The future of retirement – NEST & the pension freedoms
Today’s post is about a new report from NEST, the workplace pension scheme set up by the government.
The report is called The future of retirement and looks at the impact of the pension freedoms on what people will do with their pension pot once they have retired.
What is NEST?
NEST (National Employment Savings Trust) was set up by the government in 2012 alongside pension auto-enrolment legislation to make sure that a DC workplace pension scheme is available for employers of all sizes. This is particularly important for small employers, since there is little competition at the bottom end of the market.
All workers older than 22 and earning more than £10K pa are now auto-enrolled into a DC workplace pension. NEST is not a regulator, enforcing the implementation of auto-enrolment (that task falls to The Pension Regulator), but rather a scheme provider, like Hargreaves Lansdown or Fidelity.
NEST offers a range of five funds default, ethical, sharia, lower growth and higher risk. It works with more than 20,000 employers – due to rise as auto-enrolment hits smaller employers with less than 30 employees – and has around 2.2 million scheme members.
NEST is free for employers. For members, the annual management charge is 0.3%, but there is also an up-front contribution charge of 1.8% on money going into a member’s retirement pot.
For a member with a pot worth £10K, making £1K of contributions per year, the AMC would be £30 and the contribution charge would be £18. Total charges would be £48, or just under 0.5%.
Who runs NEST?
NEST is run by the NEST Corporation, which acts as the Trustee of NEST. This is a “non-departmental public body” (sounds like a quango to me) though it reports through the Department of Work and Pensions. There are no external owners or shareholders.
There are 15 members of the Trustee committee. None are public figures, so I presume they are a mix of industry insiders and friends of the government.
NEST also operates an Employers’ Panel and a Members’ Panel, which provide feedback on NEST’s plans and operations. Panel members are appointed for two to four years, and can be re-appointed. NEST advertises panel vacancies publicly.
What has changed since the pension freedoms?
The main change is that the pension freedoms that went live in April 2015 mean that people no longer have to buy an annuity when they retire. This has implications for what are the most appropriate assets for DC pensions to be invested in.
In particular, the recent trend towards “lifestyling” – where pension money is shifted from riskier assets (equities) to less risky ones (bonds and cash) as a scheme member approaches retirement – may no longer be appropriate.
A second and related factor is that people are living longer, and spending longer in retirement. What was reasonable for someone who was expected to buy an annuity in the first year of a ten-year retirement may be very unreasonable for someone who is looking to support themselves through thirty or more years.
What are the report’s objectives?
NEST have looked at what their members want / need / say they want before preparing a response.
This week’s report is a follow-up to a consultation process earlier in 2015. This resulted in the publication of an interim document containing guiding principles for the design of retirement solutions.
The current report aims to provide a framework for turning pension savings into an income stream, without running out of money before death.
Default pathways are particularly important for auto-enrolled pension scheme members as they tend to be unwilling or unable to pay for financial advice.
What do people really want?
It’s quite difficult to say. When people are surveyed, they stress the importance of an income that grows with inflation, that is secure, and that is protected from falls in the stock market. That sounds like an index-linked annuity.
But people also want to be able to access lump sums when they want, to pass money on to their dependents, and to benefit from rises in the stock market. That sounds like income drawdown.
But you can’t have both in a single product, can you?
People see annuities as a gamble rather than an insurance product. They worry that they will die early, and not get their money back. They focus on the present and over value money in their hands.1
What does the report say?
