Improving adequacy in DC pensions

The roundtable - chaired by PP editor Jonathan Stapleton and held in association with Columbia Threadneedle Investments - also looked at how decumulation decisions will differ for future DC savers and assessed at how DC investment should change in response to some of these challenges.

The DC Future Book found that members are unlikely to accrue sufficient savings in defined contribution (DC) funds for them to provide an adequate, sustainable retirement income. What are the key findings from your perspective?

Lauren Wilkinson: Auto-enrolment (AE) has successfully increased coverage, particularly for those of younger ages. The issue now is how to increase members' contribution rates, because many view the minimum 8% as a recommendation of how much they should be contributing to secure an adequate retirement income. However, estimates of the contribution rates needed to achieve target replacement rates vary from 12% to 20%.

If someone aged 22 started contributing at the minimum rate and is a median earner over the course of their working life, their DC savings would enable them to meet the PLSA's moderate retirement living standard for 12 years or its comfortable standard for four years. 

Plans to increase the state pension age need to consider the quality-of-life issues that some people will face.

Housing costs could also affect future retirees. It has become much harder for young people to get onto the housing ladder and those who can are doing so much later. Therefore, people will still be paying off their mortgages or continuing to rent in retirement, which would lead to higher costs and less housing security.

Andy Dickson: Many people are going to face retirement poverty - or the inability to afford to retire at all. There are four ways to address this - put more money in, achieve better investment returns, work longer or take less out. From a policy perspective, the first lever is the only practical one that can be fully utilised.

It will not be easy for people in many sectors of the economy to work longer, and encouraging people to save more is also difficult due to the economic environment. Therefore, I believe employers should take on more responsibility moving forward. 

Martyn James: One reference point is the defined benefit (DB) schemes that used to be the retirement saving vehicles for workers before DC. Typical employer contributions to DB schemes were often between 20% and 30% of earnings, which provided a good earnings replacement ratio when people entered retirement. If we use that as a benchmark, we are a long way from getting the same retirement outcomes from DC. More needs to go in and potentially the employer could be the source it comes from.

Sharon Bellingham: At its recent conference, the PLSA restated and updated its Five Steps to Better Pensions proposals, calling for collaboration across government, industry, employers and other key stakeholders. This included the journey to 12%, where individuals would pay in an extra 1% and employers would increase gradually up to 6%. 

Pension adequacy is an incredibly complex matter. On the surface, nobody is saving enough - but there are also specific issues that impact women, minority groups and people with disabilities.

Jit Parekh: We perhaps need to step back and think about why people might not be contributing more.From around the age of 25 to 35, many people are focused on paying down student debt or saving for a house deposit rather than thinking about their retirement savings. If they put more money into their pension, there will be less in their monthly pay packet that can be saved and put towards some of their shorter-term goals.

The policy needs to support the fact that people are at different stages of their lives. We need to create a lifetime savings vehicle that looks across the piece and asks, ‘How can we best help members save towards certain goals and milestones as they move towards retirement?'

Andrew Brown: Pension policy may need to shift towards mandatory contribution rates that escalate steadily over time in order to ensure the most basic standard of living in retirement. This is a socio-economic challenge facing the UK, and those groups not covered by AE, such as the self-employed, also require provisions. Clearly, in the midst of cost-of-living crisis, it is a difficult economic and political climate for the introduction of such policies.

This is a challenge that requires long-term thinking. It is a problem that will create consequences in 20 to 30 years, so it does not sit within the lifecycle of an elected government. 

The culture towards saving for retirement needs to be addressed, along with a focus on financial education. We need to start getting across the basic concept of saving for the future. A lack of engagement results from a deeply engrained ‘present bias', focusing more on the cost of saving, which is why policy is the last resort and may be the only possible solution.

Who are the big under‑pensioned groups?

Lauren Wilkinson: Women - in particular single mothers and divorced women - are at greater risk of being underpensioned and are far more likely to be ineligible for AE due to inequalities in the labour market.

