GENERATION DC ISSUE 1: DELIVERING THE PROMISE OF PENSION ... · GENERATION DC ISSUE 1: DELIVERING...

GENERATION DC ISSUE 1: DELIVERING THE PROMISE OF PENSION FREEDOMS

Delivering the promise of pension freedoms

Generation DC

ISSUE 1

GENERATION DC ISSUE 1: DELIVERING THE PROMISE OF PENSION FREEDOMS 2

FOREWORD

When the Chancellor introduced these freedoms, he spoke about the “trust” that we needed to place in people who had worked hard all their lives. He meant that we need to trust their good judgement and the choices they will be free to make about their retirement savings.

However, it is vital to remember that scheme members and savers in turn place huge trust in their workplace schemes and rely on their performance, which imposes a significant responsibility on trustees.

DC pension funds and their advisers have a challenging volume of change to manage, affecting investment strategies and communication profoundly. LGIM has therefore developed this series of articles to examine the key issues which confront them.

Pensions are undergoing a revolution. As an industry, we can be justifiably excited about this major overhaul of pension legislation, which has introduced the most radical change we have seen in a century.

Emma Douglas Head of DC Distribution


INTRODUCTION The rise of Generation DC

Generation DC in numbers

are ‘decumulated’, or converted into a retirement income.

When it comes to pensions, Generation X may have some DB pension income to look forward to, but Y, Z and their successors are all part of the ‘Defined Contribution Generation’ or ‘Generation DC’. With most private sector Defined Benefit schemes closed to new members, the army of savers who will be largely dependent on DC schemes is growing all the time. Research from the Office of National Statistics showed that in 2014, for the first time since 1997, occupational DB pension schemes represented less than half of total workplace pension membership in the United Kingdom. At the same time, occupational DC membership stands at 23%.1

Generation X, born in the 1960s and ‘70s, is tagged as a cynical bunch that doesn’t want to grow up. X was followed by Generation Y, also known as Millennials, who are famed as the first digitally-savvy demographic. Generation Z – those born from the late ‘90s onward – supposedly buy their clothes in charity shops, check their bank balances with apps and recycle.

At face value, these groups do not appear to have much in common. But an overhaul of the UK’s pension rulebook means that the generations will at least share one significant experience: the prospect of an entirely new retirement landscape, different from anything their predecessors encountered. This includes both the way in which they accumulate assets to fund their retirement and, more significantly, the way those assets

It is estimated that auto-enrolment will increase the number of individuals enrolled in DC workplace pension schemes2.

Auto-enrolment — the average FTSE 350 employer has just a 6% opt-out rate for new employees4.

1 2014 Annual Survey of Hours and Earnings: Summary of Pensions Results, ONS, 26 February 2015. Occupational DB — 49%; occupational DC — 23%; Group personal pension — 19%; Group stakeholder pension — 7%; Unknown pension — 1%.

2 “Standing ovation as auto-enrolment hits 5 million and auto-transfer launch plans are unveiled”, www.gov.uk, 11 December 2014.

3 “2014: The year of the master trust”, Spence Johnson, January 2015

4 Towers Watson, FTSE 350 defined contribution pension scheme survey 2015

5 “Just three FTSE 100 companies remain with DB schemes open to new members”, Pensions World, Jan 2015.

DC assets to almost triple by 2024, growing at a rate of 11% per year3.

Number of FTSE 100 companies with Defined Benefit pension schemes remaining open to new members5.

6%

10 MILLIONBY 2018 £787 BILLION

3

When it comes to pensions, Generations Y, Z and their successors are all part of the ‘Defined Contribution Generation’ or ‘Generation DC’.

OF FTSE 100


The ranks of Generation DC have been swelled by auto-enrolment. Following 2012’s auto-enrolment legislation, workers must put 1% of their wages into the scheme, which is matched by their employer. This will grow in the years to come until, in 2018, workers will pay in a minimum of 4% of their pay, with 3% coming from employers and a further 1% from tax relief. The number of workers automatically enrolled into a workplace pension across the UK has now reached five million, according to government figures published last December – a milestone halfway point of policy roll-out that aims to see 10 million automatically enrolled by 2018.2

It is widely recognised that even the 8% figure won’t be enough to fund an adequate retirement,6 but at least it is a framework to promote long-term saving and goes some way to address the inertia and lack of engagement that people had with their long-term planning.

