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Towards A New Pensions Settlement

The International Experience

Rowman & Littlefield International, Ltd.

THE UNITED KINGDOM

Gregg McClymont and Andy Tarrant

The American economist George Akerlof won the Nobel prize in 2001 for his paper The Market for Lemons. The paper analysed the consequences of information asymmetries in the secondhand car market. The greater knowledge possessed by sellers led to buyers purchasing 'lemons' - poor value used cars. Akerlof emphasised the wider applicability of his study: in markets where sellers possess much greater information than buyers, poor quality goods will inevitably drive out good ones. The market will become dominated by sellers of poor quality goods and the number of buyers will drop dramatically in response. Institutions acting as guarantors of quality are the necessary antidote to such market failure.

The UK is in the midst of major reform of pensions. The basic state pension and the earnings-related additional state pension scheme are being merged into a single flat-rate state pension. The intention is to create a foundation pension on top of which people will build workplace private pension provision. The foundation pension's value is likely to be approximately £7800 per annum. This is roughly 30 per cent of the average wage. Thus a replacement rate that provides a reasonable standard of living in retirement requires significant additional workplace private pensions saving.

Achieving value for money workplace private pensions means keeping 'lemons' at bay. This is a challenge: this is a market which features not just major information asymmetries but also a new twist on the principal-agent problem - the ultimate consumers, employees, do not choose the product, employers do. The individual - even if aware of product deficiencies - is unable to switch for this reason; more widely the principal-agent problem manifests itself via smaller employers, who do not have the time or expertise to monitor pension quality. This is why the Department of Work and Pensions found in a 2012 survey of workplace pension schemes that 59 per cent of employers running smaller contract-based schemes (sized between 12 and 99 members) did not know that their employees paid any pensions charges at all.

If common sense dictates 'the market where possible, the state where necessary', then workplace pensions, for the structural reasons examined above, necessitate government oversight. All British employees are being auto-enrolled into workplace private pensions. If 'lemons' flourish, Akerlof's insights tell us that mass opt-outs will eventually follow.

The UK workplace private pension market is characterised by a sharp decline in traditional defined benefit (DB) pension schemes. Most employers do not want to carry the substantial investment risk and actuarial risk onto their balance sheet. The number of workers in private sector DB schemes still open to new members is just 1 million; the total private sector workforce is 23 million. The provision of workplace pensions is now largely via defined contribution (DC) schemes. These pensions, unlike DB, offer no guaranteed income. Instead, retirement income depends on the performance of the funds invested. Before auto-enrolment, the providers of DC pensions had managed to persuade only a small and declining number of savers - about 900,000 - that it was worth investing in these products. The state is now requiring employers to purchase these products on behalf of potentially 10 million people.

Semi-compulsion for pension saving (auto-enrolment) was adopted because successive governments recognised the behavioural barriers to pension saving. The behavioural barriers are such that when the vast majority of pension savers are auto-enrolled, they elect to make no active choice but save into the default scheme offered by the pension provider. This has always been the case -historically, around 80-90 per cent of savers into pre-auto enrolment trust-based company DC schemes also made no active choice as to the funds in which they would be invested but were instead allocated to the default option, monitored by trustees.

WHAT MAKES A PENSION A 'LEMON'

The potential 'lemon' characteristics of British pensions are as follows:

A Lack of Transparency of Costs and Charges

Historically, pension providers have not disclosed all their costs and charges; large numbers of pensions were sold with high charges, absorbing too much of the investment gains. The result for savers was smaller pension pots and reduced retirement incomes. Under pressure from a coalition of consumer groups, employee representatives and the official opposition, the government introduced an annual management charge cap of 0.75 per cent for the default option in pension schemes. But the government has not applied this cap to the substantial pensions savings left behind by employees when they switched jobs prior to the price cap coming into effect-known as 'stranded pots'. The same pro-consumer coalition also campaigned for transparency of the costs incurred by the fund managers with whom pension schemes invested pension contributions (often within vertically integrated companies). Again, the government conceded that these should in principle be declared. The Financial Conduct Authority (FCA) is currently consulting on which costs should be declared and it remains to be seen whether effective transparency will be achieved.

Lack of Scale

Pension schemes in the UK are typically organised around an individual employer. This means that most forgo the economies of scale that would significantly reduce administrative overheads, and increase investment and, therefore, member returns. There is however scale on the seller side. The DC market is dominated by a small number of insurance companies increasingly selling group personal pensions (GPPs), although master trusts are growing too in the auto-enrolment space. GPPs enable price discrimination between the employees of larger and smaller employers. There are currently about 140,000 DC pension schemes in the UK.

