Department for Work & Pensions Reshaping workplace pensions for future generations. Response from The Pensions Management Institute

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1 Department for Work & Pensions Reshaping workplace pensions for future generations Response from The Pensions Management Institute

2 - 2 - Response from the Pensions Management Institute to the Department for Work & Pensions consultation Reshaping workplace pensions for future generations Introduction Since taking office, the Pensions Minister has indicated his commitment to revitalising the occupational pensions sector. Part of this commitment has involved a discussion of scheme design and a desire to investigate alternatives to existing regulatory structures. We welcome the opportunity to respond to this consultation, which investigates a range of options for changing aspects of scheme design. The PMI The Pensions Management Institute (PMI) is the professional body which supports and develops those who work in the Pensions Industry. PMI offers a range of qualifications designed to meet the requirements of those who manage workplace pension schemes or who provide professional services to them. Our members (currently some 6,000) include pensions managers, lawyers, actuaries, consultants, administrators and others. Their experience is therefore wide ranging and has contributed to the thinking expressed in this response. PMI s response Q1 Do you agree that a greater focus on providing members with more certainty about savings or preferably income in retirement may increase confidence in saving in a pension? In principle, we agree that providing members with more certainty about pension accrual is a desirable objective. However, it is important to consider the issues that the introduction of more certainty would bring. Certainty via the medium of a Defined Benefit (DB) pension scheme involves greater costs and risks to employers. Whilst strategies for mitigating costs are considered elsewhere in this consultation, it must be remembered that spiralling costs to employers was a major factor in the decline of DB provision in this country. Over the past twenty years or so, the average cost to an employer of sponsoring a DB scheme has risen from about 10% - 15% of payroll to about 30% today.

3 - 3 - Providing greater certainty via a Defined Contribution (DC) arrangement involves either using funds with a less volatile asset mix or introducing an explicit guarantee of some sort. In both cases, greater certainty is likely to be provided at the cost of lower capital growth. Q2 As an employer, do you have experience of, or can you envisage any issues with, employees being unable to retire due to DC pension income levels or certainty about income levels? Anecdotally, we are aware of many cases where individuals have had to defer retirement under such circumstances. It should be remembered that the average fund value used for compulsory annuity purchase remains about 30,000, and this is simply inadequate to meet the retirement needs of almost anybody. Q3 Do you have any further evidence or research planned which might help inform the development of DA pensions? No. Q4 What are your views on the feasibility of this scheme design? The removal of statutory indexation and spouses pensions will be welcomed by employers looking to contain the costs of DB schemes. But it may be necessary to place greater emphasis on the importance of scheme communications around optional spouses pensions, or we will be left with widows and widowers whose spouse may have assumed they were protected and not realised the implications of choosing a single life annuity. This is already a significant problem in DC. The concept of providing flexible and discretionary benefits over a period of many years will require a clear regime of controlled funding to limit employer costs combined with strictly defined discretions for trustees. Otherwise these schemes will end up in the Courts in future years, with either trustees trying to extract more money from employers or employers trying to prevent trustees from increasing scheme benefits. Q5 Are employers likely to be interested in providing benefits in addition to a simplified flat-rate DB pension on a discretionary basis or otherwise? We believe the basic concept has merit. An employer with a 60ths scheme today might move to a 120ths scheme plus discretionary payments. In this scenario only half the benefit is promised and so exposed to the risk of future contribution increases and deficits appearing on the balance sheet. The other half would be aspirational, and the employer could vary contributions up and down as his business allows. Trustees would use their discretion to distribute these funds to members in accordance with the trust deed and rules. But two issues may limit the uptake of this idea. Firstly the cost of even a simplified flat rate DB pension is higher than most employers are spending on their DC staff, so there isn t likely to be

