Workplace Pension Reforms Review

by Dr. Ros Altmann

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Response from Dr. Ros Altmann to Consultation on Automatic Enrolment and NEST. Further to giving verbal evidence to the Review, in a meeting on 29th July, I am also submitting written evidence for consideration. This review is crucial to the future of UK pensions and pensioners, especially as the coming five to ten years will be a period of enormous growth in pensioner numbers, as millions of baby boomers reach pension age. 2011 is the year the first baby-boomer reaches age 65 and then successive waves of that generation come through in the following years. Without adequate pension coverage, we risk increasing poverty in our population and long-term economic decline.

Executive Summary

This Review is of critical importance to the UK’s social, economic and financial future.

I believe it needs to be considered as part of an overall review of our entire pensions framework. This is an opportunity to reconsider retirement saving in the context of our overall pension system, most particularly whether and how encouragement of private pension saving fits in with existing private pension provision and the state pension system.

If the objective of the current policy is – as suggested in the Review’s remit – to tackle pensioner poverty as quickly as possible, disturb existing provision as little as possible and maximise voluntary private savings while minimising administrative burdens on employers, as well as delivering value for money at low risk for the Exchequer, then the policy will fail.

Just getting people to contribute small amounts to a pension arrangement does not solve the problem of inadequate retirement income. And by automatically enrolling everyone into workplace pensions, the Government runs the risk of future litigation from pensioners who were not given adequate risk warnings about the dangers of our current pension system.

The fundamental problem that requires attention is the inadequacy of our State Pension and the excessive complexity, as well as mass means-testing, which prevents our state pension from providing a clear and adequate social welfare minimum on which private savings can be safely built.

A pension may not be a suitable product for low to moderate earners, since mass means-testing and pension credit could penalise their pension income in retirement.

The best way to tackle pensioner poverty quickly, especially for women, is to pay a decent universal state pension, as of right, to all citizens. Even if that is paid from age 70, 72 or even 75, at least there will be a particular age beyond which private income will be free from means-testing penalties.

Pension saving cannot quickly reduce pensioner poverty, since pensions take many years to build up. As the demographic time bomb kicks in from 2011, will millions more pensioners as the baby boom generation reaches their 60s over the next ten years or so, automatic enrolment will not address the looming pensioners crisis.

Without radical reform of our state pension system, I believe it will be almost impossible to ensure private pension savings are safe for average earners.

An alternative possibility would be to change the nature of the pension product itself, to enhance its suitability. For example, if pensions are no longer a ‘locked box’ but the pensions vehicle could be redesigned to be more like an ISA/pension hybrid, or a lifetime savings account, then means-testing penalties can be avoided. In addition, if those with big debts or who want to buy a home can spend the money in their pensions if needed, or if the state means-testing system were to ignore workplace savings income up to a certain level for the means test, again pensions would be safer to force workers into.

Reform of the proposed system of auto-enrolment is required to make it simpler and to only enrol into existing schemes first
The currently proposed system of auto-enrolment should be reformed. It places too heavy a burden on employers and is far too complex. Indeed, these automatic enrolment rules are a classic example of over-regulation. We need to focus on simplification, rather than the traditional UK pension policy approach which seems to be ‘if it’s pensions, it must be complicated’.

Auto-enrolment should not start with a ‘big bang’ approach. It would be much better to first enrol into existing pension schemes. These are almost all better than the statutory minimum.

By first enrolling into existing schemes, the dangers of levelling down would be reduced. Nearly all employers are already contributing more than the 1% or 3% statutory minimum. Average contributions into money purchase schemes are 6-7% of salary. By specifying such a low minimum, the Government has already given employers are much lower target to aim at and this runs of the risk of making pension provision for many workers worse, not better. It would be far better for the Government to have just let employers automatically enrol staff into their existing schemes, without setting its own minimum contribution level, especially one that is so much lower than existing average contributions.

In addition, enrolling into existing schemes would also give useful practical information on how many people do opt out, to be able to assess the likely impact of policy more accurately.