Inadequate Governance

Traditional DB schemes can be aligned with the interests of their members because they have trustees who are legally required to make all of the decisions about the scheme and to do so prioritising the interests of the members above all others. Contract DC providers have to take the savers' interest into account but are legally obliged to prioritise their shareholders. In a market absent of extensive information asymmetries, buy-side pressure would normally serve to align shareholder and member interests. Insurance companies do provide trust-based DC schemes where employers request them. However, such provision needs to be universal. Faced with consumer groups and Labour party complaint as to the inadequate nature of DC governance, the last government opted instead to require contract-based providers to install 'independent governance committees'. Conflicts of interest are permitted on these bodies, which are appointed by the pension provider and which are advisory rather than governing.

Inadequate Regulation

Trust-based pension schemes are regulated by the Pensions Regulator (TPR). Contract-based schemes are regulated by the FCA. In short, their respective approaches could be summarised as follows. TPR prioritises the savers' interest but has inadequate powers, the FCA has adequate powers but is relying on heretofore absent buy-side pressure to drive product improvement.

Retirement Income Free-for-All

The market for annuities provides a good example of the FCA approach. Until last year, retirees had to purchase an annuity with the savings pot they had built in a DC pension scheme. (An annuity is a regular income stream purchased with a lump sum formed from the pension savings accumulated prior to retirement.) However, inertia characterised the behaviour of a large proportion of savers and they were channelled into buying annuities directly from the pension provider with whom they saved, without first considering all the offers on the market. The consequence of this was an income in retirement which was often 20 per cent below what could have been achieved. The FCA approach was to increase the prompts given to savers rather than ensure that savers were offered the best product available.

The unpopularity of annuities generated a political reaction. The government legislated to lift the requirement to purchase them. However, this does not remove the existence of longevity risk (ie the risk that you may live longer than you expect and therefore run out of savings) and therefore the need for an annuity or annuity-type product at some point in retirement. So annuities still require effective regulation.

The majority of purchases will now be of income drawdown products where the savers pension pot stays invested and a mixture of profit and capital is withdrawn to provide income. All of the 'lemon' characteristics described above will now apply to the retirement income phase, but neither the government nor the FCA have any plans to regulate. The FCA is consulting on its regulatory approach to retirement income products in 2016, but, consistent with its standard approach, the direction it gives respondees is to answer questions relating to consumer prompts. There is now a logical disconnect between the semi-effectively regulated default saving phase and the unregulated retirement income phase. With respect to the latter, the government's approach is to rely on offering savers a non-mandatory short 'guidance' interview to help them with a complex one-off purchase with potentially life-changing implications. The worry must be that many savers will simply buy drawdown products in the same way they purchased annuities. This outcome is hardly what savers say they want from a pension system, which is "pension provision that supports members' best interests without requiring active customer choice".

No System to Direct Employers to Schemes with High Quality Default Products

There is no licensing system for workplace pension schemes in the UK. Such a licensing system would be ideal for dealing with asymmetry of information and ensuring a reasonable number of scale, well-governed, low-cost providers, such as Nest, could compete in the market. Employees could be secure in the knowledge that their employer had selected only from pension schemes that meet quality criteria with respect to delivering value for money, including governance criteria. Furthermore, the absence of a licensing scheme is one of the factors which facilitates the pension scammers engaging in fraudulent activity.

AUSTRALIA

Jeremy Cooper

The Australian retirement system is a three pillar system. Two key pillars are a government safety net, the age pension, and the private workplace pension market, superannuation.

The age pension is available to all retirees over the age of eligibility, but is subject to means testing via an asset and income test. About 50 per cent of retirees receive a full age pension and another 20 per cent of retirees are eligible for a part payment of the age pension. Age pension increases are linked to wages and the cost of living. Payments continue for the life of the retiree, however, the level of the age pension is inadequate for most retirees, given that it is intended as a safety net only. Age pension payments are bench-marked to 25 per cent of average male weekly earnings. Importantly, the age pension is not a contributory pension, but is funded purely by current day taxpayers.

Superannuation is a compulsory, employment-related defined contribution (DC) system introduced to supplement the age pension and reduce the burden of retirement social security on taxpayers. 'Super' in Australia is mandatory for all employers whose employees meet certain working conditions. A percentage of wages are paid by the employer into a DC savings scheme of either the employee's choice or a default fund if no choice is made. Superannuation is a retirement savings system, rather than a retire-merit income system. Employer obligations effectively cease on retirement, and there are no requirements for retirees to stay in the system. The implications of this are only just being appreciated in Australia.

THE CURRENT SUPERANNUATION SYSTEM

Australia has very few regulations around how retirement savings (benefits) should be taken once preservation (access) age has been met, currently 56, but increasing incrementally to 60 by 2024. Retirees have a number of choices on reaching preservation age, the two predominant choices being a lump-sum withdrawal or an income stream. Roughly half the population still take a lump sum, and income streams or annuitisation are not, and have never been, mandatory in Australia.

