Implementing choice

The UK's proposed National Pensions Savings Scheme (NPSS) is intended to promote personal responsibility for retirement savings. But what kind of platform is needed to make this work and what lessons can be drawn from similar schemes in Sweden and Denmark? Clive Davidson reports

The notion of choice is central to the debate over what form the UK's proposed National Pensions Savings Scheme (NPSS) will take. It is a notion that is finding increasing favour in public and private pension plans, and in sketching out its options, the UK government is only following the lead already taken by the US, Sweden, Denmark and others that have introduced defined contribution (DC) state pension schemes allowing members to choose where they invest.

In the pensions debate, choice is often presented as the other side of the coin of personal financial responsibility. Looked at from another perspective, however, it can be seen as an attempt to transfer risk from the provider of pensions to the receiver. But whether the UK government is trying to promote personal responsibility or transfer risk, it will only work if the NPSS is designed and implemented in such a way as to encourage members to exercise their choice.

Promoting personal responsibility for saving for retirement is one of the key aims of the NPSS. Within the framework of a state saving scheme, "The choice of how much to save, the level of risk to take with investments, and how long to work must be available to the individual," says the government's white paper on the NPSS (The design of the National Pensions Savings Scheme and the role of financial services regulation, May 2006). Furthermore, the scheme should be simple and affordable, says the government. But balancing choice, simplicity and affordability is not in itself simple.

Most of the models that the government is considering - models put forward by the Pensions Commission, the National Association of Pension Funds (NAPF), the Which? consumer organisation, the Association of British Insurers (ABI) and others - propose that members choose the level of risk they take with their investments by selecting from a number of fund options. Which? suggests the choice should be limited to five options - low, medium and high risk/return funds; a long-term fund (the default fund) based on lifecycle principles where savings are invested in medium-to-higher risk assets such as equities at the outset and progressively switched to lower risk assets towards retirement date; and an ethical fund. UK life insurance company, Norwich Union, proposes something similar, adding the possibility of religious faith-compliant funds.

These proposals lean heavily on the Federal Thrift Savings Plan (TSP), a pension scheme for US Federal workers, including those in the armed forces. The TSP offers six options - five characterised by their asset classes (government securities, fixed income, major US stocks, small and mid-cap US stocks and international stocks), and a lifecycle fund. When the scheme was set up in 1987, government securities was the default fund (initially there were just two other options - fixed income and major US stocks), with the default changed to the lifecycle fund on its introduction last year.

"Participants (in the TSP) don't have to make a choice of where their funds are invested, but they are strongly urged to do so," says Tom Trabucco, director of external affairs at the TSP. The cajoling of the TSP and its agencies (Federal employers), and the nature of the funds, seems to work because the vast majority of the scheme's 3.6 million members actively choose which fund their savings are invested into, says Trabucco.

Denmark has roughly the same number of members (3.2 million) in its Special Pensions Savings Scheme (SP), a supplement to its two main government pension schemes. However, less than 1% have bothered to choose from its list of alternatives to its default fund. Meanwhile, in Sweden, where around 5.5 million workers are members of its Premium Pension scheme, around 60% have exercised their choice of investment funds. There are a number of factors that help explain these variations, not all of which are as clear-cut as they first appear.

The first factor is the number of funds on offer. ATP, the organisation that administers Denmark's SP, offers 197 funds. With a take-up of under 1%, this proves that the more choice members are offered, the less they are likely to exercise that choice, say many observers. "Give people a huge choice and the most likely outcome is confusion - they will become debilitated by uncertainty and most probably won't actively choose anything," says Richard McManus, member of the management group at global management and technology consultancy PA Consulting Group.

But the number of choices is not the only factor, nor even necessarily the most significant one. Although organisations like Which? and Norwich Union point to the success of the constrained choices offered by the TSP, Sweden's Premium Pension offers around 780 funds yet still has an active choice level of 60%. Critical to this take-up level appears to be the marketing and media exposure that accompanied the launch of the Premium Pension.

"We launched the Premium Pension in 2000 and it received more media attention in Sweden than the Sydney Olympics which were on at that time," says Daniel Barr, chief economist at the Premium Pension Authority (PPM) which administers the Swedish scheme. In addition, the PPM ran a marketing campaign that included television advertising, billboards, and so on. On top of that, the third-party funds into which Premium Pension members could invest their savings did their own marketing. With that kind of profile, it is perhaps not surprising that so many members directed where their savings should go. However, statistics since the launch are more ambiguous. Last year, 400,000 existing members switched their savings to different funds, but only 8% of newcomers to the scheme bothered to exercise their choice. Barr points out that these newcomers were mostly young people who traditionally show little interest in pensions, or immigrants, or housewives earning their first income. The fact that they have left their savings in the default fund initially does not necessarily mean they will always be disinterested in where they invest in the future, he says.

