Will Nest deliver the wrong eggs?

History is full of unintended consequences. And with this in mind we take a look at the launch of the National Employment Savings Trust (Nest) next year.

For decades all employees have received a state earnings-related pension (Serp) to top up their basic state pension. But the state is withdrawing this, with the confirmation that instead all employees who are without workplace pensions will be enrolled in Nest, a national pension scheme on a grand scale, endorsed by the government.

Nest has already been plagued by controversy, most recently about the planned charging structure – it was meant to be a low-cost scheme but all members' contributions are to be subjected to a hefty 2 per cent up-front charge, on top of an already-known annual management fee of 0.3 per cent.

Pensions campaigner Dr Ros Altmann responded: "Call me cynical but this scheme has disaster written all over it." Plus eyebrows have been raised because the scheme is going to be administered by an Indian company (Tata Consultancy Services – the only company to bid for the contract) on a 10-year contract worth £600m.

Whether or not Nest is successful, it may have unintended consequences for employees already enrolled in workplace pension schemes. Some of these consequences may be beneficial and others detrimental.

When Nest is launched, decisions will need to be made on whether eligible employees should go into Nest or into an employer's own private scheme. This inevitably makes Nest the benchmark against which employers, employees and trustees will compare any private scheme. Even if you are not employed, Nest will still become the yardstick against which to measure your own pension provision and investment strategy.

Let's focus on the positives first. The benefit of Nest is that its founders are tasked to find the best solution for members, so there is no vested interest, unlike the provider side of the industry.

In addition to contracting with consultants, Nest has had input from some of the best brains in the industry both in the UK and overseas to try to find the best defined-contribution pensions solution.

Perhaps the most significant contribution to defined-contribution investing is the work that has been done to help formulate the decision on the design of the Nest default scheme. Auto-enrolment means that it is most important that the design of the default fund is the best that it can be since inertia is likely to mean that once in, few members will ever leave.

The investment consultation paper that was published in May 2009 amassed an extensive base of knowledge and research and makes interesting reading for investors.

Asset allocation is held to be responsible for the majority of investment returns and Nest is doing something interesting with its asset allocation policy. Conventional investment wisdom dictates that the longer you have until retirement, the more risk you can afford to take with your investments. However, Nest is going against the grain by giving members under the age of 30 a lower risk profile in the default fund. Mark Fawcett, Nest chief investment officer, says: "Volatile investments in the early years could lead to members withdrawing contributions. Therefore we are going to have lower risk than people should be taking when they are young.

"The investment return engine is in the growth middle period," says Mr Fawcett. "We are giving members enough risk without too much risk."

In the last 10 years before a member's retirement, the scheme will use lifestyling to reduce risk using target date funds. Lifestyling simply changes the percentage you have in risky assets such as equities to slowly increase the amount you have in 'lower-risk' assets the closer you get to retirement. It reduces the risk of losing a large proportion of a pension pot in the few years before retirement. If Nest adopts this strategy, then more employers may follow suit.

The benchmark for investment is also interesting. The objective is to achieve returns in excess of inflation after management charges. "Returns in excess of inflation are very important but we are not putting a hard target on real returns," says Mr Fawcett. This objective is intended to help create confidence by having an aim, at the minimum, to maintain the buying power of members in retirement.

Many pension funds have a benchmark of a relevant index such as the FTSE All-Share, and if they beat that then they believe that they are doing well. But not only is an index benchmark deemed inappropriate, Nest is going to avoid comparisons with a UK index. Mr Fawcett says: "A UK Equity bias doesn't make sense for Nest members as they are exposed to the UK economy. The FTSE All-Share has lots of industry risk, in financials, oils, pharma and mining. We expect to be similar to global market capitalisation."

Rather than the traditional building blocks of defined-contribution pensions, such as equities, bonds and cash, Nest is going to use a wide range of asset classes, including property and commodities. "The traditional approach is 100 per cent equities in defined-contribution default funds but schemes are starting to diversify. We will diversify more than equities," says Mr Fawcett.

Nest has decided that the most dominant investment style should be passive management in order to meet the commitments to deliver personal accounts at low cost. Active management was thought to have an important role to play in areas where it can add value and where a passive approach is less effective or unavailable, such as smaller and less efficient equity markets and alternative asset classes.

The scheme's contribution limits will eventually be 8 per cent, made up of 4 per cent from the employee, 3 per cent from the employer and 1 per cent in tax. Eight per cent of salary is not a great deal to be saving and there are worries that if employers are only obliged by the government to contribute 3 per cent, then employer pension contributions may come down across the board.

According to the National Association of Pension Funds, the average employer contribution is currently 6.1 per cent, with some employers putting in more than 15 per cent. Dr Ros Altmann warns: "A further danger is that many employers will cut their pension contributions back to the Nest minimum (which is less than half of current average employer pension contributions), so those who are currently in an employer scheme would end up with less pension in future.

"This levelling down effect is already starting, as the government has given employers a new target to aim at – all they need to put in is 3 per cent. Hardly a surprise, then, that the Confederation of British Industry supports it, while the Federation of Small Business does not."

The failure of policymakers to take these dangers seriously is deeply depressing. "We try to shy away from the fact that we're going to influence the market," says Mr Fawcett.

Nevertheless, as a government-endorsed pension scheme with between two and six million members, it will be a benchmark that other pension schemes measure themselves up to – not only in terms of structure, but also investment strategy, fund choices, charges and contributions. Unintended consequences are inevitable and raise the question: Could we be watching pensions disintegrate, amid claims of hugely improving the situation?

Nest investment mandates – initial building blocks for the default fund