That also applies to people from ethnic minority backgrounds, in particular Bangladeshi and Pakistani backgrounds, as well as people with disabilities or caring responsibilities, and people in non‑traditional employment, such as multiple job holders and the self‑employed. 

Part of the gender pensions gap is to do with societal views about a woman's role in childcare. A third of people think the best way to manage childcare for a pre-school-age child is for the father to work full‑time and for the mother to stay at home. Those gender roles remain embedded in our society, which prevents us from rectifying inequalities in the labour market.

How can employers look at those issues? 

Andy Dickson: Employers and their advisers could re-consider the basic design of the pension contribution structure and have an adequacy objective, rather than creating a one-size-fits-all contribution structure. 

Why does a contribution structure have to just be based on percentage of income? If you adopted an adequacy objective, you could pay a flat rate employer contribution to lower earners, which could start to address some of these issues. 

Martyn James: For our trustee clients, we conduct analysis that looks at each employee and what they are on track to receive at retirement relative to the PLSA living standards. 

From that data, both trustees and employers can then make interventions as necessary. You can cut the membership data by gender or employment role/grade, for example, potentially trying to engage that workforce sector or even having different contributions structures in place for different parts of the workforce.

You can intervene with communications and engagement with specific parts of the workforce and say, ‘This is what you are on track to receive. Do you want to do something different?'

Andrew Brown: It is difficult to categorise employers in one group; indeed, a large paternalistic organisation will be better equipped in terms of resource and understanding to impact employee behaviours and their benefits.

Consolidation has arguably not helped with messaging either. For example, when transitioning from an occupational trust-based scheme into a master trust, the employer may lose some of its connection to the pension scheme, which is no longer managed in-house and there are no trustees in the building. 

Andy Dickson: Adequacy and addressing the gender pay gap is a fundamental governance challenge for a master trust board as they are often responsible for the decumulation phase as well, in contrast to a single-employer trust. 

How will decumulation decisions differ in the future?

Lauren Wilkinson: These decisions are vastly more complex than ever before. Previous generations were reliant on DB entitlements so decumulation was all done for them - they just took the income. Unfortunately, some younger savers have assumed that the same will apply to them.

Annuity sales have dropped off massively and it is uncertain whether they will increase again as people reach older ages. Many 55 year olds have accessed their pension pots to take a tax-free lump sum, but it is unclear what they will do once they reach retirement.

There needs to be more communication to show people the value of having a guaranteed income, perhaps in combination with flexible access. If people have a pot of a certain size, they can split it and purchase an annuity to secure a basic minimum income for comfortable living and then have a drawdown account to access the rest flexibly.

How can we provide more support to help members prepare for retirement? 

Martyn James: Mercer believes the way to make a real difference is for individuals to get advice. Digital advice tools are now available that can provide regulated and affordable advice to the mass market, even if people have small pension pots or low levels of overall wealth. 

We introduced one such advice tool into our master trust, which gets people thinking about what they will need in retirement. It aggregates their overall wealth and then provides digital regulated and affordable advice to them, not just as they approach retirement but in retirement as well. 

Jit Parekh: There is a clear advice gap, and the affordability of advice is very important. A recent Pulse survey asked people what they want when they get to retirement. Everybody said they wanted flexibility and to be able to access their pot. The next question was, ‘Do you want guarantees?' They responded, ‘I want a guaranteed income'. The former is more drawdown, the latter is almost an annuity. It demonstrates that there is a lack of understanding, so people need advice.

We need to recognise that people have different requirements and circumstances, not just at retirement but throughout their journey. We need to create investment strategies that enable flexibility and recognise that once people pass a certain age they may require an income, or they may continue to invest for growth.

Andy Dickson: Tailored guidance can efficiently support individuals when they face the challenge of constructing a retirement income. People want a product; they do not want a process. Annuities did a fabulous job of providing a guaranteed income in a single product. But at this time, people are faced with a process full of imponderables. 