Freedom and choice

In his landmark 2014 budget announcement, Chancellor George Osborne took an axe to the traditional

concept of a pension. While the ins-and-outs of the changes are well known, it is worth reminding ourselves of the huge degree of freedom it allows. The new regime lets us tap into our capital. We could, if we wished, simply spend what we have taken a lifetime to save. Steven Webb, former Pensions Minister, had no illusions about the extent of these freedoms, as his comment about the freedom to buy a Lamborghini illustrates 7.

The core changes of Freedom and choice: • First, the end of the requirement to buy an annuity.

• Second, drawing cash out of your pension pot won’t be met with a 55% tax rate.

• Above the 25% tax-free limit, you will pay your marginal rate of income tax.

• These changes came into force in April 2015, alongside a charge cap and emerging plans for a “pot-follows-member” system.

Regular income from an annuity

Regular income from an annuity, cash, income drawdown

POST-APRIL 2015

PRE-APRIL 2015

6 Assessing value for money in defined contribution default funds, Cass Business School and the Pensions Institute, January 2014.

7 “Minister fuels pension debate with Lamborghini comment,” BBC, 21 March 2014.


For pension scheme trustees, these landmark changes mean getting to grips with a much more complex and uncertain retirement landscape and deciding how far their fiduciary duties stretch into the decisions their members make. Members will need guidance but, with DC members now having access to their pension pots, so the risks of any mis-selling increase.

George Osborne described the reforms as “the most radical changes to pensions in almost a century”. But how will the retirement landscape develop, and do models exist elsewhere in the world that could provide government and trustees with some guidance in managing the transition?

Opportunities and a cautionary tale

The changes have been cautiously welcomed by the pensions industry, which sees the end to compulsory annuitisation as a positive, particularly for those with smaller pension pots. David Fairs, chairman of the Association of Consulting Actuaries (ACA) and a Partner at KPMG, suggests that, for a typical DC pension pot of £30,000, buying an annuity that offers £10-£15 a week will not help much in paying living costs. For people on low incomes, however, being able to access that £30,000 to bridge the gap for a few years before reaching state pension age could transform their quality of life.

“There’s some evidence that people start to claim sickness benefit or Disability Benefit in the run-up to retirement,” says Mr Fairs, “resulting in a large kick-up in benefit claims as people reach State retirement age.” Many people couldn’t afford to retire because they had no flexibility on how to use their pension savings, he explains, and they couldn’t access their state pension early, “so they just claimed State benefits.” The pension changes should benefit this group of people, he believes.

For those with larger pension pots, income drawdown might appeal, leaving a proportion of their DC plan in growth assets. “Then, somewhere in the middle, there are probably people who still want a secure, stable income but do not want to buy an annuity around that,” Mr Fairs adds.

“There’s some evidence that people start to claim sickness benefit or Disability Benefit in the run-up to retirement, resulting in a large kick-up in benefit claims as people reach State retirement age.”

David FairsChairman, Association of Consulting Actuaries

8 “40th Annual Survey” NAPF, 3 December 2014.

on average in trust-based DC schemes vs. 4,500 for DB8

ACTIVE MEMBERS


The Australian experience As the UK embarks on this virgin journey of pension freedom and choice, examining the ups and downs of a similar experiment in another developed economy may give pause for thought. The Australian government introduced compulsory saving – ‘superannuation’ – and pension liberalisation 20 years ago, but is now considering changes to the scheme that would re-introduce some form of annuitisation.

