UK Pensions Briefing | A shake up of all things DC, starting with retirement options

What’s happening?

The world of defined contribution, or DC, pension saving is going to see a seismic shift in the near future.

Pension freedoms (the ability to decide how and when to draw on pension savings) are all well and good, but not all members are equipped to take the right steps or decisions with their savings. That means poor outcomes in retirement. The pendulum is therefore swinging back towards protecting members from their own folly.

There have been a lot of different UK government policy initiatives in recent years which are now beginning to coalesce, so this briefing and one to follow will bring the main strands together for you. The key factors are reform of the post-retirement phase, value for money, small pots consolidation and targeted guidance, with pensions dashboards providing support and pensions adequacy trailing behind. We focus in this briefing on decumulation.

Post-retirement phase: guided retirement (decumulation)

“Decumulation” has come to mean the period starting when a saver first takes benefits from their DC pension savings pot and ending with their death.

July 2023 feedback from a DWP 2022 call for evidence indicated that generally smaller schemes offered fewer decumulation options and had less access to the full range of retirement products on the market. Allowing members to take their pot as cash was the most likely option whilst some either offered UFPLS (where the DC pot is gradually taken out in lump sum payments with each payment having its own tax free lump sum) or an annuity broker service. Respondents highlighted that for some of the single employer or smaller schemes their rules prevented them from offering a range of decumulation services.

However the DWP also noted a trend for schemes to partner with commercial master trust providers for signposting and transfers at retirement. Some schemes have partnered with multi-asset funds to offer drawdown and UFPLS products to their members whilst others have also partnered with insurance companies to offer secured income to their members.

That wide variation in cover is all set to change. All trust-based DC schemes are going to have to offer a default retirement option, under draft laws to be presented “soon” for adoption by Parliament this year. The Bill (draft legislation) isn’t published yet, but the DWP has briefed industry bodies on what the requirements should look like.

Default retirement option

Trustees of DC arrangements will have to provide a default retirement option for every member, applying when they ask to start taking benefits. That means a structure for payments to the member, alongside investment of the remainder of the savings pot, for the remainder of the member’s life.

Trustees will have to decide on the shape of the default to be offered, while staying inside the remit of a money purchase benefit. The main building blocks will therefore be drawdown (flexible or UFPLS), annuities or a combination of the two, with some allocation to tax-free cash. In the future collective defined contribution (CDC) options may be part of the mix as well. But trustees will also need to decide on the rate of drawdown, a default investment profile for remaining capital, the degree of tax-free cash and annuity allocation, the age at which any later life annuity kicks in, and whether any annuity should have additional features such as dependants’ benefits and/or index linking.

These are all decisions which most DC savers are currently expected to make themselves.

In the real world the right structure for retirement income for any particular individual will depend on a multitude of factors personal to them and the state of the market at the time at which they come to take benefits. It’s going to be different for everyone. Everything from your overall level of savings, the amount of debt you have at retirement (e.g. a mortgage to pay off), your family circumstances to your mortality expectations. And that is before comparing available annuity rates with drawdown options and expected investment return. The size of the pension pot in any one scheme could also be a determinant: trying to buy a pension from a small pot may be disproportionately expensive, or indeed impossible.

Statistics included in a DWP consultation in 2023 on helping savers understand their pension choices highlight the challenge: only 29 per cent of 55–59-year-olds said they had a clear plan for maximising their later life income, and 17 per cent reported that they did not know they had to make a choice. Of those that had a plan, two-thirds (66 per cent) reported that they planned to take at least some of their pension as a lump sum whilst one in five (22 per cent) reported that they planned to take all of their pension as a lump sum. As the DWP put it at the time, this presents a risk to the adequacy of their future pension income.

How are trustees expected to decide on a one-size-fits-all default?

There are likely to be some minimum requirements imposed around the factors to take into account when deciding on the default retirement option. It is clear that DWP expects very careful consideration by trustees before selecting a default retirement option, and for trustees to revisit that decision at appropriate intervals to make the most of an innovating market.

The number one priority for the DWP is to have longevity protection at the heart of the decision-making process. Members should not be put at risk of their income coming to an end before they die.

Combine that primary objective with traditional pension trustee caution and you might expect annuities to sweep the board. Annuitisation gives a guaranteed income for the remainder of the saver’s lifespan. But that can be expensive, and there are other factors to take into account.

The DWP also expects trustees to take heed of members’ views, and to use their knowledge of their own membership to determine the right balance of risk versus certainty. A low paid demographic may have different views of what a comfortable retirement looks like compared to the more affluent, and the price (and availability) of annuities will vary with pot size and health expectations.

That presents a practical challenge for trustees: deferred members are the most likely to disappear off the map until it comes to retirement age. Keeping in touch with them is difficult, but this may be where pensions dashboards come into their own by creating a new link back to old forgotten pension pots.

The message coming from the DWP is (and we paraphrase wildly here), trustees’ chosen solution doesn’t have to be perfect for everyone, but trustees must be able to show that they have thought hard about their membership and what their members might want and need before deciding on a default, and that they are revisiting those needs and that decision on a regular basis. We expect the Pensions Regulator to have some involvement in assessing that exercise.

There will be the option to offer different defaults for different segments or cohorts of members. Segmentation of members by reference to their needs will be a new learning curve for trustees, but there may be help on hand here. The FCA’s proposed reforms to make retirement guidance both accessible and meaningful. The FCA proposes a new category of “targeted support” where FCA-authorised firms would be able to provide suggestions appropriate to “people like you” without needing to consider the individual’s own circumstances in detail. Trustees should be able to tap that new expertise when designing defaults.

Delivery of the default retirement option

The next question is how to provide the default.

The watchword in the various consultation papers has been “partnership”, but successive pension ministers have had differing views on what this actually entailed. The initial plan was to require the originating scheme to remain responsible for the member’s savings throughout the member’s retirement, and indeed to intervene and adjust retirement arrangements already in payment where appropriate. Even though the administration of this phase could be outsourced to a third party provider, the trustees would remain liable.

DWP policy has now switched to accepting that the default does not need to be provided from within the original scheme. Trustees should be able to work with a third party retirement provider to establish a suitable structure and transfer DC pots to that third party if the default retirement option is engaged.

We also expect the incoming value for money requirements to be extended to offering and managing default retirement options. For many non-commercial DC schemes, securing a third-party solution for default retirement options may be the only way to satisfy that standard.

The member experience

From the saver’s perspective, the plan is to make things as simple as possible. Savers will remain free to transfer their DC savings out of their workplace pension plan to another, preferred retirement model, or to aggregate their various pots in one arrangement, or indeed to take up any other options their current plan may offer. But if they ask to start payments without also directing how their savings should be dealt with, their pot must be applied as per the scheme default retirement option.

What isn’t clear yet is whether and for how long trustees will be expected to review and intervene in a member’s retirement option once it is in payment.

Members will also see a much more coherent and continuous communication strategy. Trustees will be expected to explain how the decumulation phase works from the day an individual joins a DC scheme, and to ramp up the explanations and communications over time. Combine that with access to pension dashboards and we may start to see more financially educated savers able to take better decisions, but with the protection of a default retirement offering which is designed with the saver’s security in retirement in mind. This initiative may even drive a better focus on adequacy of pension savings and higher contributions.

What’s next?

In a subsequent briefing we will address the main other factors we see driving a sea change in DC pensions savings provision and member experience. With value for money, small pots consolidation and targeted guidance all in sight and pensions dashboards becoming a reality, it’s going to get busy.