We must address three principal risks - sequencing risk in drawdown, inflation risk and longevity risk. In the Australian and US markets, longevity risk is being tackled to some extent in pooled collective investment strategies. And you can also address sequencing risk by applying, for example, bucket strategies. These types of product developments coupled with tailored guidance could go some way to supporting retirement income needs. 

Andrew Brown: This is why decumulation has been known as the nastiest problem in finance. Some of the greatest fears are about people outspending their savings and longevity risk. In more mature DC markets, however, people are not taking as much income as they should and not spending enough early on. 

We should focus on a cohort of workers to create an overriding policy in this area. For example, Australia has targeted middle earners as they are the least likely to have the desired replacement rates. Lower earners already have an acceptable replacement rate based on a state pension underpin while higher earners are more likely to have savings elsewhere to sustain their living standards. 

Sharon Bellingham: It is about looking at the full lifetime picture, all the way through. Education (and from an early age) is key - we must help people imagine the type of retirement they want. 

It is also more than a pension; initiatives such as open finance, open banking and dashboard all have a lot of potential to support a holistic view - our research has told us that having everyone in one place will help people engage with their pension.

Are we all in the right place now, for both the pre- and post- retirement phases? 

Jit Parekh: Private assets, private markets and trying to access the illiquidity premium has been a topic in the industry for many years. Everything that has been pushed through has been very welcome and now there is a greater commitment in the industry.

Ultimately, it still comes back to how trustees determine whether 5%, 10% or 15% in a particular type of vehicle is suitable, relative to where else they can invest.

Trying to put in the right investments and balancing that with cost has been the biggest challenge in the industry. Consolidation has been happening in the market, so naturally there is a price war - a price war that is dictating how investment strategies should be constructed. 

The big issue here is price dictating what investment strategies look like. That has been one of the barriers to getting more innovative ideas into DC portfolios.

Martyn James: Trustees are looking very closely at investment strategies right now. Even though there has been market volatility over the last 18 months, we must recognise that it is long-term investment returns that are important in DC. 

We need to take away the noise of, ‘What was your one-year return?' Instead, we need to look at what we are trying to achieve for members over the long term in terms of adequate and sustainable incomes, especially with reference to investments in the accumulation or growth phase.

DC is a long-term investment, so for me, private market assets have to be in portfolios. There is enough evidence that it would add value to returns after fees over the long term. But it has to be the right type and mix of assets - well designed and well diversified, for example by geography and sector.

Sharon Bellingham: The pricing point is very important and a key consideration given the downward pressure that we've seen on pricing over the years, when the focus should be on overall value. Pension providers need to continue to innovate and develop to meet customer needs but there also needs to be an understanding of relative value and the possibility that price will not continue to drop - we may see charges increase in some instances.

Andy Dickson: These private market assets are intrinsically more expensive to access, implement and manage in terms of ongoing governance, which has an impact on the overall cost.

Over the longer term, investing in private markets can provide an illiquidity premium that historically has had a range of returns between 1% and 7% depending on what sub-asset classes invested in, such as infrastructure to global venture capital. An increase in annual returns of 1% as a result of allocating to private markets in a portfolio over a 40‑year timeframe would increase the member's pot by 49% according to Pension Policy Institute research.

The UK workplace master trust market is intermediated and there has been too much focus on lowest cost. We have to accept that investing in private markets will increase scheme costs, but overall, it can improve the member outcomes.

Andrew Brown: It is clear that cost pressures have stifled innovation in DC for a number of years. As a provider of solutions to open DB schemes, we can tailor portfolios that utilise a wide range of asset classes. When it comes to DC, there is reduced demand primarily because of cost. For a master trust, an extra 10 or 15 basis points is significant in terms of the percentage increase of the standard member-borne charge.

Equities, bonds and private markets behave differently. Asset classes that behave differently with different economic cycles help to smooth returns and reduce the disparity of expected outcomes. 

Private markets have a role to play in this. Whether trustees or master trusts are going to be dictated to, about how and what they invest in, is another story. We are moving in the right direction, but there is still a long way to go. 

This roundtable was held on 9 November 2023 in association with Columbia Threadneedle Investments