Developing a DC pensions growth strategy for life insurers

At a glance

• The DC (Defined Contributions) pensions market is estimated to reach £800bn in assets by 2030¹ with most scheme members / customers in the UK relying heavily on their DC schemes for their pension income.
• Securing good retirement outcomes for DC scheme members is a challenge. At present most customers decide to go into drawdown or cash-in their pensions at retirement (see Figure 2). This does not always lead to the best long-term retirement outcomes because customers are left managing longevity, investment and inflation risks on their own.
• Life insurers play a significant role in the DC market, from product development, risk management, customer support and servicing of products through retirement.
• There are three reasons why we believe it is the right time for life insurers to rethink their DC pensions strategies. First, there is a material commercial opportunity in the expected growth of the sector. Second, under the Consumer Duty (the Duty)², insurers need to demonstrate they are delivering good retirement outcomes. This includes providing effective support to help customers make better decisions at retirement. Third, insurers already have the technical expertise, data, and know-how to deliver a better DC proposition for customers.
• In our analysis we outline three key pillars of action for insurers to develop a DC growth strategy. Pillar 1: retirement products and services must meet the changing needs and circumstances of customers in the short and long-term. Pillar 2: customers must be supported during the decision-making process to achieve good outcomes. Pillar 3: for life insurers to be successful, they must adapt and develop products and services that meet customer needs, this strategy should be sponsored by the CEO Office.
• In a series of forthcoming articles, we will analyse each of the three pillars of action to describe actions and recommendations for insurers in planning their DC growth strategies.
  

Introduction

The pensions market landscape in the UK has changed dramatically over the past 20 years. Whilst Defined Benefit (DB) schemes have become a rarity outside the public sector, Defined Contribution (DC) schemes continue to grow (approximately 26.4m members are enrolled in DC schemes as of 2023 in the UK³).

Most scheme members will need to rely on their individual DC savings to secure a reasonable pension at retirement. However, a reliance solely on DC savings presents many challenges for consumers and evidence indicates that without material policy and market changes, retirement outcomes may well worsen⁴.

Life insurers play a significant role in this market. In this first paper we:

• describe what the UK DC pensions market looks like today and will look like in 2030; and
• why insurers should act now focusing on the three pillars of action.

We will follow with a deep dive into each of the pillars of action in subsequent papers which will include recommendations for insurers to develop their DC retirement business strategy.

The UK DC pensions market: today and in 2030

DC pensions market in numbers

The DC pensions market is split into the trust-based market where a pension scheme is governed by a board of trustees who manage investments on the scheme members’ behalf and is regulated by The Pensions Regulator (TPR), and the contract-based market where the scheme is governed by a provider (regulated by the FCA) and an Independent Governance Committee (IGC). In trust-based schemes, insurers offer their pension products, known as workplace retirement products, to employers and their board of trustees. In contract-based schemes, insurers offer their pension products directly to the retail market.

Figure 1: The private pension landscape in the UK – Total active members (2022)

Various studies estimate the overall DC pensions market will be around £800bn by 2030 based on 2023 prices with the trust-based market accounting for about £400bn. This growth comes primarily from the reduction of the auto-enrolment age, driving an increase in the overall number of active DC scheme members who by 2030 will have been contributing for close to two decades.

Good retirement outcomes: a challenge

The lifecycle of a pension product has two phases: accumulation and decumulation. Each phase presents unique challenges to achieving good retirement outcomes. During accumulation, it is widely acknowledged that most workers are currently saving too little (the retirement funding gap), with 61% of scheme members saving less than 8% of annual salaries⁵. The 2015 Pensions review estimated that, to secure an appropriate retirement income, the level of savings should be around 15% of annual salaries. In addition, less than 20% of self-employed workers are saving into a pension and the overall number of those self-employed is set to increase, creating a significant class of under-pensioned workers.

At retirement, the prevalent choice of drawdown products means that consumers are left to manage longevity, investment and inflation risks on their own. At retirement decisions are complex and support levels for customers have been relatively low with an estimated 52% of pots accessed with neither advice nor guidance between October 2019 and March 2020⁶. We will refer to this challenge as the support and advice gap. Figure 2 shows the prevalence of cashing in the lump sum (fully or partially) and going into drawdown as being well above the take-up rate of annuities across all pension pot sizes between April 2021 and March 2022.

Although the introduction of Pensions Freedoms in 2015 was expected to stimulate product innovation, in the pensions market, this has not happened.

Figure 2: Number of pension plans accessed in the UK by pot size and method of access (2021 - 2022)

The role of insurers in the DC market

Insurers play a significant role both in the accumulation phase and customer decision-making at the decumulation phase. The role of insurers includes:

• Offering and delivering a range of relevant pensions products that meet the needs of customers and scheme trustees (in the UK mainly drawdown-based products and annuities).
• Providing support to customers making retirement decisions through their pension journey both during accumulation and decumulation phases. Support can take the form of guidance, enhanced guidance or regulated advice depending on need and customers’ ability / willingness to pay.
• Fulfilling the products sold during the decumulation phase (drawdown services, annuities in payment).
  