4 - 4 - much money available for the discretionary pot. And secondly the proposition is pretty unattractive for staff a substantially inferior DB pension to what they had before combined with a rather vague prospect of getting something on top in the future if someone else exercises their discretion in your favour. Retirement planning would be difficult if reliant substantially on such an arrangement. Q6 What role do you see for scheme trustees in relation to discretionary payments? For example: Should they be involved in deciding whether a discretionary payment is made at all? Should they be involved in setting out how these payments are apportioned to members or should this be down to the employer? We recommend that employers should decide the level of discretionary payments and trustees should decide how the benefits are apportioned to members. The first decision how much to pay is a labour market decision related to the profitability of the underlying business, overall remuneration rates in the labour market that this firm operates in and what shape of remuneration package will best serve the need to attract and retain good staff. These are clearly employer decisions as they relate to the business and are not areas where trustees are well placed to exercise judgment. The second decision how to distribute the payments fairly plays to the strengths of trustees being able to take a wider, dispassionate view of the members interests. Legislation allows trustees a great deal of freedom, and provided they can demonstrate that they followed good practice in reaching a decision as to how they exercised their discretion on distributing available sums, the result should withstand criticism. But if employers had to decide they would have to follow all manner of employment law, some of which is European and takes precedence over UK law, and they would be at grave risk of having their earlier decisions overturned subsequently in Tribunal or Court. Q7 Do you agree that our starting point should be to keep regulatory requirements around discretionary benefits to a minimum? No. Members will need some protection that these long term benefits are safe. The timespan over which these benefits will first accrue and then be drawn down will span several management lifecycles. The structure will need some robust regulation to ensure that discretionary funds provided in good faith by a benign management cannot subsequently be damaged by future corporate raiders. Trustees also benefit from having in place a number of best practice guidelines, typically written as the lowest tier of regulation. The answers the trustees come up with to the difficult issues of

5 - 5 - apportioning discretionary funds are more robust and less open to challenge if the trustees can demonstrate that they followed best practice guidelines in finding their way to a decision. Q8 How do you see funding for the non-discretionary DB element being sufficiently protected while allowing for extra discretionary benefits? For example, is there a risk that paying discretionary benefits could threaten the funding for non-discretionary DB benefits for younger scheme members? One option would be to ring-fence the non-discretionary assets and liabilities. This would ensure that they were at all times properly protected. Another option is to throw everything together in one pool. This maximises the funding flexibility for the employer and would enable the trustees to agree to lower contributions in times of business stress such as a recession. But it heightens the risk that the employer will pressure the trustees to accept reduced contributions and after a while the scheme may exhaust all discretionary funds and provide bare non-discretionary benefits only. As market conditions can change faster than trustees may react, such a scheme could well pay out too much early on and be left with insufficient assets to pay younger members even their basic benefits. We therefore favour the former option. The non-discretionary assets and liabilities should be run pretty much as pension schemes are today. And the additional discretionary benefits should have a controlled regime whereby the employer determines the contributions into the scheme and the trustees determine the payments out. Q9 What are your views on the feasibility of this scheme design? We think this design is the least preferable of the three designs put forward. It is feasible and may be attractive in some circumstances, for example to employers/employees where a significant proportion of the workforce remains with a single employer either for the whole or the latter part of their working life. However, for the majority this is not the case, and we question whether, without significant safeguards, this would provide a suitable form of benefits for employees. It may be difficult to plan for an adequate retirement if the form of the pension remains dependent on continued employment through to retirement. Q10 If employers are able to use scheme designs 1 and 3, do you think it is still helpful for legislation to allow for this scheme design? We think legislation should permit any design that encourages effective retirement provision, and includes appropriate safeguards for members. This third design may have a place within a Defined Ambition umbrella but we suggest that there is a more detailed consideration of the transfer terms if it is introduced in its current proposed form, as the range between a traditional cash equivalent transfer value and the cost of purchasing an annuity can be very large. We have responded to

