The UK pension industry has seen a dynamic shift from defined benefit (DB) to defined contributions (DC) schemes over the past 15 years. However, as automatic enrolment comes into effect from October, Steve Webb, Pensions Minister has proposed further overhaul of the pension system towards defined ambition (DA). Defined ambition pensions are a halfway house between defined benefit and defined contribution, like a DB scheme the employer takes on some of the risk but with a guarantee linked to DC schemes. The need for reform is understandable; DC schemes rely on contributions from members and employers; over the past decade, an ageing population, dwindling contribution and participation rates have caused a serious problem for the government.
Despite the popularity of DC schemes amongst employers, these schemes are far from the perfect solution; members are left to face the volatility of the stock market and a complex annuity market. As firms all the over the UK have been closing their DB schemes to new members, and the effects of an ageing population have increased the requirement for higher contribution and return rates. Thus the new models proposed by Webb will not sit comfortably with employers, who will be reluctant to take any responsibilities for their employees’ pension pots that add risk to their business.
The proposed models have been taken from Denmark and the Netherlands, however the UK pension system infrastructure is very different and this has raised questions over the viability of the model. The current UK system is highly inefficient, particularly due to its unfriendly approach towards pension transfers as people move jobs which leads to the rising number of small (and often dormant) pension schemes. Whereas the Dutch and Danish models are based on collecting DC funds together and sharing risk amongst generations, allowing schemes to exploit economies of scale, increasing assets and cutting costs. There is a need for a change to the industry; the UK requires a low cost pension system, with a limited number of suppliers helping to provide low charges for members. Before DA can become a reality in the UK we need a change to the structure of the pension system. The Dutch and Danish systems are able to use Collective Defined Contribution (CDC) as their schemes operate with scale and a focus on member interests instead of providers.
Therefore the focus should be centred on making DC work; the UK’s pension system has the infrastructure and ability to make these schemes work. However the problem with pension funds is the low contribution rates have meant many people are unable to retire with sufficient income. New figures from the Office for National Statistics (ONS) found that the average total contribution rate (employee plus employer contributions) for private sector DB occupational pension schemes was 20.9 per cent, while for DC schemes it was 8.9 per cent. If DC contribution rates were anywhere near DB levels members and assuming pension providers are able to produce good investment returns many would have a more secure retirement income.
There are five factors the government should focus on to make DC schemes work: a staged increase in contribution levels over time, reducing costs on members’ pots, increasing transparency, creating default funds that do not expose members to excessive risk and a simplification of the complex annuity markets which has resulted in pensioners losing thousands of pounds each year. If these issues can be tackled the advent of auto-enrolment provides the perfect opportunity to re-shape the DC market. If providers can put members at the centre of their proposition by providing default funds that produce strong return for members and can encourage a culture of saving; maybe DC could be the future.