Reform of the auto-enrolment rules:
The concept of band earnings should be abolished. Contributions should be based on entire salary.

Only those with earnings above £15,000 should be automatically enrolled.

There should be a three month waiting period, so temporary workers and short-stayers have more chance to opt out.

If workers know in advance that they definitely do not want to be in a pension scheme, the employer should not be forced to automatically enrol them. For example, overseas workers or those with pensions elsewhere.

Should NEST go ahead?
The idea of NEST is good, but the risks and costs to the Exchequer of introducing it, as currently designed and into the current UK pension system are too high.

Investment and annuity risks have not been adequately addressed and, with a 2% initial charge, the cost advantage is relatively weak, at least for the coming few years.

DETAILED RESPONSE

SECTION 1: Policy and objectives

The objective of increasing private saving will not necessarily provide adequate retirement income
Before proceeding with reform of workplace pensions, Government and this Review need to urgently consider the appropriateness of the stated policy objective of increasing private saving through mandatory automatic enrolment into workplace pension schemes. This policy objective may be flawed. Just getting people to contribute small amounts to a pension scheme does not solve the problem of inadequate retirement income
The Pensions Commission work, on which the current policy framework is based, was designed to increase private pension savings, following analysis showing that millions of people are not saving enough to ensure their retirement income can meet their aspirations.

Critical analysis of the rationale underpinning the current approach
Increasing private pension saving aims to increase the retirement incomes, especially of people on modest lifetime earnings, who are least likely to save. The Pensions Commission recognised that future pensioners will not have sufficient income to live on at a decent level. Its proposed solution to this problem was to increase private pension saving. This solution, in my view, cannot work as currently proposed and in the current UK pension system.

The real problem is the inadequacy of our state pension
The objective of increasing private pension income is considered particularly important because the UK state pension is so low (a full Basic State Pension is just £97-65 a week). This means anyone with little other income risks poverty in retirement. Some workers will receive more than just the Basic State Pension from their State Second Pension, but this may still not be sufficient to bring their incomes up to the minimum level of means-tested Pension Credit – which ensures that anyone over age 60 is entitled to at least £130 a week.

Employer and private pension provision have declined significantly
Pensioners need other sources of income to supplement an inadequate state pension and in the past many could rely on an employer’s pension scheme to provide additional income. In recent years, however, employer provision has fallen sharply, with most private sector final salary schemes now closed, at least to new members, and the replacement money purchase arrangements being much less generous and much less reliable. Those with private pensions are already finding their pension income expectations have not been met, due to poor investment returns, high charges and plummeting annuity rates.

Mass means-testing and pension credit undermine private pension saving – pensions are not a suitable product for many workers
Even on the Government’s current forecasts, around half of future pensioners will be entitled to means-tested benefits in retirement. The problem with means-testing penalties in the state system is that any pension savings they accumulate could end up being penalised by the means-test and, therefore, those who are automatically enrolled into a workplace pension scheme may find they are little or no better off than if they had not saved at all.

The Review needs to consider this carefully. Without radical reform of the state pension system, it is not clear whether pensions are a suitable investment for low to moderate earners. If pensions are not suitable for such workers, there are surely significant risks in automatically enrolling them into a pension scheme.

Need to revisit earlier pays to save analysis – including annuitisation risks
The previous work on whether ‘it pays to save’ needs to be revisited. I assume the Review will be doing so. However, the means-testing penalties and the alternatives of saving in an ISA rather than a pension need to be considered, as well as the annuity rate risks. The point of saving in a pension fund is to provide an income in retirement – this is delivered, in most cases, by purchasing an annuity. The previous analysis of whether it pays to save ignored the annuity risks, yet these are fundamental to the case for automatic enrolment into pensions.

