UK: the Pension Act 2008

The Pension Act 2008 introduces three major changes to workplace pension provision in the UK. First, employers have a duty to automatically enrol their eligible employeesFootnote ³ into a qualifying workplace pension scheme. Employees can opt out after automatic enrolment if they wish.

Second, once the reforms are fully implemented, employers must contribute a minimum of 3 per cent of an employee's qualifying earningsFootnote ⁴ to their pension pot if the employee remains in the scheme. This is the first time that UK employers have been required by law to contribute to employees’ pensions. Overall contributions to the employees’ pension pot should total a minimum of 8 per cent, including 1 per cent in the form of tax relief. The minimum contribution made by employees is therefore likely to be 4 per cent in most cases.

Third, the National Employment Savings Trust (NEST) has been set up to facilitate automatic enrolment. It is designed to offer simple, low-cost pension plans to people on lower earnings, and to meet the needs of small employers. Employers can enrol employees into an existing workplace pension if it meets certain standards; alternatively, they can use a new scheme or NEST.

New Zealand: KiwiSaver

KiwiSaver is primarily a work-based savings scheme, although anyone under sixty-five can set up a KiwiSaver account, and accounts can also be opened for children. Like the UK workplace pension reforms, KiwiSaver's basic features include automatic enrolment. But while New Zealand employers must automatically enrol eligible new employees into a KiwiSaver scheme, in the UK all eligible employees (not just new ones) will be automatically enrolled.Footnote ⁵ KiwiSaver also requires minimum contributions from employees who are automatically enrolled and their employers. But while compulsory contributions to KiwiSaver are based on gross earnings, in the UK they will be limited to a narrower band of qualifying earnings.

Since its inception in 2005, there have been significant changes to KiwiSaver (see St John et al., Reference St John, Dale and Littlewood2011). One major change is the level of contributions. The initial aim of KiwiSaver was to achieve a total minimum contribution of 8 per cent of gross earnings by 2011 for employees who had been automatically enrolled: 4 per cent from employers (starting at 1 per cent and increasing annually) and 4 per cent from employees. Changes announced in 2008 by the new centre-right National Party Government meant that from 2009 employees make a minimum contribution of 2 per cent from their pay. The employers’ compulsory minimum contribution was capped at 2 per cent. In other words, the total minimum contribution is now 4 per cent, not 8 per cent. Minimum employee and matching employer contributions will increase to 3 per cent from 1 April 2013.

KiwiSaver's generous incentives and benefits have also been reduced. To promote take-up among the wider population and encourage members to voluntarily contribute to their account, the scheme initially offered a capped dollar-for-dollar annual Member Tax Credit and an annual fee subsidy, as well as a one-off tax-free ‘kick-start’ payment. To reduce scheme costs in the face of the global financial crisis, the National Party Government has halved the maximum Member Tax Credit and abolished the annual fee subsidy; the ‘kick-start’ payment remains. The Employer Tax Credit, to help offset the cost of the scheme to employers, has also been abolished.

Australia: Superannuation Guarantee

Introduced in 1992 by a Labour Government, the Superannuation Guarantee is a mandatory employer contribution to a private pension plan which (with some exceptions) applies to all employees.

The compulsory employer contribution rate was originally 3 per cent of qualifying employee earnings (4 per cent for large employers). It gradually increased to 9 per cent over the following decade. In 2010, the Labour Government announced a rise in the employer contribution from 9 per cent to 12 per cent, to be phased in over the period 2013 to 2019.

Employees are not obliged to contribute to their superannuation plan, but since 2003 lower-income workers have been encouraged to save by means of government co-contributions (or matched savings), up to a maximum entitlement. The original government match rate was 150 per cent (i.e. AUD 1.50 for every AUD 1.00 saved, up to AUD 1,500). From 2009, however, the match rate and the maximum entitlement were temporarily reduced ‘to support the longer term sustainability of our pension system, and the budget more broadly’ (Swan, Reference Swan2009). In the 2011 Budget, the government announced plans for a new superannuation contribution tax rebate for low-income workers, which if introduced would benefit an estimated 3.5 million employees.

Comparing pension reforms in UK, New Zealand and Australia

On the face of it, New Zealand's KiwiSaver scheme is a close comparator to the UK workplace pension reforms. There are, however, important differences in the details of the schemes (for example, how contributions are calculated). Taking into account the near-universal access to KiwiSaver and the contribution holidays and withdrawals that members are permitted to take, it is arguably more like an ISAFootnote ⁶ than a pension plan.

Like the UK reforms, the Australian Superannuation Guarantee focuses solely on extending workplace pension coverage. Unlike the UK reforms and KiwiSaver, however, the Superannuation Guarantee places the onus for contributions squarely on the employer. The minimum contribution in Australia is also higher in percentage terms than either the UK or New Zealand.

