The United States 401(k)-style defined contribution (DC) system is large by global standards, but most in the industry know improvement is needed. The good news is that other DC systems make good case studies on a variety of issues.
For instance, in the United Kingdom’s system, plan sponsors and regulators have taken noteworthy steps to help drive better participant outcomes. While the U.K.’s system is still relatively small (DC plans represented 32 percent of the U.K.’s retirement market in 2015, versus 60 percent in the U.S.1) and the transition began later than in the U.S. and Australia, it’s growing quickly due to mandatory auto-enrollment requirements that began in 2012. Known as “DC schemes” in the U.K., the plans themselves are similar in many ways to their counterparts in the U.S.
The U.K. system has been the beneficiary of both forward-thinking and fortunate timing. For example, by the time DC plans in the U.K. were implemented on a mass scale, the importance of auto-enrollment and proper default funds was better understood.
Key takeaways
Multi-employer schemes
- The government-sponsored National Employee Savings Trust (NEST) and the private People’s Pension are two of a handful of multi-employer schemes, or “master trusts,” as they are known in the U.K. They are available to any self-employed person or employer.
- These schemes have been extremely successful in bringing high-quality, large employer-style plans to the small market. Master trusts now cover 33 percent of DC scheme members, with 1.7 million new members added in 2015 alone.2
Mandatory auto enrollment and minimum contributions
- Mandatory auto-enrollment is being phased-in between 2012 and 2017 — beginning with the largest employers.
- Opt-outs are allowed. Opt-out rates have been lower than expected at about 10 percent, with 56 percent of employers in one survey reporting opt-out rates of less than 5 percent.3,4
- 59.2 percent (5.2 million) of U.K. employees were automatically enrolled in a DC plan in 2015, up from 3 million in 2014.5
- Minimum contribution requirements are being gradually phased in and will peak in 2019, with a minimum of 8 percent total contribution: 3 percent employer, 5 percent employee (including 1 percent tax relief).3
Higher use of default funds
- On average, 90 percent of participants utilize the plan’s default option.6 In the U.S., only 68 percent of participants have balances in default funds.7
- 84 percent of default funds are lifestyle options, which are glidepath-driven model portfolios.2
- Target date funds are not as common in the U.K., but are beginning to gain traction.
Greater acceptance of alternative investments
- The use of alternative investment strategies is more common in U.K. plans than in the U.S., where alternatives adoption has been slow.8
- With larger plans, the alternatives exposure is typically found in lifestyle portfolios through multi-asset strategies called diversified growth funds (DGFs), similar to what is popularly used in U.K. DB plans. Among larger DC plans, 24 percent of default assets are invested in multi-asset portfolios.2
- Direct real estate is more common in U.K. DC plans, and is even included in the target date fund allocations for the government-sponsored NEST scheme.9
Limits on default fund charges
- The expense rates of default funds are now limited to 75 basis points due to a new regulation that took effect in 2015. One of the limiting features of the expense cap is that it includes most administrative costs.
Less leakage
- Loans are not allowed, and hardship withdrawals have stricter standards than in the U.S.
Key challenges
Adjusting to flexible payout options
- Mandatory annuity payouts were dismantled somewhat unexpectedly in 2014. As a result, the glidepaths of many default lifestyle funds (which assumed an annuity purchase) have become incompatible with the needs of scheme members.
- Some plan sponsors and providers are adapting to the new rules by implementing two glidepath options for participants based on whether they plan to buy an annuity or not.
Auto enrollment administration
- Auto-enrollment has been successful in general, but it is an administrative burden for employers due to the complexity of the rules.4
Benchmarking
- Due to the lack of reporting requirements in the U.K., comparisons and benchmarking of scheme features have been challenging, particularly in the area of investments and default options.
Bottom line
Auto-enrollment and the resulting coverage success in the U.K. is off to a promising start, highlighting a model that could be more palatable in the U.S. compared to Australia’s compulsory system. Despite being hampered by rapid, complex, and significant regulatory changes like the expense cap which have curtailed innovation, there remains hope for rejuvenation. One area ripe for exploration in revitalizing the DC landscape is the integration of alternative investments, offering potential for diversification and risk management.
Each DC system worldwide faces its distinct challenges, yet the U.K.’s approach offers valuable lessons, particularly in treating DC plans with aspects traditionally associated with DB plans, including access, investment options, and the requisite contribution levels for satisfactory outcomes. As the U.S. navigates the transition from DB to DC as the main retirement scheme amidst issues of coverage, costs, and fund leakage, embracing alternative investments could be a step forward. Learning from global counterparts underscores that the journey towards improving retirement outcomes is a shared endeavor.
Greg Jenkins, CFA, is senior director and chair of Invesco’s Defined Contribution Institute.
- Towers Watson Global Pension Study 2016
- Spence Johnson, UK Defined Contribution Intelligence 2015
- Department for Work and Pensions 2014
- Barnett Waddingham/Standard Life DC Report, March 2016
- The Pensions Regulator, Automatic Enrollment Commentary and analysis, July 2015
- Aon UK Defined Contribution Survey, 2015
- Aon Hewitt 2014 Universe Benchmarks
- Plan Sponsor Council of America, 58th Annual Survey, 2016
- nestpensions.org.uk