Employer contributions are not ‘free money’ – they come from an overall employment cost budget
In addition, it needs to be stressed that the case for pension saving relied heavily on the idea that the employer contribution is somehow ‘free money’. With a 4% contribution from the individual, plus 3% from the employer and 1% from tax relief, the analysis suggested that each £1 an individual contributed to their pension was generating another £1 in their pension. However, the employer contribution is just another part of the employee’s pay – it comes from the employer’s budget for wage costs and, although the employer can benefit from some tax advantages when contributing to workplace pensions, the net contributions will come out of the budget for salaries and, therefore, employees’ wages will be impacted by the pension contribution. In the absence of pension contributions, wages would be higher, but this effect was ignored in the previous analysis. Some estimate of the impact of pension contributions on overall wage levels needs to be made in order to assess the true value of pension saving.

There are two separate but interconnected strands to this review.

1. to consider the process of automatic enrolment into workplace pension schemes.
2. whether Government itself should organise a national pension scheme (NEST) into which workers can be automatically enrolled if their employers do not provide any alternative suitable arrangement.

Tackling pensioner poverty: Auto-enrolment will not reduce pensioner poverty quickly
The fastest, more effective and most appropriate way to tackle pensioner poverty as quickly as possible, especially for women, is to improve the state pension. Private pension saving cannot and will not quickly reduce poverty among the elderly. Firstly, accumulating savings takes many years and secondly, there are significant costs and risks associated with private pensions.

Demographic trends mean we cannot wait
Just automatically enrolling more people into a pension scheme will not address the problem of pensioner poverty – and will certainly have no impact in the short-term. Given that 2011 is the year the first baby-boomers reach age 65 and, thereafter, millions more older people enter the retirement zone, we need to address the problems of inadequate retirement income immediately. We cannot wait for several decades.

To make auto-enrolment work safely, radical state pension reform is first needed
The fastest way to address pensioner poverty, as well as making it safe to automatically enrol workers into pension schemes would be to introduce radical state pension reform. This would entail paying a much higher state pension, without mass means-testing, to immediately lift older people above the Pension Credit level. This would be of enormous benefit to pensioners – especially older women. It could be achieved by combining the Basic State Pension, Second State Pension, Winter Fuel Allowance, Christmas Bonus and all other ‘free’ universal pensioner benefits into one weekly payment. This ‘citizen’s pension’ would need to be paid from a later age, but at least there would then be some age beyond which the state no longer penalises private pensions.

What is a pension?
Just going back to basics, it is important to stress that there are two functions to pensions and the policy debate has confused the two. On the one hand, pensions are social welfare payments received by people too old to work, which ensure they do not live in destitution. This should be the role of a state pension.

On the other hand, the word ‘pension’ also refers to something very different from this – a long-term savings vehicle that delivers extra income in retirement. Workers (perhaps helped by their employers) put money aside while working, in order to have extra when they retire. It is only this aspect that the current Review and policy framework has been addressing.

State pension does not provide adequate social welfare so private savings are not safe
However, the two strands of pensions interlink. The problem for UK policy is that the state pension system undermines private pension savings. The state pension pays far too little, which means anyone without other income ends up in poverty. The state pension has been cut continuously since the 1980s, which has left it far too low – it is about the lowest in the developed world. It is also very complex, with a flat rate Basic State Pension, an additional (partially earnings-related, but soon to become flat rate) Second State Pension and then a host of means-tested benefits including Pension Credit, Housing Benefit, Council Tax benefits as well as extra universal non-means tested pensioner benefits such as Winter Fuel Allowances, free bus passes, free eye tests, free TV licences, free prescriptions and Christmas Bonuses. This system is very costly to administer and almost impossible for most people to understand. Because the state pension is so complicated – and because so many pensioners end up entitled to means-tested benefits, pension savings can be a waste of money. Many pensioners may be no better off – or very little better off – for having saved. This, coupled with disappointing investment returns and a series of unfortunate scandals, has shattered confidence in private pensions. Without radical reform of the state pension system, I believe it will be almost impossible to ensure private pension savings are safe for average earners.

Will proposed regime maximise voluntary private savings and how quickly?
Increasing private saving is a stated policy aim, but ‘maximising’ voluntary private savings is not necessarily a valid objective. Firstly, it may not be appropriate for everyone to save. As described above, the state pension system can penalise private savings. More specifically, it is not necessarily appropriate for everyone to save in a pension.