Meanwhile, Denmark's launch of its SP failed to ignite the same local media hoopla as Sweden's Premium Pension, and as Danes greeted their new-found freedom to invest part of their pension where they liked with indifference, ATP cut back on its marketing. "We found it difficult to continue to justify expenses on marketing and information," says Frank Olesen, executive vice president of ATP.

But the real reasons for the low level of active choice in Denmark is that individuals have so little money in the scheme, and they do not believe they can beat ATP's own investment managers who have a very good record of returns, says Olesen. The SP is only a part of the Danish government's pension provision, so contributions are relatively small (1% of salary). Furthermore, the Danish government has taken to treating the SP as a fiscal instrument, and has stopped contributions because the economy has slowed down, says Olesen. This has left individuals with an average of 20,000 Danish kroner (£1,800) in their SP. "That is not an amount that people want to spend much time thinking about," he says.

When people do spend time thinking about their pensions investment, they want clear-cut options, believes the TSP. "We have tried to ensure that each of (the TSP's) funds, which are all broad-based index funds, are distinctive choices with no overlap, and are easy to explain," says Trabucco.

In addition to keeping it simple, the TSP also goes to some effort to educate its participants about their choices. "We're not trying to sell any particular funds - they are all good choices," says Trabucco. TSP aims to provide information and support to help people decide the most appropriate fund given their risk tolerance and investment horizon. For example, when it launched its lifecycle fund last year, it sent all 3.6 million members a DVD explaining the new fund, and updated all its other support documentation.

The US and Sweden's experience show that education and marketing are important factors in the success of a choice-based pensions scheme. Furthermore, choice involves transferring at least some investment risk to the individual, so there is an onus on the provider to supply adequate information and decision support tools. But what does this add to the cost of the system, and how might this affect the design?

Unlike a conventional government pension scheme, a choice-based system must hold members' savings in individualised accounts, and allow for them to access those accounts and move their savings between funds. Denmark spent around EUR30 million building its SP scheme. It is a web-based system, with considerable online guidance and analytical tools to aid individuals in their fund selection. Through an online questionnaire, individuals can define their risk profile over the life of their pension. This is then translated into a 'personal curve' - a graph plotting the proportion of savings invested in higher, middle and lower risk instruments over time. Members have three options as to how they invest their savings: leave their savings in the default fund, personally choose a portfolio from the funds on offer, or make a 'joint choice' - after the individual defines their personal curve, the system suggests a number of options for a portfolio and the individual makes the final choice of the portfolio's compostion. Considerable information is available on the returns, risk and costs of each fund.

One innovation of the scheme that has caught the attention of the financial sector in Denmark is the 'atpRating' system, in which ATP calculates the costs of a fund (the sum of its up-front, administration and transaction costs), and assigns it a rating. Borrowing from the well-known Morningstar returns rating system that uses star symbols, the atpRating is expressed by a number of crown symbols. On the ATP website, each fund in the SP scheme is given a crown and a star rating. "There is a debate as to whether (fund) costs have an impact on returns or not," says Olesen. "We believe so, and our crown system provides cost transparency."

Although sophisticated and informative, the SP system does not come with a hefty operating cost. The annual cost per member is around £2.50. "This is an eye opener to NPSS stakeholders that I have presented our system to," says Olesen.

The secret of the low running costs is automation and the use of the web for interacting with members, says Olesen. "We have been building know-how for 40 years on how to automate pension schemes and we took advantage of that," he says.

PPM's Barr says that although the incorporation of choice added to the cost of Sweden's Premium Pension system, "On the whole, it was a marginal cost." However, where the system could have been more cost effective is in limiting the number of fund choices, thereby concentrating savings in few funds and achieving economies of scale in asset management. "By all comparisons with other schemes internationally, the cost of our system is low, but it could have been much lower if we had fewer choices," says Barr.

Trabucco at the TSP says the fact that their system is on the web has allowed them to drastically reduce two of their three major costs - paper and postage (the other cost being personnel). The use of the web and DVD technology enabled the organisation to run an educational programme for its new lifecycle fund for substantially less than the $10 million that was budgeted for it. "The web is terrific for pension plans like this," he says.