Research published by Australia’s largest annuity provider, Challenger, indicates that Australians are accumulating debt in advance of retiring, using their pension pots as collateral. The research showed that just 4% of ‘super’ savers purchased an immediate lifetime annuity on reaching retirement, while 32% used their pension pots to pay off a mortgage, buy a new home or cover home-related expenses. Just over a third paid off a car or bought a holiday, and 27% put the money in a savings vehicle outside a ‘super’, such as a bank account.9

As a result, concerns have grown that Australian retirees who can access their cash at 55 are running out of money by the time they reach 70, leaning as heavily on the (means-tested) state pension as before.

In another report on superannuation and retirement in Australia, published in 2012, Alex Malley, chief executive of the accountants association, CPA, said pension savings were “being treated as a windfall and being used to pay for the lifestyle that’s been lived now instead of being put aside to provide income in retirement”. 10

The government is now considering recommendations from an independent inquiry into the country’s financial system to bring back some form of compulsory annuitisation to avoid retirees in their 70s and 80s running out of money. The wide-ranging Financial Services Inquiry, led by the former chief executive of the Commonwealth Bank, David Murray, observed that many retirees found it challenging to navigate the transition to the retirement phase of superannuation. The task of managing multiple financial objectives and risks in retirement is complex, and the quality of financial advice can vary significantly.

Accordingly, the Inquiry recommended that institutional super funds be required to offer their members a ‘pre-selected’ comprehensive retirement income product which, where appropriate, includes a regular and stable income stream, longevity risk management and some flexibility. A product involving

some mix of an account-based pension and deferred annuity was one example proposed. This would allow for longevity risk pooling, which provides an opportunity for higher consumption streams for participating retirees.

According to Paul Trickett, Independent chair of Trustees of the L&G Mastertrust, while Australia had been “really good at accumulation of DC, it was not very good when it came to spending it”.

Jackie Wells, Head of Policy and Research at the National Association of Pension Funds (NAPF) agrees, although she adds that there are also country-specific features to consider. “In Australia,” she says, “it’s not unusual for someone drawing down on their DC pot to run out of money several years before they die.” She applauds the retirement income recommendations from the Murray Inquiry introducing longevity, protection, insurance and annuities – in whatever form it takes to provide people with an income for life.

“There are lessons to be learned,” Ms Wells adds. “However, you have to contextualise them, because what happens in one country can’t necessarily be lifted and put in place here. They have a different history of pension provision, and nowhere is as complicated as the UK.”

“In Australia, it’s not unusual for someone drawing down on their DC pot to run out of money several years before they die.”

Jackie WellsHead of Policy and Research, NAPF

9 How much super do Australians really have? Challenger Retirement Income Research, 2012.

10 Pension freedom? Australia shows what can go wrong, citywire money, September 2014.


Along with choice – complexity and risk Industry commentators, while supportive of the UK’s sweeping reforms, point to a number of potential pitfalls as the changes take root. Some point to the potential for mis-selling and fraud; others warn that savers could – with the best intentions – run out of money by underestimating the challenges of making drawdown deliver sustainable income.

Emma Douglas, LGIM’s Head of DC Distribution, believes that the reforms have strong positives, as long as people have a comprehensive view of the risks. “There is certainly more complexity now but it’s a positive development. It’s helpful for savers and should boost the popularity of pensions. I think the flexibility can be good news for people, particularly at the lower income level. The state pension will be quite a good replacement ratio for the income they’re earning whilst working and they may see their DC pot as a ‘top-up’ to this income that they can dip into as required”.

“However, there will be an increase in the risk of people doing the wrong thing in the retirement phase. You have to think about all sorts of things. How long will I live? How can I counter the effects of inflation? What do I do with the cash? Do I buy an annuity and if so, when?”

The financial track record of UK consumers shows that, as a nation, there is legitimate concern about our understanding of financial risks and long-term planning.

According to recent research from think tank, Strategic Society Centre, DC members over the age of 50 have a low level of financial engagement with inflation, stock market movements and financial products. The Centre also found that this got even lower with age.11

As an illustration of a collective failure to grasp the merits of diversification, there is a clear history of Britons placing too much emphasis on property as part of retirement planning. Research has shown that as many as 2.5 million people

plan to downsize and sell their homes to get enough money in the bank to pay the bills in old age. And a further 3.5 million say they are planning to rent out or sell another property.12 This narrow focus occurs at the same time as high household debt levels — in 2013 the UK had the fourth-highest total household debt in the world at £1.8tn. People are being offered buy-to-let solutions as a retirement investment choice, without appearing to give careful consideration to the ramifications of tax, management fees, upkeep costs and so on. This over-reliance on a single asset class suggests that many need education on the merits of diversification and impact of high costs over time.