While all three countries provide incentives to members to save for their retirement, Australia and New Zealand offer financial inducements over and above tax relief, which is not the case in the UK. Of the three countries, only the UK has created a simple low-cost pension scheme (NEST). The simplification of default scheme options has, however, been discussed in both New Zealand and Australia (see below).

Investment choice

In common with many other countries, the pension reforms in New Zealand and Australia are designed to allow employees to choose how their pension savings are invested, if they wish to do so.

There is, however, a large body of evidence that individuals are often not willing or able to make those choices. Most only have a basic understanding of financial risk; they do not have a clear idea of what these risks actually are; and many do not appreciate the impact of time on risk (IFF Research Limited, 2007). In addition, knowledge and understanding of pensions is poor, and individuals may not even appreciate that pension funds are invested on the stock market (Hayden et al., Reference Hayden, Boaz and Taylor1999; Bunt et al., Reference Bunt, Adams, Koroglu and O'Donnell2006; Clery et al., Reference Clery, McKay, Philips and Robinson2007). It is hardly surprising, then, that members often find choice in pension schemes confusing and feel ill-equipped to make decisions about the sorts of funds to invest in (Bunt et al., Reference Bunt, Adams, Koroglu and O'Donnell2006).

The evidence shows that a significant proportion of employees in New Zealand and Australia do not make an investment choice for themselves. The majority of New Zealand employees who were automatically enrolled (82 per cent) into KiwiSaver did not choose the pension scheme into which their savings would be invested. Instead, they were allocated either to a default scheme by the Inland Revenue or to their employer's nominated scheme (Inland Revenue, 2010). Some of these employees may, of course, have considered other options before deciding to remain in the scheme to which they had been allocated.

All KiwiSaver schemes offer a range of investments from which members can choose if they wish. Very few members chose to switch from one fund to another, however. Only 4 per cent of default scheme members had switched fund in 2010/11; the figure for members who had actively chosen to join a scheme was around 2 per cent (Financial Markets Authority, 2011).

In Australia, the number of employees that make active choices is similarly low. Since 2005, the majority of employees who receive superannuation contributions from their employer have been able to choose their superannuation fund. Yet fewer than 10 per cent do so (Fear and Pace, Reference Fear and Pace2008).

Around 70 per cent of superannuation funds in 2010 offered investment choice to members.Footnote ⁷ But, as in New Zealand, around 80 per cent of superannuation members in Australia do not make an active investment choice (Australian Government, 2010). It has been argued that this inertia or lack of interest in making superannuation investment choices is rational, given the low account balances of most employees and the costs of making a better decision (Sy, Reference Sy2008).

In the UK, the lessons from New Zealand and Australia (and indeed elsewhere, see for example Tapia and Yermo, Reference Tapia and Yermo2007) are reflected in the investment strategy adopted by NEST. As a result, the investment choices faced by employees will be considerably less complex – at least for those who are automatically enrolled into NEST. For those who do not want to remain in a default fund, there will initially be a choice of five investment funds.Footnote ⁸ The expectation is, however, that the majority of NEST members will remain in a default fund (NEST, 2011).

Default funds

If pension fund members do not make an active fund choice, their contributions are generally directed to a designated default fund. Where the majority of employees do not make active choices, as in New Zealand and Australia (and expected in the UK), the composition and performance of default funds is an important factor in determining pension income in retirement.

In New Zealand, employees who are automatically enrolled into KiwiSaver are allocated to their employer's chosen scheme. If their employer does not have a nominated scheme, the Inland Revenue allocates employees to one of six government-sponsored default providers. By the end of June 2011, 26 per cent of all KiwiSaver members were allocated to a default scheme by the Inland Revenue following automatic enrolment. Contributions are automatically invested in the default providers’ conservative investment fund option, which must limit the proportion of equity assets to within 15–25 per cent of total assets.

In Australia, the default fund into which superannuation is paid is determined by the relevant industrial award which applies to the individual's workplace. In the absence of an award, the employer chooses a default superannuation fund for their employees. The default fund investment portfolio is selected by the fund trustees and there do not appear to be any legally defined criteria for default funds in this respect.

There have been debates in both countries about the structure of default investment funds, revolving around the perceived need for greater standardisation and rationalisation. Some pension experts in New Zealand have questioned the need to have as many as six default KiwiSaver providers (see Collard and Moore, Reference Collard and Moore2010). In 2011, the government-sanctioned Savings Working Group recommended the creation of a new low-cost default scheme which should only invest in index-based shares and bonds, and offer only a limited number of investment combinations. It also recommended setting up an ‘ultra-low-risk’ fund which invested only in government short-term securities (Savings Working Group, 2011).