Pensions are a ‘locked box’ and ISAs may be more suitable for many workers
Pensions are a special kind of long-term savings – they are money locked away until retirement (or at least till age 55) and, even if you need the money desperately, you cannot get it back. This means it may not be safe to encourage people – especially those who are young, with debts or who do not yet own their own home – to save in a pension. That does not mean they should not save, but the pension vehicle, which has little or no flexibility, may not be the best choice. ISAs may be more suitable. For example, younger workers, with large debts and those who have not already bought their own home, may need the money urgently. At the moment, policy does not recognise the specific risks of pensions savings.

Given the economic climate, it is also not clear that Government wants to maximise private savings at the moment. Those who can afford to save should be encouraged to do so, but those who need to pay back debt or cut spending to affordable levels should be helped to understand financial planning and given financial advice, not shoehorned into a pension that may be unsuitable for them and where their money is locked away for decades.

Redesign private pensions – Lifetime Savings, ISA/pension hybrid?
An alternative way of helping make pension saving suitable for workers is to redesign the pension vehicle. If people were able to get their money back, if they really need it, then the dangers would be reduced. Allowing people to take their money out of a pension fund, under certain circumstances, or for particular purposes (such as if they need to buy a house, stop their home being repossessed, pay for retraining to help them find new work, support themselves when unemployed, pay for care if they become ill etc.) would alleviate some of the drawbacks of pensions. Perhaps policy can approve a new vehicle which would be an ISA/pension hybrid. Perhaps a fixed term – say 5-year – ISA that can become a pension later. This would be a form of Lifetime Savings Account – perhaps called a ‘LifeSaver’ – which people could access their money but have to pay a penalty to do so. This penalty could be to refund any tax relief received.

SECTION 2: Auto-enrolment

Will the currently proposed regime minimise administrative burdens on employers?
The currently proposed regime places significant burdens on employers. The regulations are in urgent need of reform – they seem to be a classic case of ‘over regulation’ and an example of the UK rule which seems to be ‘if it’s pensions, is must be complicated’. Simplification of the auto-enrolment rules is required, to make it easier for employers to know who to enrol and whether existing schemes actually qualify. That will entail redefining ‘band earnings’, clarifying which workers should be enrolled and helping smaller employers tackle the complexities of administering pension contributions and the forms for opting out of pension schemes. A waiting period, say 3 months, would be helpful, which would allow employers not to enrol temporary or short-staying workers.

Will proposed regime damage existing provision? – Yes, levelling down is a huge threat
This is one of the biggest risks in the current proposals. By recommending a level of employer contribution that is so substantially below existing contribution levels, the policy poses the threat that workers in existing schemes will end up with worse pension income than if the policy had never been introduced. In final salary schemes, employer contribution levels are around 20% of salary and in defined contribution schemes average employer contributions are 6-7% of salary. This means the current policy proposals offer an attractive opportunity for employers to cut costs substantially. In fact, by proposing a 3% contribution – and initially just 1% – many employers have already seen the opportunity to cut costs in existing schemes or have decided not to set up new workplace pension schemes just yet, but to wait for NEST which will allow them to contribute at a very low level. This means that many workers will end up with lower pensions as a result of this policy.

This levelling down threat is significant. Very often in pensions the minimum becomes the maximum, so employers will be looking at the opportunity to cut back to 3% contribution levels. Employers are obliged to look after their shareholders, not just their workforce, and cost cutting is high on the corporate agenda. Policy should not, in my view, be giving them such a golden opportunity to cut pension contributions.

Automatic enrolment into existing schemes would be a better way to increase pension coverage, with far less risk of levelling down.
If policy reform starts by introducing automatic enrolment into existing employer schemes, there will be far less risk of levelling down. Before forcing all employers who do not already have a pension scheme to start contributing (at very low levels) to staff pensions, it would be more sensible to see what happens when employees are automatically enrolled into existing schemes.

