Why the pension system is broken, and how to fix it By Michael Johnson

Over the next few decades, the cost of preserving our pensioner population will place increasing pressure on the UK’s public finances. In parallel, our domestic supplies of capital are likely to be depleted, exacerbated by a shrinking savings pool. Japan’s once legendarily high savings rate is expected to turn negative this year, as pensioners spend their savings. The UK is perhaps 20 to 30 years behind (subject to immigration policy). Given that other developed nations will likely experience a similar phenomenon, albeit over different timeframes, a battle for international capital is coming. The Conservatives’ response to this crisis-in-waiting is enshrined in David Cameron’s “personal responsibility” mantra. The next generation of pensioners should interpret this as a euphemism for “you’re on your own.” But while the Department for Work and Pensions wants people to save, the Treasury favours consumption. This position manifests itself in contradictory policies and ambiguous communication, doing little to stimulate a savings culture. Meanwhile, the Government has a vested interest in real interest rates remaining negative. This facilitates bank recapitalisation and erodes debt, benefitting the two most indebted sectors of the economy, banks and the Government, to the detriment of savers. Given that most people save in the form of cash, the Government cannot legitimately encourage them to save. A more appropriate message should be: “consider reducing your consumer credit debts as a form of saving.” Financial self-sufficiency will likely become a prerequisite for an enjoyable retirement. It would also mean that pensioners are less reliant on taxpayers, helping to preserve inter-generational harmony. Furthermore, an enlarged savings pool is critical to the nation; savings fuel investment, driving increased productivity and growth. Without this, our quality of life will certainly

deteriorate. But today, a savings culture is absent from most of the adult population. One reason is that it requires engagement with a financial services industry which is widely distrusted. The industry: in the Last Chance Saloon of public opinion Industry performance has been terrible. Over the last decade, UK workplace pension funds were the third worst performing OECD (returning negative 0.1% per annum) and, as a whole, the UK’s pension funds returned a mere 2.9% per annum, amongst the worst outcome in the developed world. Inefficiency (including excessive pay) and a lack of transparency are to blame, with pensions, in particular, characterised by obfuscation and bamboozlement, perfect for insider enrichment. To be clear, few enter the industry with the express purpose of enriching others. Only the industry can redeem its own reputation but, to-date, its self-interest has overwhelmed any inclination to demonstrate a common purpose with its customers. It has long forgotten that it is customers who provide the scare resource upon which the industry relies: their savings capital. There are many initiatives that the industry could take, some of which are detailed in a 2012 paper, Put the Saver First.1 These include the construction of an industry-wide defined contribution (DC) pension pot consolidation service, to assist portability, with a bridge across to the National Employment Savings Trust (NEST), the new, state-facilitated, workplace-based retirement savings scheme. An annuities clearing house should also be established, in which all annuity providers would be required to participate. This would replace the Open Market Option (OMO), which has patently failed: the take-up rate is only 35%-40%, leaving providers to profit via an “ignorance arbitrage”. The clearing house should offer standard and enhanced annuity contracts, and incorporate pre-auction bundling of small pots to introduce real pricing tension and help individuals harvest some economies of scale. More broadly, the industry should deliver to customers what they want: simplicity, low costs and absolute transparency.


Put the saver first: catalysing a savings culture, Michael Johnson, Centre for Policy Studies, July 2012. The paper is available at www.cps.org.uk


Simplicity Simplicity would be greatly enhanced by radically reducing choice. In the UK there are some 6,000 retail funds (including some 2,000 unit trusts and OEICs), more than 200 fund managers and more than 300 insurance companies vying for attention. Savers are therefore faced with over 360,000,000 combinations to choose from; effectively an infinite universe. It is little wonder that they are confused, which provides a ready excuse to procrastinate…...and do nothing. Low costs: passive, not active, fund management Performance analysis of the 1,188 actively managed funds in the main UK sectors shows that only 16 achieved top quartile returns in each of three successive years (2008 to 2010, inclusive), i.e. 1.35%. This is less than what could be expected from random2 fund selection: luck outwits skill (once costs are factored in). As Daniel Kahneman, Nobel laureate, observed, “there are domains in which expertise is not possible. Stock picking is a good example”. Given that no one is able to accurately predict which fund managers will perform best, the suggestion is that the additional costs of active management are not justified. Transparency Fund managers widely quote their Total Expense Ratio (TER); this does not provide investors with a full understanding of the return-eroding costs of active fund management. The TER excludes some explicit charges (taxes, entry and exit charges) and implicit transaction costs (including the bid-offer spread) and, crucially, fails to provide any indication of portfolio turnover. Transaction costs should be disclosed using the prior year’s asset turnover, to tackle a serious issue. Often, after fund management fees have been negotiated down, a significant rise in portfolio turnover arises. An enhanced role for the state The industry’s strategic importance to UK plc. legitimises state intervention, not least because the Treasury fields the consequences of industry failure, via welfare payments, a by-product of an under-saving nation. Furthermore, industry products are pit-propped by more than £50 billion in annual state subsidies (including tax relief, NICs rebates, tax-exemptions and tax foregone

