A new white paper released today by WTW emphasises that UK employers, pension trustees, pension providers and regulatory bodies need to take steps to protect workers’ futures. Employers should consider changing their defined contribution (DC) pensions default to start enrolling new employees at higher contribution levels, in order to avoid millions falling short of their retirement income needs.
The paper, titled ‘What can the UK do to ensure future retirement adequacy?’, highlights that many employers offer generous matching DC contributions, but enrol employees at minimum levels by default. Employees can voluntarily choose to increase their contributions, and receive higher corresponding contributions from their employer, but due to lack of awareness and inertia, many do not.
These missed contributions are leading to lower retirement savings across the board and the real risk of widespread pensions inadequacy for many employees.
According to the Pensions and Lifetime Savings Association (PLSA), over 50% of the population will fail to meet the retirement income objective set by the 2005 Pensions Commission.
While pension contributions are a significant factor in DC outcomes, there are other important steps that can be taken to improve outcomes too. The paper emphasises the need for immediate action to address this issue and proposes three key elements to ensure future retirement adequacy:
- Save More: The white paper recommends increasing pension contributions to ensure individuals have enough savings for retirement. It suggests implementing a higher default contribution rate under automatic enrolment, with the option to opt down if affordability is an issue. This would help individuals achieve higher levels of contribution and build a buffer for unexpected events.
- Maximise Returns: The paper highlights the importance of taking enough investment risk at the right time to generate long-term growth. It suggests investing predominantly in growth-seeking assets, such as equities and private market investments, during the early years of saving and to retain exposure to these assets for longer. This approach can significantly impact retirement outcomes, particularly now that traditional ‘cliff-edge’ retirement is less likely for many, and can help individuals achieve a more comfortable standard of living in retirement.
- Make Better Retirement Choices: The white paper emphasises the need for individuals to make informed decisions at the point of accessing their pension benefits. It calls for the implementation of the Government’s proposed Mansion House Reforms, which require pension schemes to offer suitable decumulation solutions consistent with pension freedoms. The paper also supports the use of Collective Defined Contribution (CDC) decumulation models to provide additional income options for retirees.
Helen Gilchrist, Head of DC Consulting at WTW, stated,
“The retirement adequacy issue in the UK requires immediate attention. WTW is considering some bold initiatives to address the issue in a wider context but, in the meantime, there are practical steps that can be taken to ensure DC savers have a secure and comfortable future in retirement.
“By saving more, maximising returns, and making better retirement choices – together with continued efforts to improve financial literacy and education throughout the UK – retirement outcomes can be significantly improved for millions of people.
“Enrolling employees into DC schemes at a higher default level is one very practical way of addressing long-term adequacy issues. Individuals should be free to proactively lower their contribution levels if needed whilst remaining compliant with auto-enrolment rules. But we know that even those that can afford to contribute more, and know they should, often need encouragement in order to do so. Most people assume that the default contribution level at which they are enrolled will be adequate for their needs, which we know is currently not likely to be the case.”
Addendum
Pension people think of “default” as the normal way of doing things- getting rich by accident. Of course there is another kind of default.
Following on Adrian Boulding’s excellent analysis on why CDC should outperform alternatives https://henrytapper.com/2024/04/29/adrian-boulding-keeps-my-faith-in-cdc/ all of which applies to open collective DB except the drawback that CDC pensions could go down, surely WTW should be encouraging employers to consider how they can provide the best predicted pension outcome for their employees rather than encouraging them to pay contributions above minimum requirements.
It is likely to be those who will require the best possible pension in retirement are most likely to struggle with higher contributions now and hence most likely to opt out when faced with a higher default.
While whole life CDC appears stuck in a regulatory quagmire – opening DB accrual is available to many employers now. Has WTW worked out what pension benefit they could realistically be expected to provide using the Company’s workforce profile for a given level of contributions, and using realistic long term assumptions (say a 1% real return as the low risk discount rate).
The minimum DB benefits levels for auto-enrolment are an accrual rate of 1/120th of relevant earnings on an average salary basis with minimum rate revaluations and pension increases of the lowest of CPI, RPI, or 2.5%. Could an employee contribution of 5% plus whatever contribution the employers is prepared to commit (whether 3% or more) fund that level of benefit? Would DB benefits at that level be expected to provide a better pension outcome for the employees than could be expected with the same level of contributions paid into any alternative DC arrangement? These are the questions that should be asked.
If the employer is particularly risk averse, a hybrid scheme (ala the USS) could also provide a pensionable pay cap for DB benefits with contributions above the cap paid into a DC section (which would likely be the first source for the retirement cash sum) and gives drawdown flexibility to higher paid employees.
An open DB scheme increases the possibility of future member benefit enhancements and surplus distribution to the employer/sponsor under the Government’s current proposals.
Very significant further advantages accrue to employers with closed DB schemes. They do not have to consider the imminent additional cost of buy-out or other off balance sheet consolidation against asset market values. The short term cash drain on the pension schemes assets is reduced or indeed may be reversed. There is also the effect of the introduction of a tranche of new younger members into the Pension Scheme’s valuation data. Over time these will almost inevitably reduce the deficit contributions to paid in addition to the current year’s payroll contributions to nil
A paternalistic employer may also wish to consider subsidising the employee’s contribution for certain groups of workers (e.g. the low paid or the young) to discourage opts. The ulterior motive will be that the such employers will also gain for the advantages of the size and duration of the pension scheme.
No sign from WTW that higher contributions come at a cost. It’s not rocket science: contribute more and your DC pot will be larger. The real question is if I contribute more, what do I lose? To a man or woman with a hammer, every problem looks like a nail. As a former WTW actuary, this shallow analysis is embarrassing.
In the states, we had legislation in 2006 that clarified the process for using behavioral economics tools, processes and concepts. Remember that in a traditional voluntary system, the “default” election is a $0 contribution – if you do not take action, you will not be a participant. So, all we are discussing here is which default to use.
In the states, the best default is likely one that maximizes the employer financial support as early as possible/practical. So, in the states, the employer will typically match $.50 per $1.00 contributed, up to 6% of pay. So, the “default” in an auto enrollment structure, should be 6% of pay from the first day of eligibility. Some plan sponsors, recognizing worker financial fragility, will start at a lower percentage, coupled with an auto-escalator provision to get to 6% of pay as soon as reasonably practical.
The challenge, in the states, is that median tenure of American workers has been less than 5 years for the past 7 decades. So, failing to start at hire, and failing to contribute a significant percentage of pay is likely to result in sort of a “doom loop” in terms of accumulating assets – fail to enroll when first eligible, fail to save enough to get full match, followed by separation before fully vesting in the employer contribution, followed by a cash distribution – leaking retirement savings.
In the states, the plans that are the most effective at maximizing participation and minimizing leakage, do not allow for in-service or post-separation pre-retirement distributions (or minimize them), but, they acknowledge participants’ need for liquidity, especially among the considerable number of workers who live paycheck to paycheck. Those plans couple automatic features and “liquidity without leakage along the way to and throughout retirement” – via plan loans “done right”.
Happy to share more if you want to know more.