Pensions auto-enrolment: Factoring in costs

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• Measures, such as salary sacrifice, can help employers reduce costs.

• Creating a two-tier pension system might be perceived as unfair.

Auto-enrolment could collectively cost employers over £3 billion a year, so employers need to get a look at all options to keep a cap on costs and to budget for the inevitable

The Department for Work and Pensions (DWP) estimates that auto-enrolment will cost employers around £3.5 billion a year. In addition to the tangible employer contribution costs, which will rise incrementally from 1% to 3% over three years, there will be a number of other administrative and planning overheads to factor in

Affordability is a critical issue and the costs will largely depend on how much money employers have to invest into their administrative processes, as well as the proportion of staff that stay in the scheme once they have been auto-enrolled. How can employers comply with the legislation and manage their budgets effectively?

Jeremy Mindell, senior reward and tax manager at Henderson Global Investors, says that one of the first things employers should do is assess their organisations’ expected take-up rate. The government estimates that around 25% of workers will opt out, but Mindell says employers might actually be surprised by the numbers of employees that remain in the pension scheme. “Lots of people probably will not bother to sign the opt-out agreement, so employers might end up with a participation rate of around 90%.”

Benchmarking your organisation

Kelly Bol, HR manager, reward, at disability charity Scope, says that it is worth employers benchmarking their organisation against another that has already carried out auto-enrolment, and is in a position to share take-up figures. Such an exercise will be most effective if both organisations have similar demographics and are in the same sector. “If [it is not possible to benchmark], the best an employer can do is to provide an overgenerous estimate of what proportion of staff will stay in. Then at least an employer will have over-budgeted rather under-budgeted.”

A survey to gauge interest and potential take-up rates could also give employers more of an idea of what to expect.

Bol says: “I am considering a gradual drip feed of communications on auto-enrolment and, after the first messages, a possible sample survey of staff to try and get an estimate of what the percentage of opt out might be.”

Neil McKie, head of reward at law firm Herbert Smith, says it is also worth reviewing management information on current pension participation levels and the pattern of previous joiners selecting the benefit. “Then employers will need to estimate a much higher take up of say 80% and cost the difference between the two.”

Meanwhile, Brian Newman, international HR director at entertainment firm Live Nation, thinks that basing estimates on the existing membership of group personal pension (GPP) plans and previous levels of interest in stakeholder schemes could also help gauge engagement levels. “Education around pensions will remain key to the success of this, as is the case with take up into our GPP. It is also possible to conduct a number of internal focus groups to see what the levels of likely take-up would be,” he adds.†

After estimating what proportion of employees will remain in the scheme compensation and benefits professionals should shop around until they find a payroll and administration system that fits their organisation and can cope with auto-enrolment. “There will be an upfront cost, but employers have to invest now to save later on”, says Mindell.

Reducing contributions

Of the 1,000 respondents to The Association of Consulting Actuaries’ Survey on Auto-enrolment and Nest, conducted in July 2010, more than 40% of employers will have to reduce their current pension contributions to meet auto-enrolment costs. According to the panel, however, there are a number of ways that employers can meet the additional cost of auto-enrolment, other than reducing contributions across the board.

Salary sacrifice, whereby pension contributions taken out of gross pay (resulting in tax and national insurance (NI) savings for both the employer and employee) could be one way, although relatively few employers use it. Paul Armitage, consultancy director, employee benefit solutions, at JLT Benefit Solutions, says: “Salary sacrifice is still bizarrely unused, but there is a huge amount of scope to change that now. There is still a reasonable amount of resistance about it though. I think HR view it as something the employee will not really want to do, but that needs to change.”

Charles Cotton, public policy adviser, reward, at the Chartered Institute of Personnel and Development (CIPD), says that the current economic climate has not been favourable to salary sacrifice schemes. “The problem is [salary sacrifice] came about when people still had pay rises so they could allocate pay rises into it. But, over the past few years, we have been having pay rises of about 3%, which is 2% lower than inflation, so it has not been a good time to talk to employees about salary sacrifice.”

Henderson Global Investor’s Mindell adds: “Employees and employers are missing out on opportunities by not doing it.”

Two-tier system

Adopting a two-tier pension system could also be another option for employers looking to meet the cost of auto-enrolment. But this can be divisive among staff and lead to the perception that one group of employees is in some way inferior to the other. Herbert Smith’s McKie explains: “Culturally we would not want to offer a two-tier system. There is a danger of unfairness around it. We would not like to draw a line and treat some employees as second-class citizens. Instead we use one scheme with different layers for staff.”

There will, however, undoubtedly, be some groups of employees that are more interested in pensions than others and age will probably be a contributing factor. The Business Case for Pensions report, conducted by the CIPD between March and July 2010, found that employees between the ages of 40 and 49 were the most likely to engage with their pension scheme and 60% of those over 55 were worried about having enough money to rely on when they retire.

Richard Wilson, senior policy adviser at the National Association of Pension Funds (NAPF), says employers should focus more on specific groups of employees, particularly when it comes to age-related or service-related contributions. “There is a big proportion of the workforce where you really want them to buy into you as a good employer with good benefits, but other parts of the workforce that you are less concerned about,” he explains.

As a way to reduce costs, some employers may opt to switch to a trust-based defined contribution (DC) scheme which, unlike a contract-based DC scheme, permits employers to take back any contributions if an employee leaves within two years .

Paul Gilbody, director of market engagement at Nest Corporation, says that many of the employers the trust has spoken to are not planning to use Nest exclusively, but combine it with other schemes, so it does not have to be divisive. “The feedback we have had from employers is that they are not considering Nest for everyone there.

Large employers are probably already contributing in excess of auto-enrolment demands.

“If Nest is used there is nothing to stop the employer putting more in. Nest does not equal the default level of contribution. Just because an employer is using Nest it does not mean that they cannot contribute more.”

Levelling down costs

Spencer Roach, compensation and benefits manager EMEA at technology and manufacturing firm Honeywell, says that levelling down contribution costs is inevitable and there is considerable pressure on organisations to be conservative in their estimated spend on auto-enrolment. “Be aware that there are other costs and savings to offset against auto-enrolment. The irony here is that if an employer ends up reducing their other costs then the total pension spend will go down, especially if it is based on a 100% take-up rate and they only get 60%.”

NAPF’s Wilson said the average NAPF member is contributing around 8% but admits the association may be getting a somewhat biased view. “The battle is getting bosses to explain the extra amount that they are putting in so staff really value it.”

Cotton, however, says that finance professionals are more aware of the advantages of investing in people. “The recession has shown us how important it is to invest in people and there is more of a realisation in finance that employees can be encouraged to save for themselves. There is more of a focus among finance people in rewarding people, just as HR is now more focused on costs.”

Armitage also points out that longevity levels will probably drive up contribution rates because employers will have to make provisions for an ageing workforce. With the average life expectancy increasing significantly, this could prove to be very expensive indeed.

Read more from the roundtable discussion on pensions auto-enrolment