Research shows DC is maturing rapidly, but more work needs to be done to boost contributions, finds Jack Jones

Defined contribution (DC) has grown up in recent years, but has some way to go before it is up to the job of replacing defined benefit (DB). Those are the main findings from Willis Towers Watson’s FTSE 350 DC pension scheme survey 2017.

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Almost all new joiners at the country’s biggest employers are now put into DC arrangements, and there has been a boom in annual contributions and fund size. But the amount of money going into the DC system is still dwarfed by DB contributions, and most employers are putting off thinking about how this will affect the way they manage an aging workforce.

So are these just growing pains? And what can schemes do to make sure that contributions are high enough to give members a decent retirement income?

Universal coverage

The most obvious trend identified in the report is the rapid replacement of DB schemes by DC – 98% of firms now only offer new joiners DC. On the FTSE 250, just over a quarter of firms have DB schemes that are open to future accrual, while on the FTSE 100 half of schemes are open to existing members.

If you go back to the early 2000s it was less than 20% of companies that put their new employees into DC

Willis Towers Watson senior consultant Richard Sweetman says: “If you go back to the early 2000s it was less than 20% of companies that put their new employees into DC, by 2010 that had increased to about 90%, and now DC coverage for new entrants is almost universal.”

This influx of members has given DC schemes a shot in the arm when it comes to funding. Median contributions at blue chip firms have risen from £7m a year in 2013 to £18m this year – while the mean annual contribution now stands at £40m. For the slightly smaller companies, the median contribution tripled over the last two years to £6m. Sweetman says this dramatic change was driven largely by auto-enrolment.

The result is that DC schemes are getting bigger. Average fund sizes on both indices doubled in size from 2015 to 2017, driven by increasing contributions, strong investment gains (around 30% was typical last year) and consolidation of schemes. The median fund size on the FTSE 100 now stands at £201m, and the mean value of scheme assets is almost £500m.

But these schemes are still small compared to mature, multi-billion pound DB funds. The amount going into them each year is also considerably lower, although it is difficult to put an exact figure on the cost of DB.

Companies are contributing double the amount to DB in deficit contributions and ongoing costs that they are to DC

“The comparisons are difficult to make,” says Sweetman. “But we think companies are contributing double the amount to DB in deficit contributions and ongoing costs that they are to DC. Considering the vast majority their active employees are in DC, that’s quite a stark picture.”

Default contributions 

This is despite the fact that, on the face of it, big firms continue to offer healthy contribution rates. The average flat contribution structure in the FTSE 100 has remained relatively stable over the last six years and currently gives staff a 9% employer contribution for a 1.6% employee contribution.

The average structure offers members a combined rate of 16.5% if they pay in 6.2%

Those that offer matching structures appear more generous, and have also remained stable. The average structure offers members a combined rate of 16.5% if they pay in 6.2% of salary. Firms in the most generous quintile give a combined 22.9% while those at the least generous end have average contributions of 9.2%.

So even the stingiest employers appears to be well ahead of the average DC contributions reported by the Office of National Statistics of 4% (1.5% employer and 2.5% employee). But Sweetman says looking at the maximum matching contributions can be misleading. Some 89% of FTSE 100 and 94% of FTSE 350 firms default employees into schemes at the minimum contribution rate. Just 8% and 6% respectively default to the highest rates.

Inertia tends to rule here, so if people are enrolled at the lower rate, typically they won’t increase that

“The headlines look quite generous if you take up the opportunity of the full matching contribution but, as we know, inertia tends to rule here, so if people are enrolled at the lower rate, typically they won’t increase that,” says Sweetman.

People also tend to assume that once their employer puts them into a pension scheme, that means their retirement income will look after itself. “Often employees will say ‘I’m in a pension scheme’ and they don’t know if it’s DB or DC. The man in the street often just assumes that means they’re alright – with no idea what they’re paying in or what the outcome might be. In DC, that’s not necessarily the case.”

A typical 25-year old would be able to retire six years earlier if they took advantage of the full match

Modelling from Willis Towers Watson shows what a big difference extra contributions can make. A typical 25-year old member of an average FTSE100 scheme would be able to retire six years earlier if they took advantage of the full match, the firm’s calculations suggest.

This puts quite an onus on trustees to engage with members to get them to understand exactly what their outcomes are likely to be – when they will be able to retire, and what level of income they can expect at current contribution rates.

Trustees also have a strong obligation to engage with DC members over their retirement choices. The report flagged up some interesting differences in how contract-based and trust-based schemes had adapted investment strategies in light of the retirement flexibilities introduced in 2015.

Contract-based schemes were split fairly evenly between strategies that still target annuities and those that have introduced ‘balanced’ de-risking paths, with a handful targeting drawdown. Trust-based schemes had taken a wider range of approaches, however, with one in eight currently targeting short-term cash.

Although this figure could seem alarming, it is likely to reflect the fact that most people retiring from these schemes over the next few years have fairly small pots, and plenty of DB benefits to rely on – meaning they are likely to cash out their DC pots.

As the member starts to approach retirement, you would hope they would start to put a lot of effort into educating

“If you’re a trustee and you say, in the next five years the majority of members will take cash, then the default should be cash, but you have to keep that under review,” says Sweetman. “A well-run scheme would have a fairly robust engagement strategy, so as the member starts to approach retirement, you would hope they would start to put a lot of effort into educating and flagging to the member what the situation is, and putting options in place to allow them to do something different.”

But there is also a responsibility on firms to start thinking about how they will manage a DC workforce. Sweetman says there is an “intellectual recognition” that companies will struggle to do this if members cannot afford to retire.

This only becomes a problem if the employer is on your books when you want them to retire

“But in reality, it’s usually tomorrow’s problem,” he says. “They have more urgent and pressing things to focus on. Also, this only becomes a problem if the employer is on your books when you want them to retire. It’s like musical chairs – are you the employee that is left with that employee when the music stops.”

But without a concerted effort to raise contribution rates in DC, some employers will be left standing when the music stops, and many members will be left disappointed.

How Nationwide boosted contributions

By defaulting members in at the highest contribution rate, Nationwide building society increased the number of members making extra contributions from 9% to 84%.

The 12,000-member scheme has a core employer contribution of 13% and an employee contribution of 4%, and gives a further 3% in matching contributions.

But until it flipped its default contribution in 2015 very few members took advantage of the extra money on offer.

The scheme spent 12 months communicating with members before making the move, giving them more information about expected retirement incomes, and talking about their aspirations for when they finished work.

Head of pensions Ian Baines says: “It’s a logical extension to auto-enrolment itself. We’re using that inertia, and in many cases apathy, to get people in the right place.”

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