In Australia, concerns have been expressed about the differential performance of superannuation default funds, which implied differing risk characteristics for similarly labelled options (Gallery et al., Reference Gallery, Gallery and Brown2004). Various proposals for a national superannuation default fund to simplify the existing arrangements have been put forward (Sy, Reference Sy2008; Ingles and Fear, Reference Ingles and Fear2009). Following a review of the superannuation system, the Australian government plans to introduce ‘MySuper’ − a simple, low-cost superannuation plan with a standard set of fees and single diversified investment strategy − to replace the existing default funds from 2013.

In the UK, it is likely that a considerable proportion of employees will be automatically enrolled into the default fund of their employer's existing pension scheme. These schemes may offer little or no investment choice to members.

NEST's default strategy comprises over forty-five Retirement Date Funds, and members will be enrolled into the fund that targets the year they expect to take their money out. NEST's investment strategy is informed by evidence that its members are likely to have a low capacity for risk due to lower median incomes and lower savings than existing pension savers, who tend to be drawn from the top quartile of the income distribution. They are also likely to be risk averse, with those on low incomes and in their twenties in particular shown to have strong negative and emotional responses to investment loss, even if this is temporary (NEST, 2012). For younger members, therefore, the strategy in the first five years is deliberately very low risk to encourage persistency of saving and avoid negative reactions to volatility (ibid.). This has been criticised by some in the pension industry as too low risk, and against conventional thinking about young people's greater capacity for risk.Footnote ⁹

Fees

Fees and charges can have a significant impact on the income that pension savers eventually receive in retirement (see, for example, Senate Select Committee on Superannuation, 2002). In both New Zealand and Australia the level and complexity of fees and charges have been a matter of concern.

In New Zealand, competition in the KiwiSaver market is felt to be hampered by complex fee structures that make comparison difficult for ordinary savers (Rashbrooke, Reference Rashbrooke2009). Investment return comparisons are also fraught with difficulty (St John et al., Reference St John, Dale and Littlewood2011). The government-sanctioned Savings Working Group recommended that KiwiSaver providers should be required to produce regular reports that specify all fees and charges, as well as the net investment returns to the member after deducting all costs (Savings Working Group, 2011).

In Australia, there is evidence that investment choice in superannuation accounts has led to a higher cost structure, without necessarily maximising savings for most workers (Sy, Reference Sy2008). The fees vary markedly by fund type and complex cost structures are difficult for many investors to understand (Chant, 2008, cited in Sy, Reference Sy2008). One goal of the superannuation review undertaken in 2009/2010 was to reduce the cost of superannuation to individuals and raise retirement income, with a major focus on administration fees and commissions. In both New Zealand and Australia, standardisation and rationalisation of default investment funds is seen as a major way to reduce costs to members, as described above.

In the UK, any pension scheme used for automatic enrolment should demonstrate value for money and transparency of charges (Work and Pensions Committee, 2012). NEST, the new scheme into which employers may chose to automatically enrol their employees, was also intended to offer low-cost products. NEST members are expected to be charged a 1.8 per cent contribution levy on the value of each contribution to cover set-up costs, and an annual management charge of 0.3 per cent of the fund value. Industry and pension experts have criticised these relatively high charges, particularly given the low-income profile of NEST's target group. The CBI Director-General, for example, described it as ‘not cheap enough’ and there are concerns that the costs are higher than for existing large occupational pension schemes.Footnote ¹⁰ The contribution levy is expected to be removed, making the scheme cheaper, but it is unclear when this might happen.

Participation

As in New Zealand, eligible employees in the UK will be automatically enrolled into a workplace pension scheme, with the opportunity to opt out if they want to.

There is encouraging evidence from New Zealand about the effectiveness of ‘soft compulsion’ to bring people into pension saving. The majority of employees who were automatically enrolled into KiwiSaver have remained in the scheme. Roughly a third of those automatically enrolled each year decide to opt out (28 per cent in 2011, down from 34 per cent in 2008 and 2009). Early evidence found that employees mainly opted out because of the minimum contribution rate of 4 per cent of earnings (Inland Revenue, 2008), which was reduced to 2 per cent in 2009. Evidence that is more recent indicates that higher earners are also more likely to opt out because they have other forms of saving (Inland Revenue, 2011).

One of the drivers for pension reform in the UK is to bring more young people and those on lower incomes into pension saving. The statistics indicate that ‘soft compulsion’ is effective in this respect. Young people aged between eighteen and mid-twenties (who also tend to be on lower incomes) are over-represented among KiwiSaver members, compared with the eligible population, reflecting the automatic enrolment of young people entering the labour market (Inland Revenue, 2011). The home purchase subsidy provided by KiwiSaver also attracts young people to the scheme (ibid.).