1. Low levels of engagement, investment abilities and overall financial acumen.

Reforms have strong positives, as long as people have a comprehensive view of the risks.

The three biggest challenges in the new pension environment:

11 Default Reform: Preventing low incomes with an automatic income plan, The Strategy Society Centre, March 2015.

12 “Millions of Brits unwisely rely on property to fund retirement warn experts”, The Express, September 23, 2014.

13 Featured in “Going for Slow Money”, John Godfrey, Prospect Magazine

11.9 MILLION

People have not saved enough retirement income (DWP estimates)13


The lack of experience of managing investments and low financial acumen create uncertainty about the choices future retirees will make. In particular, how people will choose among the three paths of cash, annuity and income drawdown. The government provides an impartial and free guidance service through Pension Wise to support Generation DC through their post-retirement plans. However, this service is not in itself able to solve some profound issues, such as lack of engagement or interest, or lack of financial literacy. Laura Myers, Partner at the actuarial consultancy Lane Clark & Peacock, says: “The shock budget announcement made everybody in the industry consider what retirees will do going forward. There has been a lot of concern about people taking cash and maybe blowing it all or taking drawdown and not being able to manage it.”

Retirement patterns today are in a state of flux. Working full-time and retiring at state pension age is no longer the norm; the new norm has become a retirement journey where we work longer or part-time. There is even considerable uncertainty about longevity. People routinely underestimate how long they will live.

“There are millions of people affected, so there will be some who indeed make the wrong choices. That is inevitable.”

Paul TrickettIndependent Chair of L&G Mastertrust

The L&G Mastertrust’s Paul Trickett is sanguine about the changes: “We’re going to be hit over the next few years by a stream of popular outcries. For instance, politicians will indulge in chest-beating that people have made the wrong choices. There are millions of people affected, so there will be some who indeed make the wrong choices. That is inevitable.”

These instances need not hold back progress, asserts Mr Trickett, provided trustees and the industry address

them: “I don’t think that many people understand mortgage products, but they’re able to cope with getting one and buying a house. Nobody understands car leasing, but millions of people lease a car. So people can cope with these products. But the quality of the communication and the service we as trustees and providers show to members must increase. We are old-fashioned in the way that we do that at the moment.”

2. Poor choices.

3. Uncertainty about member behaviour and demographics.

14 “New figures show retirement is changing”, Department for Work and Pensions, January 2015.

17%Today, only a minority of people say that working full-time and then stopping work altogether would be the best way for them to retire.14


Following the introduction of the pension reforms in April 2015, the financial services industry experienced a huge upswing in calls about the new freedoms. The Association of British Insurers reported that in the week following the pension changes, its members handled a total of 229,932 phone calls from customers asking about their choices. This represented a massive 214% increase in expected average call volume. The association’s members also received more than 10,000 written and email requests. This was twice the normal average.15

On 6 April 2015, the starting gun was fired on pension freedoms. According to Keith Stoneham, Head of DC Customer Service at Legal & General, call volumes at Legal & General’s DC-based contact centre were up 25 to 30% in the days following the changes.

One of the early emerging trends has been savers with smaller pots who are interested in accessing cash. “The experience we have seen, and this is probably no surprise, is people considering taking cash lump sums,” says Stoneham. “Given the smaller fund sizes in question, they’re not going to be overly affected by the tax implications of that, or the annual allowance implications either. I think what we’re seeing is the pent-up demand of people going, ‘Right, I’m going to cash in’. They’re not necessarily looking at the longer term.”