6 - 6 - question 12 on what we consider to be a better way of offering something similar to design 2, which addresses the transfer problem in a different way. Q11 Do you think this scheme design could be extended to permit employers to automatically transfer members out of the scheme at retirement? Anything would be possible starting from a clean sheet, but we challenge whether this element would be necessary or desirable. Within the current regime, employers could usually remove liabilities by arranging for annuities to be purchased and members can often transfer their benefits at or close to retirement if that best suits their circumstances. We therefore assume the proposal would be that the transfer could be set at below the cost of securing the benefits in the market. We question whether this would provide adequate protection to members. We are also unclear how this type of scheme could be communicated to members the scheme design would be providing a pension that looks like a defined benefit which would not be provided, and which a member could not necessarily replicate. This could lead to confusion and disappointment. Q12 What would be the most suitable way for benefits to accrue under this model? And how might this best be communicated to ensure members understand the value of their pension benefits? We suggest that this design might work better as a DC scheme, with an underpin based on design 1, or a member option to transition to design 1. This would appear to provide a better solution for members, avoids the difficulties identified of determining a fair compulsory transfer value, and would provide employers with a manageable level of risk if they are also allowed to control the investment options offered to members. The key features of such an approach could be communicated to members in a simple way. It may be possible to accommodate this approach within existing legislation and the introduction of scheme designs 1 and 3. Q13 Assuming a CETV would not represent fair value for the accrued rights when the member leaves or retires, how might it best be calculated? Should the basis for calculation be different when the transfer is initiated by the employer (for example on redundancy)? Whether or not a CETV provides fair value in such a scheme would depend in part on the circumstances of the member, and of the scheme. Avoiding a cliff edge is crucial in all circumstances, and not just redundancy, to protect the interests of employees. A possible model for a compulsory transfer value basis might be a transfer around a current CETV basis at younger ages and which then includes greater caution as a member approaches retirement age, for example using something around the expected annuity price shortly before a member could have retired on a pension.

7 - 7 - Alternatively, greater flexibility could be given to employers to set transfer values at the level they think is appropriate but this must go hand in hand with very clear member communications (with illustrations) so that they understand the position. A third option might be to underpin any transfer value by an accumulation of the contributions that would have been invested had employees been enrolled in a DC scheme for auto-enrolment purposes at the minimum level required for that purpose. An appropriate investment return might be that achieved on the scheme s assets. Q14 For schemes providing a lump sum benefit, what are your views on how the cash value should be calculated for members who leave before retirement? Should the net present value of the lump sum be calculated on how many years away from pension age they are? Employers should be allowed to design a scheme based on providing a lump sum benefit, and should have flexibility in how that is delivered. A sensible approach would be to provide benefits on a net present value basis, but we do not think this should be prescribed. It is more important that employers should be able to design an appropriate scheme, and that regulations ensure that it is fairly and clearly communicated to members. Q15 Could the accrual rate and pension value be along similar lines to existing cash balance arrangements? We consider that they could and as noted in our response to question 10, we consider that a DA framework should be flexible allowing employers to design any arrangement which adequately protects members interests. Q16 What forms of regulatory requirements would be needed to: prevent avoidance activity? ensure the scheme has access to sufficient funds to enable a transfer when a member leaves? Measures are needed that protect the interests of members, both to ensure an adequate pace of funding, to ensure that a scheme fulfils its intended purpose, and to ensure that adequate transfers can be paid, although under our alternative suggestion for Design 2, this might be achieved by including some sort of money purchase underpin. Any funding requirements should be restricted to coverage of members guaranteed benefits. Within the constraints of the proposed design, protection could be included by requiring schemes to retain benefits in the scheme (possibly on a DC basis) if a full transfer value cannot be afforded, hence allowing transfers only where these are fully funded or requested by the member.

8 - 8 - Q17 What are your views on the feasibility of this scheme design? There is a real concern that scheme members would view such a scheme design as moving the goalposts - particularly if it involves possible changes to past benefits. Clear communication and explanation of this design will be essential and this is reflected in our answers to the remaining questions in this batch. We firmly agree with the statement in paragraph 42 that protections are needed for employees approaching retirement age and consider that 10 years is the minimum protection period required. Q18 It could lead to more schemes having proportions of accrued pension payable at different pension ages. Would this further complexity outweigh the benefits? Conceptually a single retirement age for all parts of a member s scheme pension is more attractive and easier to explain. But, in reality, member opposition to changing past benefits may make this unattractive. The pensions industry is used to managing tranches of benefit with different pension ages (eg due to Barber or other reasons) so, whilst it would add costs, it is not insurmountable. Paragraph 40 opens the possibility of different pension ages within the same scheme. The effects of different employments or location on longevity are well established and schemes should be able to reflect such factors within their scheme. Q19 What role do you see the scheme trustees playing? Should they be involved in setting a new NPA, or should this be down to the employer and the employer s actuary? From a communication perspective it is essential that the trustees are involved with the decision and, at the least, have a veto on any changes proposed by the employer. Scheme members are more likely to accept increases in pension age if this has been decided, or at least endorsed, by trustees rather than the employer. Q20 What are your thoughts on how future pension ages are set? For GAD to publish a standard index based on longevity assumptions? Or do you prefer schemes linking their NPA with the State Pension age, so that when the latter changes, the scheme s pension age automatically changes in line with this? For ease of understanding and simplicity schemes NPA should be linked to State Pension Age. Again, members are more likely to tolerate retirement age increases linked to the State rather than made by the employer, or even GAD.