Contribution levels

Once the UK pension reforms are fully implemented the total minimum contribution to an employee's pension pot will be 8 per cent of their qualifying earnings. The Pension Commission, among others, has stressed that 8 per cent is the bare minimum required; a comfortable retirement would almost certainly require a higher level of contributions, particularly for those with few other sources of wealth. The evidence from New Zealand and Australia is less encouraging in this respect with few employees or employers contributing any more than the minimum.

In 2011, 43 per cent of employees who saved into KiwiSaver through deductions from their salary or wages were contributing 4 per cent of their gross earnings (the original default rate). A further 53 per cent were contributing 2 per cent (the default rate since 2009). Only a small proportion (4 per cent) chose to contribute 8 per cent (Inland Revenue, 2011).

The default level of contribution clearly has a strong influence on members’ behaviour, with most tending to ‘set and forget’ (Inland Revenue, 2010). Of employees who joined KiwiSaver before April 2009, the majority (62 per cent) contribute 4 per cent of gross earnings (the default when they joined). Of those who joined the scheme after April 2009, 80 per cent contribute 2 per cent of their earnings, the new default. This implies that the majority of UK employees who are automatically enrolled and do not opt out will only contribute the required minimum amount (likely to be 4 per cent).

The picture is the same with regard to employer contributions. The majority of employees in New Zealand (91 per cent) receive the minimum 2 per cent KiwiSaver contribution from their employer (Inland Revenue, 2011). A concern for the UK is that employers who currently contribute more than the minimum to their employees’ pension saving may ‘level down’ their contributions to that rate once the workplace reforms are implemented (see, for example, National Pensioners Convention, 2011). Based on research with employers, however, the government considers this risk to be low (Work and Pensions Committee, 2012).

In Australia, 27 per cent of employees receive employer contributions greater than the Superannuation Guarantee required amount (Bingham, Reference Bingham2003). The Superannuation Guarantee does not require Australian employees to contribute to their superannuation savings but they are encouraged to do so by means of tax incentives and, for people on low and middle incomes, by a system of government co-contributions (or matched savings). These have been relatively ineffective, however. In 2007, only 27 per cent of Australians in employment were accumulating superannuation by salary sacrificing, contributing from their own after-tax income or receiving contributions from their spouse's after-tax income. Regardless of age, cost was the main reason why Australians did not contribute to their superannuation account (Australian Bureau of Statistics, 2009).

Income and living standards in retirement

The eventual outcomes of pension reform for individuals and their households will be the result of a complex range of factors. For employees on lower incomes generally, the interaction of their private pension saving with the UK's complex state pension and benefits system will undoubtedly be the most important factor that determines whether or not their living standards in retirement improve as a result of the workplace pension reforms. While it was beyond the scope of this article to explore these interactions and implications, this section provides some indications of the impact of pension reforms in New Zealand and Australia in terms of income and living standards in retirement.

In both countries, pension reforms were anticipated to significantly increase the replacement rate that people achieve in retirement.Footnote ¹¹ In New Zealand, it was estimated that for someone retiring at age sixty-five on average earnings, KiwiSaver would increase the net replacement rate from 41 per cent in 2006 to around 55 per cent (the OECD average is around 70 per cent). For a KiwiSaver member on half average earnings, it was estimated that the replacement rate could be in excess of 90 per cent (Rashbrooke, Reference Rashbrooke2009).

In Australia, it was estimated that a single male on median earnings with thirty years superannuation contributions (at nine per cent of earnings) could expect to retire with a total replacement rate of 76 per cent (comprising age pension plus superannuation). This would increase to 85 per cent had contributions been made for forty years (Bateman and Kingston, Reference Bateman and Kingston2006). By way of comparison, the replacement rate of a median Australian earner in 2006 was estimated to be 59.2 per cent of net earnings (OECD, 2009).

A key question for pension reforms that require contributions from employees (as in New Zealand and the UK) is whether this money is additional to other savings or a substitute for them. Early indications from New Zealand show that 36 per cent of the money contributed to KiwiSaver would otherwise have been consumed through daily activities and outgoings; in other words, it was new saving. The majority of money (64 per cent) would have been used for other forms of saving or to reduce debt (Inland Revenue, 2011); other saving may not, however, have been earmarked for old age. There is also evidence that KiwiSaver has (so far) only reached between a third and a half of its target population – people who would not otherwise have saved enough to maintain their standard of living in retirement (Inland Revenue, 2011).

In addition, there are concerns about the impact of the considerable number of changes to the KiwiSaver scheme since its inception. It is estimated that changes made to KiwiSaver in 2009 resulted in an average benefit reduction of 34 per cent, with the highest percentage reduction (38 per cent) experienced by those on the lowest incomes (St John et al., Reference St John, Dale and Littlewood2011). Uncertainty about the scheme's future is also a barrier to KiwiSaver membership, alongside affordability (Inland Revenue, 2011).