In many ways, economic growth is a game of pushing along every available margin in order to improve living standards for the population. Once in a generation technological innovations aside, most of the time sustained economic growth is delivered via a series of mundane and often marginal improvements. A tariff removal on a particular good, or a single piece of infrastructure will rarely win a place in history textbooks but when taken together, it is these marginal, unremarkable improvements which ultimately build the prosperity we can all enjoy. In the game of economic growth, no pile of money, no matter how small should ever be willingly left out on the pitch.
(Sadly, this is a point which is not always grasped by the wider public or the media. As the recent round of sneering at proposals to reduce the frequency of MOT tests demonstrates, anything which is not a silver bullet, fix all solution is often dismissed as not being worthwhile.)
One area where there currently exists a not-so-small pile of money being left out on the pitch is private pensions. This is an area where the Government has actually achieved significant success over the past decade. The introduction of Automatic Enrolment in 2012 was a great example of using economic research to improve outcomes by exploiting status quo bias to help overcome the UK’s historic undersaving into private pensions.
As part of the introduction of Automatic Enrolment, the Government established NEST (National Employment Savings Trust) to offer a low cost pension provider for employers, particularly those who now found themselves having to set up a pension scheme for their employees for the first time. Since its creation, NEST has proved to be a hugely popular pensions provider, and by 2022 had over 11 million members, managing assets of £24.1bn. NEST therefore now plays a significant role in the future retirement prosperity of almost a fifth of the UK adult population.
Like all private pension schemes, NEST invests the contributions of its members in assets such as equities, bonds and properties - growing the value of their ‘pot’ during their working life to maximise the income the individual is able to call upon in retirement. NEST offers 6 main types of fund, however 99% of its members are enrolled into its default option: The Retirement Date Fund.
Strictly speaking this is a series of funds rather than a single fund, one for each ‘retirement year’ from now until 2068. The fund the individual joins depends on the year when they will retire and claim their pension pot. For example, if an individual is born in 2000 and will reach State Pension Age in 2068, then they will join the ‘2068’ fund along with everyone else retiring in that year. The makeup and investment strategy of the fund then changes as the cohort ages and approaches their retirement. For example, when the cohort is in their 20s, 30s and 40s, the fund is its “growth phase” where it takes more risks than in the “consolidation phase” in the years immediately preceding retirement where it prioritises stability.
NEST’s default funds perform relatively well, delivering good returns and regularly meeting their target return of CPI + 3%. However, rather than simply aiming to maximise the value of the pot when the cohort retires, the fund’s objective is to achieve ‘steady growth’ throughout the cohort’s working life. This means that the fund trades off growth with volatility and as a result it adopts a relatively conservative position. In 2022, the fund's 2040 portfolio (still in the ‘growth’ phase and almost two decades from the point of retirement) was split approximately 60% equities, 25% bonds and 15% other (property, commodities etc.).
Over the past century, equities have generally outperformed bonds over long time horizons. These increased returns do come at a price, with equities also experiencing greater volatility and therefore carrying more risk. This has led to the common wisdom that investors should balance their portfolio between stocks and bonds to achieve that ‘steady growth’ that NEST aims for. Although a balanced portfolio is wise when an individual may withdraw their money at short notice or if their investment horizon is less than 10 years, the same logic does not apply to pension funds. An individual can only withdraw their pension pot after a fixed date, known well in advance and the time horizon for the investment is decades rather than years. Therefore, reducing volatility and achieving ‘steady growth’ doesn’t really matter for pension saving, all that matters is the final number on the day of retirement - no matter how bumpy the ride was to get there.
(Aside: on this point, plans from the Money and Pensions Service to introduce a pensions dashboard may prove to be misguided for this reason - encouraging people to regularly look at their pension performance may lead to them prioritising low volatility rather than high growth).
The consequences of this decision by NEST to reduce volatility rather than maximise growth are highlighted by the contrasting performance of its Sharia Fund. According to Islamic Law, Muslims are instructed not to charge or make interest payments. Since bonds are essentially interest based loans, for a fund to be Sharia compatible, it must consist of equities only. As a result, the NEST Sharia Fund provides us with a reasonable counterfactual of the returns 99% of NEST members could achieve if it (or a scheme with a similar makeup) were to replace the ‘Retirement Date’ funds as the default option.