NEST have divided retirement into three phases:
- mid 60s to mid-70s, where the priorities are “to maximise sustainable income in real terms” and to preserve flexibility for later periods
- mid-70s to mid-80s, where the aim is to provide “a steady income that aims to keep pace with inflation”, whilst keeping the majority of the pot liquid so that it can be passed on to dependents on death
- 85 plus, where the aim is to protect the member from “all or most investment risk and longevity risk”, at the cost of a loss of flexibility
And NEST offers three building blocks to bridge the transitions between these phases:
- an income drawdown fund – to provide a steady income that aims to protect against inflation, as well as provide flexibility (allow withdrawals); how this will be achieved is not clear
- a cash lump sum fund – highly liquid, to be used for unexpected events without impacting the core income stream; when market conditions are good this pot would be topped up with gains from the drawdown fund
- a later-life protected income fund – this is to be purchased gradually over time through small payments from the drawdown fund; these would be refundable up to a certain age (75? 85?) at which point the money is locked in to ensure a secure income for the remainder of a member’s life
So it’s almost the usual suspects in terms of products, but arranged in such a way as to preserve flexibility until much later in life than the traditional annuity route (75-85 vs. 55-65).
The guiding principles
The table below details how the blueprint within the report meets the needs of the guiding principles issued by NEST earlier in 2015:
How does it work in detail?
- 10% of the starting pot (at retirement) will be kept in liquid money market instruments in case the member wants to make ad hoc withdrawals
- the drawdown phase is designed to pay an inflation-linked income of 4% for 20 years
- during drawdown between 1.5% and 2% of the pot is drip-fed into the protected income (annuity fund)
- this is a collective fund, not an individual pot
- this is similar to the “defined ambition” plan outlined by the previous pensions minister Steve Webb
- this pot was called a “pension income builder” at that point and involved initial contributions being diverted to a separate income fund before retirement
- taking money out of the drawdown pot is going to further strain it’s ability to supply an overall 4% income – it looks as though a gross real return of 6%+ will be needed
- drawdown is also designed to have a “high probability” of generating a sustainable income until age 85
- any money left over in the income drawdown pot at age 85 would be moved into the cash lump sum fund
- the later-life protected income would ideally be provided through US-style deferred annuities
- it’s not clear at this stage whether the UK insurance industry will find this commercially viable
- equally UK pensions have no experience of, and so no pre-existing appetite for, this product
- it’s possible that the collective “pension income builder” approach will be used instead
- Industry reaction has focused on the complexity of the proposed solution, which appears more suitable to engaged investors with large pension pots, than to the NEST auto-enrolment target demographic, which is typically not interested in pensions and has a small pot.
- A second issue raised was whether the FCA would be comfortable with disengaged investors being placed by default into a risk-based retirement income solution.
- A third criticism was the cost of developing this solution to a practical implementation, and whether this a good use of public funds.
- More optimistic commentators such as Tom McPhail, head of pensions research at Hargreaves Lansdown, looked to the future. “This is them exploring what ‘good’ might look like into the future. It is a bit of a challenge to the pensions industry – how can we make it happen?”
- For a government report, this is a quite imaginative approach to the problems of decumulation in retirement
- In broad terms, the three phases and their target ages make sense
- Fees, the launch date (2017 at the earliest) and whether the product would be available to non-NEST savers have all yet to be decided
- The next step is “an in-depth conversation” between NEST and its peers and would-be partners
- In order to achieve the report’s ambitions, more clarity will be needed in particular on the underlying asset mix designed to produce real returns of 6% to 6.5% over potentially 30+ years
- NEST is very new and member pots are tiny at present (£200 on average); this plan will probably make more sense in 10 to 20 years time2
- The document doesn’t address how to engage with scheme members such that the fundamental conflicts within their attitudes to pensions are resolved:
- members want secure inflation-proof income that is not impacted by stock-market falls, but at the same time they want flexibility, the ability to pass on their pensions and the possibility of benefiting from stock-market gains
- members value choise, but are often unwilling to engage with their savings options and make complex and significant decisions about how to access their savings
- It’s not clear why the first phase begins at 65 – what happens to people who want to retire at 55?
- Nor is it clear why the drawdown surplus at age 85 should be converted to cash – couldn’t it be used to provide an enhanced income above and beyond that from the deferred annuity?
Until next time.
- I would argue that they are correct to avoid annuities in the early years of retirement, when they offer very poor value [↩]
- Things may change more quickly, depending on how the public reacts to the opening up of NEST in 2017 to accept transfers in from other pension schemes; my guess is that apathy will largely be the order of the day [↩]