Redesigning UK workplace pensions: Are defined ambition pensions the road towards sustainability

  • Ryanne Cox Ryanne Cox

In this thesis, the UK pension system and its upcoming reforms are evaluated against the benchmark of economic theory. The analysis results in a set of recommendations to improve the sustainability of UK workplace pensions.
The evaluation starts by, first, drawing up a framework for optimal pension design based on academic literature. Recommendations from this framework are that, if we were to design a pension system from scratch, it is optimal that the pension system facilitates consumption smoothing by ensuring adequate participation and contribution levels; facilitates that savings are invested using the life cycle model; consists of a pay-as-you-go first pillar and funded second pillar; facilitates, at least for a sizeable part, automatic annuitisation; avoids major sources of (actuarial and other) unfairness, and is transparent where unfairness is inevitable; ensures a high level of completeness of pension contracts and high quality trustees to make residual choices; is of sufficient scale and invests collectively to ensure optimal performance relative to costs; and has effective defaults in place to overcome behavioural hurdles in respect to participation, contributions, investment strategy and annuitisation.
Next, the UK pension system is analysed and evaluated against the optimal pension design framework. We conclude that the inadequate State Pension, in combination with low participation and contribution rates in voluntary workplace pensions result in the situation that many citizens are building up insufficient retirement income. Due to the rising costs of longevity, private sector employers have often abandoned collective and guaranteed Defined Benefit pensions in favour of individual and contract-based Defined Contributions plans, offering no certainty of retirement income, less cost-efficient pensions and a higher exposure to behavioural bias. Meanwhile, public sector pensions have maintained guaranteed benefits, though at a significant cost to the taxpayer. As a result, there is a sizeable gap between the average public and the average private sector employee’s pension, which is both unfair and unsustainable.
In the third part of this thesis, two possible directions for solutions are explored: introducing more effective risk sharing in pension schemes, and improving (public sector) schemes’ cost-efficiency. The discussion on risk sharing focuses on finding a model for ‘Defined Ambition’ pensions, as proposed by UK Minister for Pensions Steve Webb. A possible model is drawn up using elements from the new pension deal in the Netherlands, introducing a mechanism to adjust future retirement income for market ‘shocks’ based on risk sharing between scheme members and employer. The resulting model enables linking the certainty of future benefits to members’ risk tolerance, allows for effectively managing the annuities conversion risk on behalf of members, and avoids that the bill for any shocks occurring today is passed on to the next generation. Also, the case is made for consolidation among the funded public sector pension schemes as a means to improving schemes’ cost-efficiency and financial performance. By way of ‘reality check’, the input of conversations held with UK market experts on the upcoming reforms, as summarised in Box 4.1 on page 70, are taken into account when evaluating these proposals.
The discussion of UK pension reforms against the benchmark of the optimal pension design framework results in three key recommendations. First, the upcoming auto-enrolment policy for workplace pensions should be stepped up to ensure adequate levels of participation and contributions. Second, risk sharing between members and employers in trust-based, collective pension plans should be introduced to improve the quality of private sector employees’ pensions and reduce the gap between private and public sector pensions. The model as proposed in this thesis offers a transparent mechanism for organising such a ‘Defined Ambition’ pension. Finally, consolidation among the funded public sector schemes should be stimulated to improve sustainability, and reduce the cost, of public sector pensions.

Netspar, Network for Studies on Pensions, Aging and Retirement, is a thinktank and knowledge network. Netspar is dedicated to promoting a wider understanding of the economic and social implications of pensions, aging and retirement in the Netherlands and Europe.

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