challenge will come from ensuring investments are moved into safer assets at the right time. "Members invested in default funds will usually have a lifestyling strategy applied from a few years before the normal retirement age and if members do not intend to retire at that age, it could result in assets being switched into low-risk assets prematurely," warns Tim Middleton, technical consultant at the PMI.

Closely accompanying the issue of the default retirement age is that of annuity reform, with individuals who can generate more than the minimum income requirement of £20,000 able to drawdown funds from the age of 55. While this will rule out many employees, it could have a significant impact on some schemes, suggests Aitken at Towers Watson.

"The number of people who will be affected by the minimum income requirement will be a lot more than initially thought," he claims. "Anyone with a defined benefit pension of about £13,000 a year could find that they qualify, if they took that before it was taken as transfer value and converted it into a single-life level pension."

Such a setup could benefit both employers and employees, says Aitken. "For those people future pensions aren't really about pensions at all but long-term savings," he suggests. "They're going to be able to get their hands on any future defined contribution pots as taxable lump sums, which completely changes the framework of pensions. We're also going to see a lot more employers adopt the flexibility offered by the minimum income requirement to help manage down their defined benefit liabilities."

The introduction of a tangible minimum income requirement figure is also likely to encourage individuals to contribute more to their schemes, suggests Chris Wagstaff, head of investment education at Aviva Investors, although he adds that the reduction of the annual contribution limit to £50,000 a year from April 2011, and the lower lifetime allowance due to come into force in 2012, will have a greater impact for top-earners.

Some occupational plans will also be affected by the government's decision to allow schemes to switch the measure used for indexation from the retail price index (RPI) to the consumer price index (CPI). But while this should mean the cost to employers of maintaining schemes will fall, it also makes it harder to follow risk-reducing investment strategies because of a lack of readily available assets that match CPI payments, suggests Cooper.

The National Association of Pension Funds (NAPF) however, says it is difficult to tell just how significant this will be for trustees or fund managers. "We know, for example, that 61% of defined benefit schemes will not be able to make the switch to CPI for indexation of pensions in payment because they have RPI written into their rules," says James Walsh, senior policy adviser. "But more than half of schemes will be able to make the switch for revaluation of deferred pensions."

The Office for National Statistics is now reviewing the composition of the CPI itself, with a view to allowing it to include a measure of housing costs, bringing it more into line with the RPI.

"The big potential winners would appear to be the buyout companies which based their prices on prudent estimates of RPI and may now be able to pay increases based on CPI," says Atkin of Atkin & Co. "It does make you wonder whether it would be best to hold off on any decision to buy out benefits until it is clear that the government is not going to take any further steps that might reduce pension scheme liabilities, for instance changing the economy's inflation target."

Such a wave of changes mean employers and fund managers need to continue to be flexible in the face of possible social, economic and legislative upheaval, says Dave Lowe, corporate savings proposition director at Zurich Financial Services.

"The main predictable challenges will be in the management of pension arrangements over the lifetime of the member's participation; we could be looking at maintaining engagement over 50 years or more," he says. "Technological and cultural change will require much rethinking of pension arrangements, irrespective of the whims of legislators."

Nick Martindale is a freelance journalist