But where the web is the obvious technology to use for the interface between members and the organisation that ends up operating the NPSS, and automation and straight-through processing of transactions (with no manual interference) should be the goal in administering the scheme, the optimal design of the administration system is by no means clear. Here comparisons with the US, Sweden and Denmark break down because in each of those cases the schemes cover all workers (the TSP scheme covers all Federal workers) and can exploit the existing infrastructure for the collection of contributions. The NPSS, however, will only apply to a subset of the working population - those not covered by other workplace or voluntary schemes - and collection of contributions is more complicated.

The NPSS administration system will have to link with all employers whose staff are potentially eligible for the NPSS. By definition, this means small companies, often with limited IT resources. For this reason, PA Consulting's McManus suggests that instead of building an entirely new system from scratch that companies would have to interact with, the NPSS should use existing infrastructure wherever possible. Building an administration from scratch might have conceptual merits in that it can be designed for the purpose and could make cost-effective use of new technology, but it could end up costing more than planned in that employers will have to be persuaded to use it. "This could involve huge marketing costs and you still might end up with a low take-up," says McManus. It would be better to use existing infrastructure, such as the government's pay-as-you-earn (PAYE) system, or other platforms that small companies already interact with, such as utilities. "For the NPSS to get real traction, the employers have to be bound in, so you need an infrastructure that works for them," says McManus.

Another danger to avoid is having a government department - in this case the Department for Work and Pensions (DWP) - build the administration system itself, says ATP's Olesen. "In Denmark, at least that would imply a long and resource hungry process," he says. The omens in the UK are not good either. In September, the DWP scrapped a £140 million project to merge benefit payment systems. The DWP would not comment on whether it is likely to try and build an administration system for itself. Olesen recommends that DWP follows Denmark's lead and outsources the building of any required system to an independent non-profit organisation along the lines of the ATP.

Another factor that would influence the design and cost of systems to support the NPSS is whether the government decides to opt for a second dimension of choice in the pension provider. While organisations like Which? have argued vigorously that provider choice would drive up costs, potential providers such as Norwich Union Life counter that a market in providers - which would compete on the service they offered - would drive up service levels as well as participation because the providers would market strongly to individuals and employers. The providers would also be responsible for the systems, most likely web-based, that members would interact with (while the government or its appointed organisation would be responsible for the system that employers would interact with, and through which contributions would be collected). This multiple provider approach would spread implementation cost and risk, says Graham Vidler, head of pension strategy at Norwich Union Life.

One area of choice with the NPSS that has not been given sufficient attention, according to a number of people in the industry, is the possibility of opting out of the scheme. Recent revelations that savings under the NPSS could affect means tested pensioner benefits has drawn attention to the need for advice where there is choice in a scheme like the NPSS.

Stewart Ritchie, president of the Faculty of Actuaries in Edinburgh, believes the opt-out is the primary choice that workers will face with the NPSS, and it is here that there should be adequate advice available to workers. But this raises the questions of who will give this advice and how will it be paid for? There is an inherent conflict between the government's aim to drive down the costs of the scheme, and the need to provide proper advice. "There is a need to strike a balance between the right amount of information and advice and the cost of providing it," says Ritchie. Individual financial advisers would be ideal but expensive, while if the government goes for a choice of providers in its final proposal, then there would have to be sufficient allowance in the pricing structure to enable the providers to offer a reasonable level of advice, he says.

But the issue of advice is fraught with difficulty. Because of the government's handling of the pension issue over the years, and the industry's unfortunate history of mis-selling pensions in the past, neither have the full trust of workers.

"The Government ought to make a decision about the quality and quantity of advice that is required for people to come to a decision that is right for them," says Ritchie. "Whether people do or do not opt out of a personal savings account is a decision that they could potentially get horribly wrong."

Schemes such as the US Federal Thrift Savings Plan, Sweden's Premium Pension and Denmark's Special Pension Savings Scheme demonstrate how it is technologically feasible to deliver sophisticated and cost-effective schemes for investment choice, and the role that education and design (particularly in the number and characteristics of funds offered) play in their success. Meanwhile, the unique nature of the NPSS, in that it will aim for a subset of the UK workforce mostly working for small companies, means that it will require a new infrastructure or innovative use of existing platforms. Only when the government makes its decisions, expected this autumn, on the final shape of the NPSS, will it become clear just what is required to support its operation.