The current government came to power promising to introduce reforms that will deliver better returns for pensions savers – as well as increase long-term and domestic investment by pension funds. There are encouraging signs but policy will need to be more ambitious to succeed, writes Craig Berry.
The Pensions Scheme Bill, which will soon become law, is the government’s attempt to ensure pension funds deliver ‘productive investment in the UK economy’. And a new Pensions Commission – reviving the model that devised and delivered auto-enrolment into workplace pensions in the mid-2000s to tackle chronic under-saving – will make recommendations on improving outcomes for savers, potentially leading to further legislation later in the Parliament.
It is not given that either of these policies will achieve their objectives. This is partly because they are being pursued largely in isolation from each other. But it is also due to constraints on the kind of reforms the government seems prepared to make.
The first step might have been a mis-step
The Pensions Scheme Bill is a product of the government’s first pension review, focused on reorienting pension fund investment practice towards long-term and domestic assets. The Bill introduces enabling regulation for ‘superfunds’ – an alternative to insurance buy-outs (associated with conservative or impatient investment strategies) for mature defined benefit schemes – and signals a further push for pooling among local government pension funds.
Controversially, the Bill also includes a new power for the government to compel investment in domestic assets. There are concerns this means objectives other than protecting members’ financial interest will influence investment decisions.
There are good reasons for UK funds to invest more domestically, even for the narrow objective of supporting returns for members: these investments offer greater protection against currency fluctuations, and it is possible that UK equities are under-valued at the moment. However, compulsion could create market distortions that would lead funds to over-pay for lower quality domestic assets (as observed in Japan and Korea when similar measures were normal practice) and increase borrowing costs for the government.
The Pensions Commission can revive collectivist pensions
There are better ways to encourage pension funds to engage in more productive investment, while at the same improving rather than jeopardising outcomes for savers. The most obvious is to revive collectivist pensions provision, particularly defined benefit (DB) schemes, where individual members do not bear investment risks. DB investment strategies became more conservative because schemes closed to new members and accruals, depriving funds of regular cash income.
However, DB provision remains viable in industries with large, stable employers: the Commission should develop sector-by-sector strategies for the maintenance and revival of DB pensions. It could explore establishing a multi-employer DB section within the state-owned National Employment Savings Trust (NEST), which currently only offers a defined contribution (DC) scheme – this means individual members bear investment risks.
Collectivism can also become a feature of DC too: in collective defined contribution (CDC) schemes, members still bear the investment risk, but at least share it with other members, and new members and contributions help to fund the pension payments of retired members. There is already good news here: separately to the Bill, the government has planned new regulations that will allow mulit-employer CDC schemes to roll out on a voluntary basis.
The Pensions Commission should consider how more savers can be transferred to CDC provision and, again, consider how NEST can be utilised in this regard. Open collectivist schemes mean objectives around productive investment and adequate outcomes be aligned – because they can maintain allocations to higher-risk and higher-return asset classes.
Raising minimum contributions would be risky
It is not yet apparent that the Commission has the license to be as bold as required. As things stand, it seems likely that the primary focus of the Commission will be on increasing minimum workplace pension contribution rates: they remain stuck on 3% for employers and 4% for employees (applied to a band of earnings between £6,240 and £50,270). This is understandable, since low contributions are a cause of both inadequate outcomes and conservative investment strategies.
But there are good reasons minimum rates have not moved for so long. For employees, higher contributions mean lower take-home pay: a difficult ask at a time of significant cost-of-living pressures.
And employers are already having to contend with both stronger employment regulation and higher minimum wages, as well as a higher rate of employer National Insurance contributions. Each of these policies can be justified, but overall there is a sense that businesses are being asked to finance the government’s social policy goals.
Imposing higher minimum pension contributions would also have some justification. But this policy could backfire in practice if it harms jobs and growth, as well as the delicate consensus that underpins the existing auto-enrolment regime.
The triple lock should be refined not removed
The cynical take on the Pensions Commission is that it will be used to provide independent cover for the abolition of the ‘triple lock’ on state pension indexation. The government’s commitment to this policy expires at the end of the current Parliament. This would be a mistake.
The triple lock, which ensures that the value of the state pension rises each year in line with prices, earnings or 2.5% (whichever is higher) is helping to steadily drag payments towards the OECD average, after it was allowed to decline over several decades. Despite the over-heated discourse around this policy, its primary beneficiaries are young people (i.e. tomorrow’s pensioners) not baby boomers.
The balance between state and private provision is not zero-sum. Where the state pension provides greater retirement security for individuals, greater risk-taking within private saving is facilitated, and, therefore, UK pension funds’ poor record of patient investment in the domestic economy can be related to the low level of the state pension.
What the Commission could do, however, is take some of the heat out of the triple lock debate by laying out a long-term blueprint for reform. It could recommend that state pension indexation is founded on solid targets for income replacement rates, and establish a timetable for phasing out the triple lock if and when private saving produces better outcomes for all.
Pension tax relief should be on the Commission’s radar
We tend to overlook the fact that the state already plays an enormous role in supporting – indeed subsidising – the private pensions system through tax relief on contributions valued at around £50 billion annually.
The current government, like all recent governments, has shown a willingness to tinker around the edges of the pensions tax regime. A more wholesale review is required – but this does not currently seem within scope for the Pensions Commission.
It could explore ending tax relief in its current form, instead recommending a direct government contribution into pensions saving pots varied according to income level. But if this means lower levels of state support for higher earners, it could lead to a lower aggregate volume of pensions saving by introducing a perceived saving disincentive for some.
There is a far simpler solution that would enhance fairness while minimising the fiscal impact: the government could apply National Insurance to pensioners’ income. Given that pensioners tend to use a greater proportion of their income for consumption, this measure would also have macroeconomic benefits. It would enable demand to be managed without harming the living standards of working-age people, and create more scope for long-term investment by redirecting resources away from everyday consumption.
Conclusion
A new pensions commission is the right idea at the right time. But to address rising pensioner poverty, and align objectives around domestic investment and outcomes for savers, the Commission must be allowed to be ambitious. Before employers and employees are asked to contribute more to private saving, we must ensure the right structures are in place.
The views and opinions expressed in this post are those of the author(s) and not necessarily those of the Bennett Institute for Public Policy.