He does highlight, however, that

it is important to treat these developments carefully and to not rush to categorise them as definitive indicators. First, there is a difference between the numbers of people making these sorts of enquiries and those actually moving to concrete action. Second, it is impossible to understand savers’ wider financial picture. For example, retirees accessing DC savings as cash could have legacy DB schemes that will provide their long-term security.

Mr Stoneham says, “It’s too early to assess the impact of people cashing in their small pots. There’s the possibility that they have other pots elsewhere - larger pots where they’ve been saving for a longer time. So, with this smaller pot they’ve had since 2012, they’re just using this cash for something now, and they might well have other arrangements in place.”

Pensions freedom day: The front-line experience

CONCLUSION

15 “57,000 calls a day on pension reform”, The Daily Telegraph, 15 Apr 2015.

229,932 PHONE CALLS

SOS

from customers asking about their choices, in the week following the pension changes.15


The intensity of interest in the pension freedoms, after years of apathy, is a telling illustration of the size of the task ahead for trustees. For trustees and their investment partners, responding to the challenges of this radically different landscape will require significant innovation in scheme design. In the near term, schemes will be making any immediate changes required to governance, investment strategy and immediate communications about the changes. In the longer term, however, we believe that leading pension schemes will innovate in two areas:

• Investment strategy.

There is an exciting opportunity to rethink investment strategies at critical stages: pre-retirement and post-retirement. We are already seeing innovative new solutions and thinking in pre-retirement funds, the use of multi-asset funds and target-date funds, the development of specific retirement-income funds, and the emergence of a second-generation annuity. Trust-based schemes are also thinking about post-retirement solutions, from providing access to individual advice to offering drawdown within the trust.

• Digital platforms to improve communication and engagement.

Schemes and providers have a significant opportunity to build a much richer understanding of their members and create tailored communications and guidance – using digital channels and platforms – that truly engage. This will be particularly critical for post-retirement planning, and managing the risk that retirees using drawdown strategies run out of money too early.

Responding to the challenges of this radically different landscape will require significant innovation in scheme design.


With greater freedom and choice comes greater responsibility. Retirees face greater responsibility for their futures. Schemes and their trustees face greater responsibility in enabling the best outcome for their members. Schemes will need to work closely with investment management firms to build creative new investment solutions. Communications will need to embrace 21st century media to change the member experience and encourage engagement and understanding. Innovation is essential to deliver the retirement dreams of Generation DC.

In two forthcoming complementary articles, you will find our views on the implications for default strategies and investment choices, and how leading schemes can transform their member experience.

Delivering the UK’s brave new DC world: success factors

• The government’s guidance service Pension Wise will need to work and it will need to cover a lot of bases. People’s circumstances change, so they will need advice at different stages of their retirement journey.

• Education will be needed to raise the UK’s levels of financial acumen about inflation, diversification and the implications of member choices before and during retirement.

• Communications need to embrace the digital world, to become more customised, accessible and tailored for members.

• More research and understanding is required into member behaviour in a post-budget world.

• A robust default fund must be in place for those who ‘do nothing’.

FROM: Product Innovation TO: Communication & Guidance

• Tailored communications

• Digital channels

• Drawdown risk awareness

• Education

• Pre-retirement funds

• Retirement income

• Second-generation annuity

• Post-retirement solutions

Plotting a route for lifetime savings

Retirees face greater responsibility for their futures.

Important Notice

Views and opinions expressed herein are as at July 2015 and may change based on market and other conditions. This document is designed for our corporate clients and for the use of professional advisers and agents of Legal & General. No responsibility can be accepted by Legal & General Investment Management or contributors as a result of articles contained in this publication. Specific advice should be taken when dealing with specific situations; investment decisions should be based on a person’s own goals, time horizon and tolerance for risk. The information contained in this document is not intended to be , nor should be, construed as investment advice, nor deemed suitable to meet the needs of the investor. All investments are subject to risk.

© 2015 Legal & General Investment Management Limited. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, including photocopying and recording, without the written permission of the publishers.

Legal & General Investment Management Ltd, One Coleman Street, London, EC2R 5AA

www.lgim.comAuthorised and regulated by the Financial Conduct Authority.

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