Since their launch in 2011, the Sharia Fund has significantly outperformed the default Retirement Date funds, achieving an annualised total return of 15% compared to 9.1%. In the last five years the gap in performance has been even more stark: 16.1% vs 7.5%. Now the past decade has been a particularly strong one for equities compared to bonds and the gap is unlikely to always be so wide, however the nature of compounding returns means that even relatively small differences in growth rates will ultimately result in large differences in final pot value over long periods of time.
To illustrate just how much NEST’s 11 million members may be missing out on by being in the current default option rather than the Sharia Fund, consider this worked example. In 2022, Deano, a 20 year old worker enters the labour market earning £10 per hour, working 160 hours per month and hence having a total annual gross income of £19,200. With a Lower Earnings Limit for Automatic Enrolment of £6,240, an employee contribution rate of 5% and an employer contribution rate of 3%, his total private pension contribution in 2022 will be £1,036. Currently this will be put in the NEST default option to earn an average 9% fund growth per year and 10 years before retirement their pot will be transferred to the more conservative ‘consolidation’ fund, which I assume here will earn 5% returns per year. Rolling this example forward through Deano’s working life (assume CPI of 2%, AEI of 3.5% with the Automatic Enrolment thresholds being uprated by CPI), by the time Deano retires in 2070 aged 68, they will have a pension pot worth £786k. Assuming an annuity rate of 4%, this pot would be enough to provide Deano with a retirement income of £12,149 in 2022 prices. Taken alongside a state pension of £9,600 this would give Deano a total retirement income of £21,749.
Now this isn’t a bad end result - but now consider how much better off Deano might be had he been defaulted into the Sharia fund by NEST. Holding all things constant except the fund growth rate which increases from 9% to 15% would more than triple the end income Deano would receive from his private pension to £39,236. Even if we think the past decade has been abnormally good for equities and assume a Sharia Fund growth rate of 11% instead of 15%, this will still result in a final private pension income of £17,451: more than £5,000 than Deano would currently receive under the current default. Therefore, even if the Sharia Fund were to outperform the current default fund by just 2 percentage points, over a working life this would be enough to result in an 44% higher end income1.
The Government has been for some time considering an increase to the minimum contribution rates under automatic enrolment. To appreciate the magnitude of the gains that changing the makeup of the default fund could provide, I repeated the worked example but instead of changing the fund I increased the employee contribution rate. An increase in the employee contribution rate from 5% to 7% but retaining the current default fund resulted in a final retirement income of £16,705. Meaning that the relatively simple reform of changing the default fund provided roughly the same gains in retirement income as a 2 percentage point increase in the employee contribution rate, without the downside of depriving workers of more of their earnings now.
Changing the NEST default fund from the current option to a portfolio more focused on growth and less on volatility has the potential to deliver significant gains in retirement income. An objection to this would be that such a policy is needlessly reckless and would put people’s money at risk. However, it is worth bearing in mind that such an option is already provided by NEST in the Sharia Fund and a quick glance at its top 10 shareholdings suggests that it invests in fairly standard bluechip equities (Apple, Microsoft, Amazon) - not exactly sticking it all on NFTs. In addition to this, a reformed default fund option would not be restricted by Islamic law in the way the Sharia option is and would therefore have the flexibility to adopt more conservative positions during downturns in the market. For example, large losses in the initial years of saving can be particularly damaging to its long term prospects. The ‘Foundation Phase’ in the current fund aims to avoid these large initial losses and should be retained even in a reformed default.
Private pensions policy has been an area of significant success over the past decade but this should not prevent policymakers from continuing to pursue further gains where possible. Reforming the default pension fund of 11 million UK adults so it prioritises growth over low volatility would be one such gain. Increased investment returns leading to higher retirement incomes would not only reduce the need to raise current automatic enrolment contribution rates, but would also provide future governments with greater ‘space’ to lower state pension burdens if the retired population have adequate income from other sources.
Note: I repeated the example with a varying rather than constant Fund Growth rate (the default distributed N(1.09, 0.04) and the Sharia distributed N(1.11, 0.08)) - this obviously introduced variation into the outcomes but did not change the overall picture.