Pensions E-zine - The Cutting Edge with John Lawson

Standard Life's pensions newsletter for advisers

September 2006

The potential impact of the National Pensions Saving Scheme (NPSS) should not be underestimated. It will fundamentally alter the market for group pensions.

Recent Department for Work and Pensions (DWP) research revealed that there was "little evidence that employers would level down their existing schemes". That may well turn out to be true, because historical evidence from the defined benefit (DB) to defined contribution shift tells us that employers have been reluctant to force existing members out of DB schemes. Their preferred strategy has been to close the scheme to new members and offer new employees a money purchase alternative.

The DWP research then goes on to paint a picture of generous employers automatically enrolling all non-members into the existing scheme and absorbing the cost through reduced profits. At this point, I begin to find this research hard to believe. Finance directors are not renowned for their altruism. My guess is that their most likely reaction would be 'How do we comply with government policy without increasing the overall wage/pension bill?'

The cost to employers

To help understand this, take a 5,000 employee business, that doesn't use auto-enrolment. The National Association of Pension Funds says that only between a quarter and a third of businesses currently use auto-enrolment, so this should be the norm(1).

In such a business, take-up of the pension scheme by new employees will typically be around 58%(1). In other words, 2,900 employees are in the scheme and 2,100 not in the scheme.

If their average wage is £25,000 (in line with average earnings in the UK(2)) and the employer payment is 8.8%(3), the cost to the employer of the pension scheme would be £4.46M net of corporation tax relief (£25,000 x 2,900 x 8.8% - 30%).

When automatic enrolment is used, take-up amongst new employees improves to 91%(1). This means that if the employer automatically enrolled the 2,100 people that are not already members, 1,911 would not immediately opt-out. The cost to the employer, net of corporation tax relief would rise by £2.94M.

This is equivalent to giving every employee in that business a pay rise of 3.36%.

How might this cost be absorbed or reduced?

Research conducted by Deloitte on behalf of Standard Life, Aegon, Scottish Widows, Axa and CFS was based on interviews with 750 employers (10 times the number interviewed for the DWP research).
The Deloitte research shows a range of potential outcomes:

The employer could auto-enrol non-members at the current rate of employer payment and set the cost against profits (23% of employers aim to do this)
They could auto-enrol non-members but reduce their payment to the existing scheme for all employees (8% would do this)
They could close the scheme to new members and auto-enrol new employees into the NPSS (31% would do this)
They could leave the scheme open but only to new senior staff and close it to non-members and new junior staff, who would be auto-enrolled into NPSS (34%)
They could eject all but senior staff from the scheme and auto-enrol all those ejected, non-members and all new junior staff into NPSS (4%)

On the face of it, this looks like a reasonable outcome for existing schemes. However, it is not as simple as it first appears. Under options (3) and (4), which covers the intentions of two-thirds of employers, the scheme is maintained, but mainly for existing staff only.

Turnover (staff leaving, retiring) will reduce scheme membership within just a few years. Of the scheme members at the date it is closed, 40% will be in the NPSS within five years. After 10 years the split is two-thirds to one-third in favour of NPSS (4).

This should not come as a surprise.

The effect of closure

The Pensions Commission's second report said that in 2000, there were around 4.8 million active members of DB schemes. By 2004, that had fallen by 20% to around 3.8 million. This marked fall is driven by the closure of only some DB schemes to new members.

So, although there is no immediate levelling-down, the closure of the majority of schemes to new members will cause a gradual levelling-down of employer payments.

Within 15 years of NPSS being introduced, 70% of the good (better than NPSS) group schemes that exist today will have disappeared forever. Only 23% of current good schemes are maintained at their present payment rate.

This research is instructive for financial advisers and insurers in helping to shape their strategy in the group pensions market.

The role of advisers

The first thing they should do is identify which of their schemes falls into which bracket.
Advisers (and insurers) should then ensure that the service they offer to the employers who intend to keep their schemes open is first rate. The whole market will be after this business. If advisers can persuade some employers who currently intend to close schemes to new members to keep them open to all, so much the better.

For employers who do intend to close the scheme to new members, how will anti-discrimination legislation (age, sex) affect the scheme over the longer term? Will the employer ultimately need to offer the same payments for all employees?

An open discussion covering these issues is likely to drive the employer to take a more polarised view of future pension provision. Either they keep the good scheme open to all or they close it to all (except perhaps senior staff), and put everyone else into the NPSS.

For those employers tending towards NPSS, there seems to be little room for advisers to market their service. The government has said specifically that they view this as a non-advice product. At the charge levels being discussed, it is difficult for the manufacturer to make a profit on its own, let alone trying to squeeze in a distribution margin.

As for insurers generally, there is no guarantee at this stage that they will be allowed to play in the NPSS at all. For example, a joint bid from a third-party administrator and a fund manager would appear to have an equal chance of success.

Advisers can still become involved in advising employers and employees on a fee basis. If the service offered by the adviser is limited to educating employees and providing information, rather than full-blown advice, then the service could be offered at a price that the employer is prepared to buy. Remember, there is no need for the person imparting the information to be registered with the F.S.A.

Looking forward

As far as new business goes, over the next five or six years, I doubt that any insurer is likely to be keen on new schemes which do not fall into the 'likely to stay open despite NPSS' category. What is the point in incurring cost now if that cannot be recouped from charges because the scheme disappears into the NPSS in 2012?

Finally, some employers do seem to favour keeping the scheme open for senior staff. So, even if NPSS is the destination for the bulk of their employees, insurers are likely to be interested in top-hat schemes that can last the pace.

Have your say

Responses to the White Paper should be in by 11 September. It is clear that these proposals will have a significant impact upon the business models of financial advisers and consultants who are active in the group market and we would encourage you to respond.

NAPF, 'Quantity vs Quality', June 2006
Office for National Statistics
Security in Retirement (DWP White Paper page 72, data from Employers' pension Provision Survey)
Assumes a turnover rate of 10%
Pensions Commission 2nd report, figure 1.11, page 52

Tax and legislation are liable to change. This information is based on Standard Life's current understanding of law and HM Revenue & Custom's practice.

Tax rates and reliefs may be altered. The value of tax reliefs to the investor depends on their financial circumstances. No guarantees are given regarding the effectiveness of any arrangements entered into on the basis of these comments.

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