Three reasons for insurers to act

Insurers should consider the role they play today and the role they aspire to play in the future to ensure commercial success and good retirement outcomes for their customers:

1. The commercial opportunity

The DC pensions market is set to grow with assets expected to double by 2030 reaching £800bn across trust and contract-based DC pensions. With DB schemes in run-off, the future of pensions in the UK sits squarely in the DC pensions market. As the average pot size is set to increase, so do the potential options for customers when choosing products at retirement. Insurers find themselves in pole position to provide those options to customers.

2. Regulatory change

Over the past 20 years, conduct and prudential regulation have changed significantly for insurers in the pensions market. Recent reforms to the Solvency UK⁷prudential regime create more opportunities for developing new products (for example with elements of guaranteed income) as their capital intensity is set to decrease through Risk Margin reductions and other incentives.

In addition, the Duty raises the bar, with insurers having to demonstrate how their products and services will deliver good retirement outcomes and enable customers to pursue their financial objectives. At retirement decisions are notoriously difficult for customers, because of their complexity and long term consequences. Life insurers that do not have advice permissions are wary of being perceived as crossing the boundary from guidance to advice. This reluctance by insurers to be more proactive in their approach to guiding customers mixed with a lack of product innovation has led to reduced help and options available for customers at retirement.

The key question is for how long this reluctance will be a risk-free choice for life insurers. Both the FCA and HMT are very keen to explore solutions to the advice gap in financial services as the current review of the advice/guidance boundary⁸ demonstrates. Firms that are more agile in identifying the opportunities the review could bring are likely to be better placed to grow in this market.

3. The right skills, expertise and data to deliver better retirement outcomes

Insurers have the right skills, expertise and data to develop new products that offer flexibility for customers in retirement. However, insurers have a lot of work to do to ensure products can be successfully developed and distributed to achieve good retirement outcomes in a commercially viable way.

Key pension market developments - 20 years of significant change

The barriers to better pension outcomes at retirement

At and around retirement customer decisions are crucial to long-term pension outcomes. There are two clear dimensions to this challenge: consumer or demand side issues and insurer or supply side ones. Consumer-related barriers include:

• low levels of understanding and financial literacy;
• underestimation of life expectancy;
• complexity and number of factors to be considered in the decision; and
• consumers’ low appetite for taking advice (unaffordability issues).

On the other hand, there are several supply / insurance side barriers including:

• lack of product innovation, for example products offering blended solutions that include a mix of drawdown and guaranteed income component;
• current guidance / advice models are not well designed to meet customer needs with many customers relying on family and friends to help them make material and irreversible retirement decisions; and
• the steep financial, regulatory and operational costs and risks of developing alternative products and support solutions.

It is very clear that several factors contribute to the advice and support gap. Insurers’ current advice models and risk-averse approach to giving guidance is a significant one. The gap will not be materially closed unless insurers are able to address these barriers effectively.

We are of the view that in the current DC pensions market there is a clear opportunity for insurers to step in by providing products that meet customer needs and providing the right level of support. The current regulatory requirements around the Consumer Duty make this an imperative if firms want to demonstrate they are delivering good pension outcomes to their customers.

The three pillars of a DC pensions strategy

In our subsequent articles we will explore each of the three pillars and associated actions for insurers and other stakeholders. Below we provide a high-level description of each pillar.

Pillar 1: Designing products that meet the changing needs of customers

For insurers to grow in this market and make the most of its opportunities, it will be essential that products are developed for a clearly defined target market and that customers can be mapped to their corresponding target markets to ensure good outcomes. This process of matching customers to products should be the backbone of the overall strategy and will require a suitable data and technology strategy to ensure success.

There are three basic needs when it comes to retirement income decisions, the relative weight of which varies with the customer’s outlook and risk appetite. These are: income maximisation; risk management (longevity, inflation and investment risk); and retaining some flexibility and liquidity through retirement. These three basic needs can inform the approach to products.

A modular approach to product development is potentially a good fit since it allows firms to blend their products to suit different customers’ needs. For example, a more risk-averse customer might decide to set a higher proportion of their pension pot to buy an annuity, whereas a less risk-averse one might want to keep a greater amount in equity investments and retain the ability to spend more flexibly during retirement. It is also well-known that spending needs vary significantly between early and late retirement possibly giving rise to a mid-retirement review where customers can take stock of their previous decisions and potentially change the mix of products. However, product development should go well beyond combining existing products into exploring what customers want and value today and in the future. This would require more effort, but we are of the view that this is a market ripe for disruption from Government and regulatory reform, demographic trends and technology developments. Together these should act as catalysts for action.

Pillar 2: Supporting customers at retirement

Although developing the right products that both meet customers’ initial needs and evolve with those needs is crucial, they will fail in the absence of the right channels and support to enable customers to purchase them with trust.

