Words matter. And they particularly matter in legislation, where they are chosen carefully in the knowledge they will be pored over for hours by lawyers and potentially the courts to establish their meaning.
So I was interested in the words used in the new Pension Schemes Bill. This takes forward the Government’s defined ambition agenda, designed to encourage risk-sharing and provide greater certainty about retirement savings. Two terms caught my attention.
First, defined contribution schemes are added to Department for Work & Pensions legislation while money purchase schemes are removed. Although many use the two interchangeably, legislation distinguishes between them.
Money purchase describes benefits that derive on an individual basis from the contributions for a member, in contrast to collective benefits where the contributions for members are pooled. Both can include a guaranteed element.
In DWP legislation, the term DC now signifies a pension with no promised retirement benefit. This makes it different from defined benefits, where there is a full pension promise, and the new ‘shared risk’, where there is a partial guarantee of retirement benefits. DC pensions can be on an individual or collective basis. Confusingly, the new DWP definition of DC is different from the one already in tax legislation.
This change of terminology matters. For automatic enrolment, the Government must distinguish between different types of pension when setting the employer obligation, including on charges. It wants to encourage guarantees to reduce risk but these are unlikely to be practical within a charge cap of 0.75 per cent a year. Applying the cap to DC rather than money purchase will allow some relaxations for shared-risk arrangements.
The challenge, then, is to prevent regulatory arbitrage. A shared-risk scheme may levy a guarantee charge on top of an administration charge of 0.75 per cent a year, creating a potential hidden source of profit and so subsidising the administration charge. The conditions for shared-risk schemes must balance the benefit requirements of DB with the contribution and charge requirements of DC.
That is no easy task.
Promise vs guarantee
The second interesting use of terminology is that of ‘promise’ rather than ‘guarantee’ to describe the commitment to pay a certain level of benefits.
These may just be words but a guarantee feels as though it gives greater certainty than a promise, certainly in a political context. As a US Supreme Court judge said: “Campaign promises are – by long democratic tradition – the least binding form of human commitment.”
We have to hope that pension promises carry more weight and that consumers believe them.
The terminology is important but ultimately the issue is whether the increased complexity introduced by the Bill will be justified by genuine improvements for those saving for retirement.
Consumers want more security than DC offers but guarantees are expensive. In the heyday of with-profits in the 1970s and 1980s, insurance companies offered relatively high levels of guarantee in monetary terms but, with inflation also high, the real level was quite modest. In the current environment of low inflation and low interest rates, even offering a money-back guarantee on contributions comes at a price many consumers would consider prohibitive.
We looked at money-back guarantees during the defined ambition consultation process and my conclusion was the only workable approach would be for the employer to make an additional contribution each month to provide the guarantee for that month’s contributions. As a percentage of payroll the cost would be small – perhaps 1 per cent depending on the total contribution rate – and the guarantee would provide a tangible employee benefit without exposing the employer to the cost and uncertainty of a DB promise.
Other ways of structuring the guarantee looked unattractive to members.
An alternative approach enabled by the Bill is collective DC. This is true defined ambition because there is a target level of benefit for members but no guarantee that it will be achieved.
The logistics of setting up CDC are daunting and communicating how it works to members will be a big challenge. It will work only if they believe the target benefits are realistic and represent value for money, given the risk they will not be achieved.
The framework proposed in the Bill appears robust but the acid test will be whether employers adopt it and employees buy into it.
The Government deserves credit for attempting to offer greater choice for employers and consumers through the Bill. The big unknown is whether it will lead to a step-change in retirement provision or merely be a lot of well-crafted words with little practical relevance.
Ian Naismith is head of pensions market development at Scottish Widows