This has the advantage of making it somewhat more difficult for employers to cut back their contributions to the minimum level, as well as providing live evidence on how many of those not currently in a pension scheme will opt out when automatically enrolled.

Risks of auto-enrolment
There are several significant risks entailed in automatically enrolling workers into a pension scheme. Is it right for policy to effectively force people into a pension scheme without warning properly of the risks? In particular, workers may not realise that they may get little or no benefit in retirement from being in a pension scheme when working. Pensions are not a suitable product for many low to moderate earners. Government has an obligation to ensure proper advice for people before they lock their money into a pension.

SECTION 3: NEST

Establishing NEST will impose both costs and risks on taxpayers and on the workers enrolled into it. These should not be underestimated or ignored.

Costs to taxpayers:
Taxpayers will have to fund the setting up of the NEST scheme. So far, the costs are already expected to be over £1billion, and although this is a ‘loan’ which will be paid back in future, it is unlikely that the money will be recouped before 2030. In addition, if not enough workers join and stay in NEST, the payback period could be far longer. Therefore, part of the ‘success’ of NEST will depend on encouraging enough workers to join. However, that is likely to mean the Government will need to promote NEST. But, promoting the benefits of pension saving in NEST could mean misleading workers about the suitability of NEST for them. That imposes potential risks on future taxpayers.

Risks to taxpayers
Taxpayers in future could face legal action that Government misled them about NEST and its suitability for their circumstances.

The Government surely has a duty to ensure that it explains all the risks very clearly before allowing workers to be automatically enrolled into NEST. This would mean telling workers who are young, who have large debts, who may want to buy their own home in future, or who are older and at risk of needing Pension Credit that they may be better saving in an ISA, which is more flexible, than a pension. But, by giving prominent risk warnings, fewer people will join NEST, so it is unlikely that promotional material will be sufficiently honest about the risks.

Such risks could be overcome in a number of ways, but none of these have been proposed. For example the Government could:

• Reform the state pension to end mass means-testing by paying a decent, much higher state pension. Even if this pension were paid from a much later age, there would at least be some point at which private pension savings were not penalised by the state pension system
• Ensure individuals receive financial advice before being auto-enrolled
• Ignore any NEST pension in the means-testing calculation
• Allow NEST savings to be transferred into an ISA if necessary to avoid means-testing penalties

Without any of the above, taxpayers may be at risk in future, on the grounds that the Government arranged a national pension scheme which does not deliver decent pensions on retirement for those automatically enrolled into it. Claims could be made against the Government on various grounds, including the following:

Inadequate disclosure of pension risks
Workers may sue the Government for failing to explain the risks of saving in a pension. The Government knows that many people may be little or no better off by saving in a pension – indeed its own figures suggest that hundreds of thousands of people could see 100% withdrawal of their pensions, because they will not have a full Basic State Pension on retirement.

Promotion of NEST benefits without adequate risk warnings
Workers may sue the Government if the Government promotes the benefits of NEST without properly warning of the risks. They could claim that Government knows pensions might not be a suitable investment vehicle for them, but did not ensure they were aware of this before automatically enrolling them

Failure to mention ISA as an alternative
Workers may sue the Government in future if they feel they were led to believe contributing to NEST would deliver them a better pension income, but they did not realise they would not be better off in retirement and could have saved in an ISA without suffering means-testing penalties in retirement

Poor investment performance Taxpayers may be at risk of being sued for poor investment performance or poor annuity choices if NEST is perceived as a quasi-Government vehicle.

Risks to workers being auto-enrolled
Workers who are automatically enrolled into NEST face significant risks, which have not been taken sufficiently seriously by policymakers

Lulled into a false sense of security:
Workers are likely to feel that by contributing to NEST – the ‘Government’s’ pension vehicle – their retirement security is sorted. They will believe that, by doing what Government requires, they will have done enough for a decent pension. This is clearly not the case, but they will probably not realise it. Just putting 8% of band earnings into a pension scheme does not guarantee a decent pension and, if they end up being penalised by the means-test, they could have wasted their money.

