Unintended consequences of UK pension reforms

April will be a pivotal month for the UK pension industry as some of the most impactful legislative changes in recent history come into effect

William G.S. Allport

The motivations behind this month’s changes in UK pensions are clear and ‒ in principle at least ‒ hard to challenge. They include a fee cap of 75 basis points on charges borne by defined contribution (DC) plan members automatically enrolled in a workplace DC plan, alongside a simplification of the regulations concerning withdrawal of income from a DC plan.

Auto-enrolment legislation will significantly increase the number of employees participating in DC plans; so, the UK government understandably wants to ensure that plan participants will not be burdened by the private sector through unnecessarily high charges. Equally, having compelled people to build their retirement nest egg by deferring current consumption, the government has entrusted DC savers with the freedom to use their funds to best meet their needs upon retirement.

Unfortunately, these well-intentioned policies have associated – though no doubt unintended – risks. Imposing an indiscriminate cap on the “fee budget” to which all UK DC plans and providers must adhere, without any guidance as to how that budget is allocated between record-keeping and administration relative to investments, runs a significant risk.

It is a fact that the wealth generated within a DC plan is a function of the money an individual member contributes, compounded by the investment return (after fees) achieved on those contributions. Although DC plan member engagement tools are perhaps perceived as unlikely to improve investment returns on members’ wealth, they are not irrelevant distractions – far from it! Such tools can be instrumental in ensuring members remain in the DC plan and save appropriately, a key foundation to members’ long-term wealth success.

However, behavioral research – and the practical experience of many pension professionals – tells us that no matter how much effort is put into DC member engagement and education, the majority remain unengaged and ill-informed, and invested in the default investment option at the default (auto-enrolment) contribution rate. The use of engagement tools offered to members will be high among a minority, but generally have low pickup.

UNINTENDED CONSEQUENCES

As a direct result of the UK government’s fee cap, DC plan decision makers now face an unenviable challenge. While the previous decision framework applied over the administration functionality was considered separately to the underlying investment strategy, these considerations must now be brought together. Investments will no longer be assessed solely on their ability to deliver appropriate (after fee) wealth outcomes.

Investment strategies will likely be compromised as pension plans are forced to employ index (passive) strategies, not because such strategies best suit the needs of DC plan members, but because of a need to meet an explicit total fee cap.

Likewise, DC administrators may have to compromise their service quality given the high degree of fixed costs (such as call centers) involved in member record keeping. For smaller plans, administration costs could be unpalatably high, forcing simplified, and potentially sub-optimal, cheap investment strategies to be used to meet the new fee budget requirements. The focus on achieving compliance with the new fee rules has given disproportionate exposure to the notion that fees are the only metric against which DC plans should be compared. This is a misconception.

ACTIVE VS PASSIVE: FINDING THE RIGHT BALANCE

There are already UK-based DC plans that offer a default investment solution consisting of passive investment strategies at a total cost of around 0.50% to its members. If, for the sake of argument, we assume that the passive investment fees total around 0.10% and associated administration costs total 0.40%, such a solution constitutes a 4:1 ratio between administration and investment costs. In other words, four times more money is spent on the member interface than on the wealth generation component. The solution may be less costly, but does it represent sensible value for money?

By contrast, DC plans that use a combination of passive and active strategies may have an aggregated investment cost of 0.30% within a total cost of 0.70%. Although the total cost is higher, the budget dedicated to pursuing the investment outcome is three times that of the earlier case and the budget allocation between member interface and investments is more evenly balanced. If we accept the earlier proposition that generating retirement wealth is a function of the money contributed to the DC plan (together with returns), and that administration cost has no direct impact on wealth, does it make sense to tilt a scheme’s fee budget towards covering administration costs or towards investments? Granted, whether the more expensive investment proposition is good for member outcomes is predicated on those active managers delivering a return premium after fees.

PIMCO’s October Viewpoint, “Sorry, Mr. Bogle, But I Respectfully Disagree. Strongly.,” outlines why such a phenomenon continues to exist. In a world of tight household budgets that constrain DC plan members’ ability to save more, seeking increased returns has never been more valuable to DC savers.

In the final analysis, our fee-constrained world means compromises must be made. I believe DC plans ought to focus on retirement wealth outcomes, the ultimate reason for pensions in the first place! Without a genuine recognition of which elements will be relatively more instrumental in delivering those outcomes, the pension industry risks taking a naïve approach to fee cap compliance. While unintended, this could lead to severe long-term consequences for DC plan members’ final wealth outcomes.

Unintended consequences of UK pension reforms

April will be a pivotal month for the UK pension industry as some of the most impactful legislative changes in recent history come into effect

William G.S. Allport

Unintended consequences of UK pension reforms

April will be a pivotal month for the UK pension industry as some of the most impactful legislative changes in recent history come into effect

William G.S. Allport

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