9 - 9 - Q21 How might the decision to change the NPA work in multi-employer schemes? We favour trustees making decisions about NPA changes and believe this will work for multiemployer schemes. The trustees would decide whether there is a case for the workforces of different employers in the scheme having different NPAs. Q22 As an alternative to opening a new scheme, do you agree it should be possible for an employer to modify the rules of an existing scheme so that it can be re-designed as a Flexible DB scheme in relation to new accruals, for example, it is possible to change the NPA and/or introduce automatic conversion to DC when a member leaves? Yes. In reality, as far as members are concerned, there will be little difference between an employer closing a traditional DB scheme and replacing it with a flexible DB scheme or converting an existing scheme to a flexible scheme and it is likely to cost less to convert a scheme than set up a new scheme. Q23 Do you agree that employers should not have the power to transfer or modify accruals built up under previous arrangements into a new arrangement, beyond what is allowed under current legislation? Yes. We also believe that, although not legislation, the principles of the Code of Practice for Incentive Exercises published in June 2012 are a good balance between the needs of different parties. Q24 Should there be a requirement to provide independent financial advice in all cases where an employer offers to transfer a member s accrued rights from a traditional DB scheme to a new arrangement? We refer to the requirements of the Code of Practice for Incentive Exercises about when financial advice should be provided and consider that is sufficient. Q25 Do you think having more certainty than traditional DC would be welcomed by members, and help generate consumer confidence and persistency in saving? Yes, but anything that implies a form of guarantee comes at a price. Paying for guarantees could reduce the end result, an income in retirement, and this may be low already due to many members paying insufficient contributions. We believe that the asset management industry has started to look at solutions that can improve predictability of outcome. Whilst stopping short of a full guarantee we think that this may offer a lower cost route to building trust amongst members and encourage better savings behaviour.

10 Q26 As an employer, if these products mean there is no funding liability, only the requirement to contribute as for a traditional DC scheme, would you be interested in offering these products to employees? Yes. It will help provide workers with more certainty over their retirement incomes, but there will be a cost to members in some form or other and it is important that members are aware of this. It would also be important that there was clarity around any counterparty risk and that the employer could in no way be perceived as responsible or liable for that in any way. Q27 In relation to medium- and long-term guarantees outlined in model 2 (capital and investment return guarantee), and model 3 (retirement income insurance), would removal of the legislative barriers be sufficient to stimulate the development of market-based solutions? Yes. Market based products should thrive when there is a demand. Demand, however, would depend on whether or not they were value for money. If a vibrant market led to attractive and good value products then they should succeed. There has been real innovation in DC elsewhere as a function of a competitive landscape, with smarter investment strategies that manage risk and volatility well, more care about annuitisation, better governance and much lower charges. Q28 As insufficient scale has been identified as a barrier to providing affordable guarantees, is there a role for the Government in facilitating different types of pension vehicles that would create greater scale for this purpose? Yes, though we would be naturally reticent to see too much state direction given to what should be a free market for services. Q29 Are there any additional legislative barriers that stand in the way of innovation of products with guarantees? No, not as far as we are aware. Q30 Do existing protection arrangements for DC products provide sufficient protection for members in the event of provider insolvency? No. There is significant opacity for consumers, intermediaries and trustees/governance boards on any impact of insolvency. Clarity would be helpful. Q31 Would any protection mechanism need to apply in order to provide extra security for members and reassurance for the employer that it would not be liable in the event of any deficits arising? Probably, but it would depend on affordability. We are not sure many employers would want to put these kinds of protections in place for members as there would be a risk of future governments increasing both the regulatory burden and the liability of the employer (as was the case in the evolution of DB provision over time).