Investment risk and Manager Risk
NEST may not deliver good pensions and the risks have been underestimated. Firstly, investment returns are not assured. If funds are invested in low-risk investments, the returns will not be high. If they are invested in higher risk investments, the returns are not assured. In addition, the managers of NEST funds may turn out to perform poorly, which would be an added risk for accumulated pension savings. Using passive products does mitigate this risk to some degree, but does not eliminate it.

Annuity risk
Even on optimistic investment return assumptions, there are risks that annuity rates will worsen as life expectancy increases and demand for annuities rises, as well as risks of Solvency II and other changes meaning annuity rates continue to fall. Policymakers have failed to take these risks seriously enough. A pension fund is not a pension. The pension is the income received from the pension fund and that normally comes in the form of an annuity. Therefore, if annuity rates halve, (as they have done in recent years) even if investment returns double, workers will not be any better off in retirement! Perhaps the Government should consider issuing or underwriting annuity rates for NEST.

2% up front charge means NEST is no longer a very low cost vehicle
The Government has had to propose a 2% initial charge on contributions into NEST. This means some stakeholder or private pension schemes will now be lower cost than NEST. Even though this up front charge is supposed to be temporary – until the Government loans can be paid back – it does render the scheme potentially expensive, especially for people close to retirement who have less time to benefit from the lower annual costs and fewer years over which to spread the initial charge.

SECTION 4: Conclusions and Recommendations

Should the Government proceed with the existing reform agenda – i.e. go ahead with NEST an auto-enrolment with the existing complex rules?
My answer is a clear NO. Without radical state pension reform, it is not safe to automatically enrol workers into a workplace pension scheme. At the very least, they need independent financial advice and/or clear risk warnings about the dangers of locking their money into a pension. Furthermore, the current rules for auto-enrolment are ridiculously complex and place unreasonable burdens on employers to comply with the requirements.

Simplification – Abolish band earnings concept
Rules for ‘band earnings’ should be rethought. There is no need to make this complex in this way. Contributions should be based on an individual’s salary, as current schemes would do. However, I think a lower earnings threshold of £15,000 is more reasonable, with workers earning below £15,000 being asked whether they want to join and not being forced into the scheme but having to choose to be in it.

Simplification – do not force enrolment of all workers
Forcing employers to automatically enrol workers who know they definitely do not want to contribute to a pension scheme is also unreasonable. Workers should be allowed to declare they do not want to be in a pension scheme before being enrolled, thus saving the administrative headache of putting them in, when they will simply come out straight away anyway. That seems a waste of time and expense. For example, automatically enrolling overseas workers into a pension scheme is unreasonable such as nannies over here for just a short-time.

Simplification – allow small amounts (perhaps up to £500) to be paid back (perhaps after a few years), not locked away because administering tiny pools of money for decades is a waste
There are bound to be many people who are automatically enrolled into NEST or a pension scheme and forget to opt out in time. They may then find one or two months’ contributions are stuck in that pension for decades. Someone has to track and manage that money and charges will be deducted each year, but the worker has no means of retrieving that money until they reach their 50s. In practical terms, this system makes little sense. There needs to be a mechanism for paying back very small amounts, with a de minimis level (such as £500) that workers can retrieve the money after a certain period of time, say two or five years.

Simplification – allow a three month waiting period before enrolment
Also, perhaps contributions should not be paid into the pension immediately, but be held for three months to allow time for workers to decide to opt out. That should also help reduce administrative costs.

Consider using existing stakeholder pension schemes
If Government wishes to try a private sector solution, rather than taking on extra taxpayer risks, it could consider using the existing stakeholder scheme framework, instead of NEST. That would result in automatic enrolment only applying to employers with 5 or more workers, who are already legally obliged to designate a stakeholder scheme for their workers. Since all these employers should already have a vehicle available, it would be easier to start auto-enrolment with these firms.

Dr. Ros Altmann – 13th August 2010