If a retiree chooses to take an income stream in retirement, the predominant product is an account-based pension (ABP) which is really just a retirement managed fund product. With an ABP, retirees can invest in a wide range of investment options, but must withdraw a certain minimum amount each year. All benefits paid from super are tax-free once a person reaches 60 and permanently retires.

ISSUE IN THE RETIREMENT SYSTEM

The Australian compulsory superannuation system was set up in 1992 and since then it has evolved, but not fully matured. Because of its DC nature and the fact that it has been principally about accumulating savings and not the provision of secure retirement income, accumulation-style thinking and strategies permeate into the retirement phase, despite the fact that retirement demands a different approach. This is perhaps the biggest current failing of the Australian super system.

DC Is a Lump-Sum Approach to Retirement

DC savings schemes, and lump-sum approaches, fail to deal with the key risks facing retirees, these being: inflation risk, longevity risk and market risk (including sequencing risk). These risks mean that DC retirees are often exposed to too much volatility and uncertainty about the durability of their savings in retirement and how much sustainable cash flow they can expect.

Pure DC schemes do not deal adequately with any of these risks.

Measuring Success and Failure

One of the biggest challenges for funds in providing appropriate retirement solutions for their members is the lack of a clear success measure.

In accumulating assets, there is really only one goal: accumulate as many assets as possible, via the highest investment returns, with minimal outgoings and an optimal level of volatility to create the largest possible pool of savings. This provides a clear measure of success. In retirement, typically, there are four forms of expenditure to plan for and success will often involve meeting all of these objectives.

• Everyday living costs which require predictable and regular cash flows;

• Discretionary or lumpy expenditures, including emergencies;

• Expenditure beyond average life expectancy; and

• Bequests for the next generation.

REFORMS: RECENT PAST, PRESENT AND FUTURE

Super System Review 2009-10

In 2009, Australia began a major review of its superannuation system. The major reforms that flowed from the Australian government's response to the review are labelled 'stronger super'. These included a modernisation of the administration of super schemes, the introduction of a new style of simpler, more cost-efficient default fund called 'MySuper' and a range of changes to governance, transparency of outcomes, and disclosure of risk and return objectives and a focus on scale and efficiency.

MySuper

A key reform has been the creation of a new default accumulation product (not unlike the UK's National Employment Savings Trust, but having a bigger footprint across the system) called MySuper. The key features of MySuper include: a single, diversified investment strategy with no requirement for investment choices to be made by members; standardised reporting requirements written in plain English; and a limited range of fees that can be charged, with performance fees having to meet certain criteria to be acceptable. By law, a default member must be allocated to a MySuper product.

Governance

The reforms also delivered new duties for fund trustees. The Australia Prudential Regulatory Authority (APRA) has introduced a range of prudential standards and two specifically address duty of trustees and board governance. One requires funds to have a policy that sets out the standards that trustees must adhere to, and the competencies required of a trustee. Trustees must be assessed against these on a yearly basis. The standards and competencies set by the fund will be reviewed by the regulator as part of the licensing requirement.

Another prudential standard requires the trustee board to have a formal charter that sets out the roles, responsibilities and objectives of the board. This governance framework must include a specific duty to deliver value for money as measured by long-term net returns; to consider annually whether the fund has sufficient scale; and, how the board will assess its performance against these objectives. The care, skill and diligence expected of a trustee have also been raised as a matter of law to that of 'prudent superannuation trustee'. This effectively raises the standard to that of a professional trustee, rather than just a reasonable person. This is a very significant change.

SuperStream

SuperStream is a reform of the 'back office' of superannuation. It is designed to enhance the administration of superannuation, streamline processing and produce cost efficiencies. This will be achieved by implementing new data standards for transactions between employers and funds and between funds; automatic account consolidation of low balance accounts and the automation of data processing. There are about 100m transactions in super each year and these will all become processed without human intervention. It has been estimated that this will save up to A$1bn a year.

Retirement Phase

The big disappointment in the reform process was that the 2010 recommendations about retirement were not adopted by the government. Those recommendations were that the trustees of a fund offering a default retirement product should be obliged to devise an investment strategy dealing with existing factors such as risk, diversification, liquidity and the ability to discharge liabilities (existing requirements), as well as two additional factors:

• inflation risk; and

• longevity risk.

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Excerpted from Towards A New Pensions Settlement by Gregg McClymont, Andy Tarrant. Copyright © 2016 by Policy Network. Excerpted by permission of Rowman & Littlefield International, Ltd..
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