11 Q32 Are these models likely to be an attractive option for employers and members? Model 1 suggests that employers should be able to offer money back guarantees without external insurance. Model 2 may reduce outcomes considerably and increase costs so not attractive to members. Model 3 will probably be attractive to employers as they are not generally interested in how long former employees will live. Q33 On model 4 pensions income builder what are your views on this model in which members are in effect deploying their own capital to guarantee their own entitlements? Model 4 is likely to be too expensive if traditional deferred annuities are purchased from an insurer. Members will compare contributions with tiny incremental pensions thinking the former looks more valuable. If, however, this design could lead to lower cost synthetic annuities or a situation where security and liquidity were balanced more flexibly for the member then they may be attractive. Q34 Do you agree that CDC schemes have the potential to provide more stable outcomes on average than traditional DC schemes? Experience of CDC in the Netherlands has shown that such schemes provide far more stable incomes than traditional DC arrangements. This stability is achieved through paying benefits in the form of scheme pensions rather than through annuitisation. This removes all the variables associated with a constantly-changing annuity market. However, in the Netherlands it is possible for a pension in payment to be reduced in order to correct a funding deficit. Currently this would not be permitted in the UK. Q35 Given there is no tradition of risk sharing between pension scheme members in the UK, are individuals going to be willing to share the benefits of protection from downturns in the market and increased certainty of outcome, with the potential disadvantages of intergenerational risk transfer? It is impossible to predict how individuals would respond to the risk-sharing approach associated with CDC. However, it is certainly true that the public has very little faith in the current pensions system. Traditional DC involves no risk-sharing at all, it seems reasonable to suppose that the public would support a system where risk is shared between sponsor and members. It is also worth noting that intergenerational risk transfer has been a longstanding feature of the UK s unfunded social security system.

12 Q36 Is a CDC scheme designed to manage funding deficits by cutting benefits in payment going to be acceptable in the UK where traditionally maintaining the value of benefits in payment has been an overriding priority? From a public perspective, this has the potential to meet significant public resistance. It has only recently become an issue in the Netherlands, where cuts to benefits in payment have started to be made. However, it is worth comparing benefit levels under CDC with those achieved via a traditional DC arrangement. Historically, CDC pensions have been at a level where even after reduction they remain higher than would have been the case were members receiving an income from an annuity. Q37 What levels of funding do you consider would be appropriate to ensure that a CDC scheme has sufficient capital to meet the liabilities and minimise the risk of benefits in payment being cut? We believe that the actuarial profession is best placed to answer this question. However, we are satisfied that a funding regime that is broadly consistent with that of the Netherlands would be appropriate. Q38 Given the need for scale and an ongoing in-flow of new members to ensure the sustainability of a CDC scheme, will it be possible to set up a scheme without some form of Government intervention? To achieve significant economies of scale, it will be necessary to create large pension schemes. This will involve the creation of centralised schemes for non-associated employers. Achieving this would require regulatory changes to allow non-associated employers to participate. Q39 As a mutual model, it has been suggested that CDC schemes might prove attractive to the trades unions and other social partners might this be an option worth exploring? CDC schemes were discussed at the recent TUC Member Trustee Network Annual Conference. There was clear evidence of enthusiasm for the CDC model. Q40 Do you agree that creating a unified and identifiable legislative framework that brings together the legislation relating to DA schemes would be preferable to simply amending existing legislation? Yes. Pensions legislation has grown haphazardly over many years and it is a full-time job to keep track of it all. It can only help reduce costs and improve understanding if DA legislation starts from a clean slate and is logically ordered. As a precedent we refer to Stakeholder schemes which, whilst not completely successful as a policy, were governed by and large by a single set of regulations (the Stakeholder Pension Scheme Regulations 2000 (SI 2000/1403).