Since the advent of Pension Freedom reforms in 2015 and the Retail Distribution Review, DC pension customers at retirement have primarily resorted to cashing in their tax-free lump sums and gone into drawdown with very low take-up of advice. This effect is driven by a combination of inertia, over-confidence (customers over-estimating their level of knowledge of pension products), present bias (where customers place a lower value on future outcomes) and advice affordability issues. This means that developing products in parallel with the development of their sales journey including details of how they will be taken to market and whether they will require advice, guidance or a different support model are key to unlocking the potential opportunities in this market.

In December 2023, the FCA and HMT published their long-awaited review of the advice guidance boundary. The Discussion Paper acknowledges the UK has a material advice gap in financial services which includes the pensions market at retirement. Although it is very early in the reform process, there is consensus across the political spectrum that the advice gap needs closing.⁹ Life insurers are likely to be very interested in the proposals around a new targeted support framework that goes beyond guidance but falls short of full regulated advice. Under these proposals firms might be able to gather information from customers and, by mapping customers to their target markets, insurers could offer products and services based on customers in similar circumstances or ‘people like you’. This could be a game changer in the industry as the regulator is considering allowing firms to fund this service with limited forms of cross-subsidisation.

Pillar 3: Creating the right environment for a DC growth strategy

The challenges in the DC market for insurers are well known and many firms over the last decade have attempted different solutions with inconsistent success. A key element of a successful strategy in this market is to create the right environment to innovate and most importantly to create a proposition that works for the customer throughout their entire retirement journey. The challenge of significant prudential and conduct regulation in the sector can act as brakes to innovation. And inertia driven by corporate memory of past issues can amplify this effect and lead insurers to limit their initiatives to what feels familiar.

Breaking such inertia will require a concerted effort from the top of the organisation. A DC growth strategy that can help life insurers succeed in the long to medium term in this market should be sponsored by the CEO office. The right mix of experts needs to be brought together with a view to sharing and collaborating, looking at DC markets in other jurisdictions and considering product and distribution challenges together rather than in silos. This effort requires a different mindset to what we currently see in many firms, where actuarial teams dominate product development projects and consideration of customers’ needs and experience sometimes comes as an afterthought. Customer experience teams, compliance and risk teams working alongside actuarial teams have a greater chance of developing a product that customers understand and meets their needs.

Conclusion

Over the next few months, we will analyse each of the pillars to identify actions and recommendations for firms in the DC pensions market. Life insurers are facing both an opportunity in the projected growth of the DC market but also a threat in the need to demonstrate the delivery of good pension outcomes to consumers. Now is the right time to delve deeper into what needs to change to develop a commercially viable and successful DC pensions strategy fit for the UK DC market of 2030 and beyond.

References:

[1] In 2023 prices – Source: Department for Work and Pensions, Trends in the Defined Contribution trust-based pensions market, 2023, available at: https://www.gov.uk/government/publications/trends-in-the-defined-contribution-trust-based-pensions-market/trends-in-the-defined-contribution-trust-based-pensions-market

[2] The FCA’s Consumer Duty was implemented in July 2023 for open products and from July 2024 for closed products.

[3] The Pensions Regulator, DC trust: scheme return data 2022 to 2023, 2023 available at https://www.thepensionsregulator.gov.uk/en/document-library/research-and-analysis/dc-trust-scheme-return-data-2022-2023

[4] Institute for Fiscal Studies, Report 255 – Challenges for the UK pensions system: a case for a pensions review, available at: https://ifs.org.uk/publications/challenges-uk-pension-system-case-pensions-review

[5] Ibid 4 – 61% of the middle-earning private sector employees who are contributing to a pension are saving less than 8% of their earnings, and 87% are saving less than the 15%.

[6] Association of British Insurers, Future Proofing the Freedoms: Supporting customers decision about pensions withdrawals, 2021 available at: https://www.abi.org.uk/globalassets/files/publications/public/lts/2021/supporting-customer-decisions-about-pension-withdrawals.pdf

[7] For more information, please see:

Deloitte, “Solvency UK: Moving closer to reality”, 2023, available at: https://www2.deloitte.com/uk/en/blog/emea-centre-for-regulatory-strategy/2023/solvency-uk-moving-closer-to-reality.html

Deloitte, “Solvency UK Matching Adjustment: Another piece of the puzzle falls into place”, 2023, available at: https://preview2.deloitte.com/content/www/uk/en/blog/emea-centre-for-regulatory-strategy/2023/solvency-uk-matching-adjustment.html

[8] FCA, Advice Guidance Boundary Review Proposal: Closing the Advice Gap, 2023 available at: https://www.fca.org.uk/publications/discussion-papers/dp23-5-advice-guidance-boundary-review-proposals-closing-advice-gap

[9] Labour Party, Financing Growth, Labour’s Plan For Financial Services, 2024, available at: https://labour.org.uk/wp-content/uploads/2024/01/Financing-Growth.pdf?__cf_chl_rt_tk=MqNbo.XUBCpqM_fCF7AykBid0O4Hao9T_WBYRlnPANQ-1706690857-0-gaNycGzNC3s