Defined contribution pensions and the cost of living crisis

This blog was first published as a contribution to the Pension Policy Institute’s DC Future Book 2022. 

The UK is experiencing high levels of inflation for the first time since auto-enrolment and the pensions freedoms were introduced. We should expect it to affect savers’ choices. It will be some time before the data is available to tell us exactly how, but we can set out likely outcomes and reflect on how well parts of the defined contribution landscape are working for members.

On the accumulation side, increased financial pressure on households will probably lead to lower pension savings as more people opt out from auto-enrolment or make an active choice to stop saving despite being already enrolled. This could lead to long-term harm if those who stop saving do not restart when their finances improve, but this doesn’t feel like a major concern. 

Even though the squeeze on household finances is expected to worsen sharply over the coming months and continue throughout 2023, it would be a surprise if opt out and active cessation rates increased sharply because the inertia underpinning automatic enrolment is incredibly strong. 

Further, the risk of long-term harm is mitigated by the requirement on employers to automatically re-enrol eligible workers every three years. It looks like the total number of employees who have been automatically re-enrolled will pass one million in the coming year, underlining the importance of this requirement.

The more telling impact of inflation on savers’ decisions is likely to be in how and when they access their defined contribution savings, and I can see two undesirable features of the current landscape that could be exacerbated by the current cost of living crisis. 

First, it might lead to more people cashing out pension pots early and not keeping them for retirement. Savers are increasingly holding multiple pension pots and the proliferation of small, often very small, pots is well documented. However, people’s decumulation decisions are not independent of how their pension wealth is spread across pots and full withdrawals are more common for smaller pots. 

Which? has explored this using experimental research. We gave participants a fictional allocation of pension wealth and asked them to make decumulation decisions. We found that people with multiple, smaller pots were more likely to cash them out early to pay for unexpected expenses. 

The large decline in the number of full withdrawals between April 2020 and March 2021 was unsurprising as the pandemic reduced opportunities for consumer spending. It would be equally unsurprising if the number of full withdrawals increases substantially in the coming year as households are placed under financial pressure from high inflation. 

We can’t judge whether a saver is making a good decision if they cash out a pot - they are best placed to know their own needs. However, people using small pots of pension savings to cover living costs while still in employment was clearly not the policy intention. The implication is that the (safe) consolidation of pots needs to be made easier, with auto-consolidation for small pots, so that people’s decumulation choices are not unduly shaped by how their savings are distributed across pots.

Second, although the current economic situation shouldn't in principle make drawdown decisions more difficult as the inflation risk was always present, it clearly makes the risk more salient. This should lead us to reflect again on how well individual savers are able to manage this. With so many savers purchasing income drawdown products without advice then it is essential that an appropriate, institutionally-managed drawdown product is available as a default option. 

The FCA should be praised for the introduction of investment pathways, with the duty for Independent Governance Committees to oversee their value for money, and rules to deter consumers investing mainly in cash. We now need to see similar changes to the trust-based side of the market and it is welcome that the DWP is working on this. However, it is also important that the FCA evaluates whether investment pathways are making enough of a difference to retirement outcomes. 

We all recognise that defined contribution pensions place the burden of risk, including inflation risk, on members. If they can’t be adequately supported to manage this, then we need to think more radically about encouraging hybrid schemes that pool this risk.