Total services panel: The road to automation

Do you think it is a good idea to automatically increase DC members’ pension contributions? 

Martyn Bogira: Yes, as research shows that people are currently not saving enough for their retirement. However, first and foremost, contributions should be linked to a percentage of salary for their money purchase or via an additional voluntary contribution (AVC) top up. Any fluctuating amount should be factored in because people base their standard of living on their total earnings.

We are supportive of the benefits of learning from behavioural economics to encourage members to increase their contributions. Most people find it much easier to give up money that they haven’t got yet, so saving money they haven’t earned yet should ease the pain. Therefore, a good time to automatically increase contributions is when the member gets a pay rise. This way their pension will grow and they will not feel like they are losing out. 

Stephen Lefley: When a member reaches retirement age having been subjected to such a strategy, he can only be thankful. Everybody needs to take time out to understand whether their funding is sufficient and their investment risk is appropriate. However, members rarely act with such diligence and automation is a viable alternative to the ‘mañana’ principle. Small annual increases are most likely tolerable, however it must be remembered that the average modern transient employee is not likely to be an active member of a DC scheme for long enough for this application to be of significant benefit. 

Payroll administrators may not be so enthusiastic at processing ‘opt-outs,’ issuing reminders and adjusting contributions.

Mark Rowlands: Yes, this is proven to be the single most effective way to increase the amount of money being contributed. The automation of contribution increases was developed by Benartzi and Thaler, called Save More Tomorrow (SMT), and relies on an in-depth understanding of how employees think about money and savings. It has very quickly become the norm in the US market, with over 50% of 401(k) schemes now utilising this. We introduced SMT into the UK last year, and the early signs are very encouraging. 

An example, for illustrative purposes, of how SMT affects fund value can be seen here. 

This example is based on a starting salary of £25,000 with a 4% annual salary increase, a 0.7% annual management charge and a fund growth rate of 7%. The fund without SMT is based on a default contribution rate of 5%. The fund with SMT is based on an initial contribution rate of 5% which increases by 1% each year until reaching 12%.

The benefits of SMT are clear. It overcomes the main psychological barriers to saving and, as the graph demonstrates, SMT increases the fund value significantly compared to someone who remains at the default contribution level. However, if funds are not invested appropriately employees may not be maximising their benefits.

David Wareing: This is not a new concept but it is not that widely adopted throughout the UK. On balance many DC schemes would benefit from having a mechanism in place that automatically increases member contributions. Whether this is a specific design within a defined pay and reward structure or simply a way of addressing member inertia on how much they pay in automatic contribution increases are a positive thing.

What are the pros and cons of adopting such an approach? 

Martyn Bogira: Automatic increases must be a good thing to encourage people to save more for their retirement. For many younger people it could make sense to start low as they will be more likely to save from an earlier age. A lot of people find pensions off putting, but this approach means you can start at an affordable level and build up via a step-by-step increase.

This could also be a good strategy for companies closing their DB scheme down to get contributions back to DB levels and could play well as a transition strategy for schemes changing to DC.

Although automatic increases are a good place to start, this approach doesn’t address the overall need for retirement planning and does not take into consideration other benefits and performance of funds.

Stephen Lefley: Employees rarely revise the contribution percentage they select at outset and most won’t recall their contribution at all after a few months. Simultaneously they develop the mindset of “I’m in a company pension scheme so I’ll be OK”. This is a potentially disastrous recipe. Good scheme design, good communication and intelligent automation are effective countermeasures.

It is important that the provider can produce illustrations at outset which reflect the automated increase basis selected. The first rule is not to surpass the administrator’s capability. The ability to integrate the basis with illustrations and online calculators is essential.

The second rule is to work within the tolerance of the payroll operatives. It is easy to add considerable burden by creating innovative automatic increase processes. Automatic to the member doesn’t mean automatic to the administrators! These days the DC providers ‘get what they’re given’ in terms of contributions per member. In the old days they used to demand specific contributions and although this approach created continual conflict between payroll and provider, it actually lent itself more readily to ‘provider driven’ automation of increments.

Mark Rowlands: Members pay more money over time, so retire on a bigger pension and have a better quality of life. Because the contribution increases are phased, and often co-ordinated with salary increases, the member doesn’t miss the money and will continue saving. The opt out levels are very low, which shows the importance of phasing the increases. Members aren’t stupid of course; they know they need to save more but, left to their own devices, will rarely have the financial will power to defer today’s consumption for tomorrow’s savings. Automation means members may not understand or appreciate the benefit being provided.