Probability suggests 1.5625%, as 25% x 25% x 25%.


via salary sacrifice schemes). Much of this spend is mis-directed (primarily towards the wealthy); it does little to catalyse a savings culture amongst younger workers, thereby exacerbating the looming generational inequality. Certainly, higher rate tax relief should be shelved, not least because many of its recipients treat it as a tax planning tool, rather than an incentive to save. If, come 2017 (when auto-enrolment and the restraints on NEST are reviewed), substantial progress is not in evidence, then the state should be entitled to take far more assertive action, shoving (not nudging) the industry to dramatically change. Meanwhile, the trade bodies are doing just enough to keep the show on the road, giving a little here and there. But they are resolutely avoiding what is actually required to deliver the necessary transformational, not incremental, cultural change within the industry. Regulation: enlightenment and innovation required It is clear that many people are investing in products they do not fully understand, which are governed by a jungle of complex rules and tax regimes that, collectively, almost nobody understands. Savers are therefore putting their trust in the industry, and they need to be protected in situations in which the industry has a knowledge advantage. For almost all investors, this excludes very little. A less subtle description is that regulation should protect investors from the industry’s self-interest, its inefficiencies and, in some cases, its predatory instincts. Historically, regulators have regulated the industry hoping to engender trust between the industry and consumers. They have patently failed. Consequently, the blunt instrument that is classical regulation should be fundamentally reappraised. Perhaps complex rule-making and prudential oversight should be replaced by a regulator who views the industry through the experience of consumers, not market participants? Its actions could then be facilitated through sharply improved governance. Strong governance: critical The principal-agent problem, the abuse of asymmetric information by (industry) agents whose interests are not aligned with those of their customers, has to be confronted. Trustees, for example, need to behave as the principals they really are, helping to drive the reshaping of the industry. Indeed, trustees ought to be the catalysts for change, ensuring that workplace

pension schemes are structured so that decisions are made solely in the best interests of participants, by arms-length, “expert” organisations, with workers not being left to make complex savings and investment decisions on their own. Small pension schemes should be forced to merge, and the Government should lead by example, combining the Local Government Pension Scheme’s 101 disparate funds into a five regional funds, each with some £30 billion in assets. With investment management taken in-house (the LGPS spent £450 million in fees last year), supported by pooled administration and procurement, they could then become “expert clients”, capable of extracting best value from the market. Individual saving should be facilitated by a small number of large, collective DC schemes, which would enable people to pool their longevity risk and harness enormous economies of scale to drive costs down. Retirement incomes would then be larger, reducing pensioner poverty and the demand for state benefits, and the underlying pools of assets could, in effect, become akin to our sovereign wealth fund. Conclusion Public opprobrium is such that many people believe that there is no prospect of the industry challenging its own, deeply entrenched, vested interests. It has failed to overcome its fear of simplification, standardisation and transparency, and discard the deleterious practices that are enshrined in the principal-agent problem. Indeed, the industry’s pursuit of its own self-interest, at the expense of its customers may, ultimately, prove to be its nemesis. Meanwhile, politicians should consider “shoving” the industry into putting the customer at the centre of everything it does. Michael Johnson is a Research Fellow at the Centre for Policy Studies Political notes are published by One Nation Register. They are a monthly contribution to the debates shaping Labour’s political renewal. The articles published do not represent Labour’s policy positions. To contact political notes, email onenationregister@gmail.com


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