'Helping to deliver stakeholder pensions - flexibility in pension investment' - an explanation of the Government's latest proposals.
INTRODUCTION
Following the DSS's recent green paper, 'A new Contract for Welfare: Partnership in Pensions', HM Treasury has issued a consultation document introducing new ideas for flexible pensions investment. The main proposal is not for a new kind of pension, but rather for a new financial vehicle in which pension money can be invested. Some commentators have dubbed the new vehicle "LISA", for "Lifetime Individual Savings Account." In fact the DSS's paper gives it no name and we refer to it below simply as the "new vehicle." Designed with the aim of helping to develop and launch stakeholder pensions, it is a tax privileged container in which units in collective investment schemes may be held. It will be most suitable for defined contribution schemes. As with existing defined contribution pensions, the funds built up within the vehicle will normally crystallise at retirement, with no access to pension savings before then. Under present tax rules, the fund would usually be used to buy an annuity.
The tax and national insurance privileges will be the same as those available to comparable pension schemes.
The problem the government is trying to address with its plans for stakeholder pensions and the new vehicle is the failure of personal pension schemes to deliver value to middle-income savers, and particularly, the drawbacks of regular premium life policies in the context of an increasingly fluid labour market. One of the features of the new vehicle which is stressed in the consultation document is flexibility. Because the vehicle could be used in conjunction with any defined contribution scheme, it should become easier and cheaper for people to transfer savings in occupational schemes when they move jobs - perhaps just by changing the pension wrapper, without having to alter the underlying investments. The new vehicle should also be transparent: since unit prices are published (usually daily), scheme members will be able to place an up-to-date value on their fund without the need for acustomised statement.
With the advent of single pricing for unit trusts, this should be a simple process, even for the financial layman.
The paper identifies two difficult areas with life policies. Firstly, they are often sold through advisers, which can be expensive and may be unattractive for middle-income savers. Secondly, the charging structure usually features a heavy front-end load, so that the contributions made during the first four or five years can be all but wiped out by charges. Given that PIA data suggests that 40% of personal pension plan holders have stopped contributing after 4 years, this charging structure is clearly leading to poor value for many consumers. Working patterns are predicted to become less stable, which will exacerbate this problem. The new vehicle, used in connection with stakeholder or personal pensions, should be able to accommodate variable or intermittent contributions without imposing cost penalties.
MANAGING RISK
Defined contribution schemes of any sort are exposed to a degree of market risk. The new vehicle will provide some of the protection from market risk inherent in pooled funds, particularly authorised unit trusts and OEICs, which are subject to FSA rules limiting each fund's exposure to any one security. Comments are sought on the possibility of excluding geared investment trust companies from the category of eligible funds, although there is no mention of geared futures and options funds.
The consultation document raises the prospect of setting up stakeholder schemes without using the trust structure. Some protection from risk would be derived from the fact that all authorised unit trusts and OEICs, and most investment trusts, have their investment assets held by a separate custodian (the Treasury invites comments on the possibility of requiring eligible investment trust companies to have a separate custodian). Such schemes would not, however, offer any counterpart of the trustee's role in looking after the interests of scheme members. Comments are sought on non-trust governance structures generally, and on methods of achieving protection for members equivalent to that provided by the trustees in trust-based pension schemes.
INVESTMENT CHOICES AND RESPONSIBILITY
In any defined contribution scheme, it is essential to pursue a policy that avoids exposing the fund to market fluctuation as the employee nears retirement - a crash the day before a participant retires could wipe out a significant proportion of savings built up over years of contribution. A popular system in the US involves the so-called 'lifestyle' option, which automatically moves from an aggressive to a defensive investment policy as the employee gets older. Thus, a 30-year old would be invested mostly or entirely in equities (whether mutual funds or individual stocks), which are likely to provide the best growth rates in the long term, while an employee 5 years from retirement would be invested entirely in bonds. Although the pooled funds proposed by government are inherently more stable than individual equities, there would be scope for following the basic pattern: higher risk combinations of fund units for younger people, and lower for those nearing retirement.
An alternative, again modelled on US 401(k) schemes, would be a menu of funds or fund combinations, with the scheme member having discretion to invest.
In the US, employers running such schemes may be relieved of fiduciary responsibility if this option is combined with proper education of members, which has led to many employers offering substantial employee education programmes, and sophisticated information systems for scheme members. Investor sophistication is generally less developed in the UK; such education programmes would sit well with the FSA's new statutory responsibility to educate consumers, and would be very important in determining the success of a scheme.
WILL THEY BE POPULAR?
There has been resistance to the increased promotion of defined contribution schemes, notably from trade unions, who fear a raw deal for employees. However, the new vehicle is not intended to replace defined benefit occupational schemes - where these are available and appropriate, they are likely to provide a better deal for savers. The proposals are linked to the planned stakeholder pension, but their impact may first be felt in the personal pension market, where the flexibility they offer could be very attractive to some sections of the workforce. Comparisons have been made with the US, where defined contribution plans (in the shape of 401(k) schemes) have become enormously popular, but there are significant differences between the US and UK environment:
- 401(k) schemes are the only pension schemes to attract tax concessions in the US, whereas the UK regime features a range of tax-approved plans.
- Most 401(k) plans have features that make them more attractive to employees. They are frequently set up as profit-share or employee share ownership schemes, and there is often a loan facility, perhaps restricted to house purchases or school fees, and sometimes a hardship withdrawal option, making it easier to persuade employees to commit money to the scheme.
- Although equity ownership has increased in popularity in the UK, there is some way to go before US levels of investor sophistication are reached.
Defined contribution schemes may be attractive to employers, because the potential funding headache associated with final salary schemes is avoided.
Employers will not escape responsibility, however, because of the emphasis on educating employees financially. In offering a defined contribution scheme, an employer is passing the obligation to provide retirement income into the collective hands of its employees; this can only be feasible if they are provided with the tools to do the job for themselves.
If the proposals come to fruition, those most likely to benefit would be:
- the large and growing section of the workforce for which defined benefit occupational schemes and life policy personal pensions are inappropriate or poor value, and
- the funds industry, which could find new business created by savers who might otherwise have been steered towards a personal pension based on life products.
TIMETABLE
The new vehicle will be introduced by means of secondary legislation under the Financial Services Act 1986 and Income and Corporation Taxes Act 1988. The relevant orders could be made as soon as late 1999. Powers for stakeholder pensions exist under the Welfare Reform bill, which will come before Parliament shortly. The Treasury invite comments as to when the new instrument should be made available, and particularly, whether its introduction should coincide with the stakeholder pension legislation.
The consultation period runs until 31 March 1999.
This article was first published in the Spring 1999 issues of Macfarlanes' Financial Services Bulletin.
Macfarlanes' Financial Services Bulletins are intended to provide general information about developments which may be of interest. They are not intended to be comprehensive nor to provide any specific legal advice and should not be acted or relied upon as doing so. Professional advice appropriate to the specific situation should always be obtained.
If you would like further information or specific advice, please contact Bridget Barker or Tim Cornick.