13 Q41 Do you have any comments on how to characterise the defining characteristics of DA pensions? In order to ensure that DA is seen as an option in its own right and not simply a watered down DB or more certain DC option it is important to be crisp in the articulation of the concepts at play. This is particularly the case for future pension professionals who come to consider options for their plan. Whilst inevitably, for the moment, referencing where we have come from (DB lite/dc+) we should work harder at looking at consumer and employer requirements from a primary level, rather than just defining the new alternative structures as what they are not. Without a clear framework that also acknowledges the bifurcation between trust and contract there is a danger of merely adding additional layers of complexity. Q42 Do you agree that it makes sense to define DB schemes in their own right rather than simply by contrast to money purchase? Given the extensive uncertainty that has arisen in the wake of the Bridge case, we believe it would be practical for DB schemes to have their own specific definition. Q43 Do you agree that defining DA, DB and money purchase schemes should facilitate clear and proportionate regulation according to scheme type? Hopefully, but the PMI continues to hold the view that the polarisation of trust and contract with their separate regulators is unhelpful, sub-optimal and confusing for employers as well as intermediaries. Q44 Do you have any comments in relation to the suggested definitions of DA, DB and money purchase schemes? We are encouraged that the DWP states it wishes to create a clear and proportionate regulatory framework that encourages innovation. It is also helpful that DB will be defined more clearly so as to create a new space for DA. However, language is critical here and the use of particular attributes as a defining feature of DA must not become misleading. For example when the paper refers to some form of guarantee but not complete certainty we have a concern that there will be the opportunity for misunderstanding or misrepresentation. Q45 Are you aware of any schemes operating in the UK under the Regulatory Own Fund provisions? No. Q46 Aside from Regulatory Own Funds vehicles, are there any other vehicles which might be appropriate for the provision of collective CDC which offers some form of guarantee or promise? We are not aware of any such alternatives.

14 Q47 Do you think that setting up a CDC scheme should be subject to formal approval, for example licensing by a regulator? Yes we do. A CDC scheme would require closer regulation than other types of registered pension scheme. The participation of (potentially) large number of non-associated employers would make funding particularly complicated. We believe that some form of licensing would therefore be appropriate. Q48 Do you think that CDC schemes which do not provide a guarantee or promise should also be licensed? Yes we do. Q49 Do you agree that such CDC schemes should also be subject to DA requirements on governance and member communications? Yes we do. We would encourage the DWP to treat all variations in scheme design that come under the DA umbrella in the same way, with both governance and member communications managed through a short, generic list of principles. Q50 Should there also be an option for schemes that currently offer DC to convert to CDC? Yes. Getting any risk sharing scheme started is difficult, as there is not much sharing that can be done between members in the early years if there are not many members with whom to share things. So a new CDC scheme will need some kind of pump-priming to get it started and running successfully. Unless we are going to merge with existing Dutch pension schemes (which would be taking the spirit of European integration too far!) then those start up assets can only come from existing pension assets. We would support a concept of automatic transfer with opt-out. The provider of an existing DC scheme should be able to convert it to CDC on an assumed consent basis, provided all members are given a practical alternative to opt-out of the conversion and move to, say, their own individual DC personal pension pot.

15 Q51 In the absence of both a guaranteed pension entitlement and an individually defined pool of assets, how should assets in a CDC scheme be apportioned such that pension accruals can be measured for tax purposes against the Annual Allowance and the Lifetime Allowance? There are already a number of pragmatic features within the framework of the existing annual allowance and lifetime allowance rules, for example the conversion factors for defined benefit elements. We suggest a similar level of pragmatism could be applied to a CDC scheme. For example, for annual allowance purposes, the test for a CDC scheme could be based on the employer and employee contributions to the scheme rather than the value of benefits being promised). For lifetime allowance purposes the pension income could be treated in a similar way as a scheme pension, possibly using a lower multiplier if the pension could reduce in payment. HMRC should be involved at an early stage, and encouraged to apply a simple approach. Q52 What specific areas should we address in relation to governance and member communications for DA schemes? There must be clear roles and responsibilities, expected outcomes and charges and absolutely no ambiguity. At the same time communication must be intuitive, compelling and clear. A difficult balance, no doubt. Q53 - Do you have any comments on the assumptions in relation to scheme funding requirements? We agree with the comments made about subjecting CDC schemes to funding requirements. However, this should only be at the level of members guaranteed benefits. At the outset, employers will also need to be reassured that there will not be a widening in the future of any funding requirements into benefits that are provided on a discretionary basis. ***** ***** *****