David Wareing: Adopting this approach to contributions addresses a number of issues. Firstly, the issue of member contribution inertia, all too often many members continue paying contributions at the same level as when they started their planning which is unlikely to give realistic pension payments at retirement. Sponsors may also employ an automatic increase facility as part of a structured pay and reward strategy. On the other hand there are plan sponsors that are keen that members take ownership of their pension planning and introducing a structure where contributions automatically increase hardly encourages members to take ownership. Quite the contrary many members will take this as the signal to do nothing as regards contributions as they believe the process must ‘obviously’ generate the appropriate level of income they will need in retirement.

How should schemes communicate with members about such a process? 

Martyn Bogira: Annual benefit statements are a great way of communicating to members as this is the one time in the year when members are likely to take time to review their pension.

It is also important for the employer to build this into their HR pay review process and ensure employees are fully aware that their contributions may go up when their salary does.

There is a growing trend of flexible benefits which can mean that employees choose to pay less into their pension in favour of other benefits putting their retirement income at risk. Therefore, it’s important that employers have a wide-range of communications at their disposal to educate their employees. At Prudential we offer our clients bespoke websites with retirement planning tools and deliver face-to-face presentations around the UK. We also offer personalised benefit statements which are designed to capture key messages on behalf of the employer. These all help members understand the consequences of the change and contribute to effective retirement planning.

Stephen Lefley: The joining process and the annual review are the logical touch points to get right. When joining the scheme, the default position should be to opt members into the automated increase and the illustration provided should show the projected retirement picture versus the level contribution alternative. 

An electronic calculator modelled to reflect the scheme basis would be an idyllic way for members to examine any alternative increase options.

More employers are using flex benefit packages, within which the pension is a component. The annual communication is an extremely useful opportunity to remind members of their commitment and is a slick mechanism for making change. 

Mark Rowlands: The communication becomes benefit-focused rather than process-focused. This means that employees are told up front about the automation, and how it benefits them over time, as it enables them to achieve the lifestyle in retirement that they aspire to. Communication therefore becomes focused on the emotional drivers of retirement. We take the view that full disclosure is appropriate at outset and at each annual increase.

David Wareing: Unfortunately, most DC members are unaware of what their retirement income is going to be. This is partly due to apathy and partly because they do not understand the nature of DC. Arguably, nothing is more effective at getting employees to pay more into their pension than a well thought out and focused education programme. An engaged member appreciates that their possible outcome will be influenced by a combination of what is paid in, how their choice of investments perform and the make up of their final pension. Consequently, the member should be far better equipped to make decisions on what to contribute rather than having the decision made for them.

What alternatives should schemes consider to as a way of getting people to increase contributions?

Martyn Bogira: There is no substitute for building understanding and good communications. Face-to-face remains the best way to help employees understand the importance of retirement planning. The more people know the more likely they are to make the right decisions for them. 

We as an industry need to increase retirement education in the workplace and work with employers to help their employees plan. Companies should consider introducing an online training session on financial planning, offering face to face consultations and personalised benefit statements. The employer has to create an environment that retirement is a natural end to working life and this transition needs to be managed in the workplace. 

The recently launched Pension Quality Mark will help as schemes become benchmarked by contribution levels and communication, and must meet certain criteria to gain the standard.

Stephen Lefley: Automatically tiering contributions is an alternative, i.e. future increases are based on pre-determined factors such as age and service. Employer matching to a capped level is a smart feature as most employees would resent forfeiting any money the employer is prepared to direct their way. 

Peer pressure is a recent one. Personal communications reminding you of what you pay versus the average of your peer group, versus the top payer is an effective aggravation technique!

Salary sacrifice offering employer NI rebates at the top level of matching only could even be considered. And let’s not forget the benefits of employers providing access to financial advice in the workplace.

Mark Rowlands: The alternatives have been tried and resulted in mixed levels of success. Seminars and one to ones are very powerful tools to raise awareness, but will often fail to change people’s actual behaviours. Many studies have tracked employees’ behaviour after attending seminars and, according to Choi et al, only around 14% of members follow through on their good intentions to save more.

David Wareing: There are more traditional ways of getting members to contribute more towards their plan. The simplest and most effective being some form of employer matching, clearly the greater the match from the employer the more attractive and logically the greater the member traction to the idea. We also believe that members are more likely to achieve their retirement objectives if they have more clearly articulated goals and the level of interest, ability and tools to support their decision making along that journey. Through monitoring their progress against a target, members would be better placed to reflect changes in their circumstances and adapt their savings strategies as necessary.

The Panel