michael johnson - why the pension system is broken, and how to fix it

7/30/2019 Michael Johnson - Why the Pension System is Broken, And How to Fix It

1/5

1

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 UKs public finances. In parallel, our

domestic supplies of capital are likely to be depleted, exacerbated by a

shrinking savings pool. Japans 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

Camerons personal responsibility mantra. The next generation of

pensioners should interpret this as a euphemism for youre 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 mostpeople save in theform 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


2/5

2

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 UKs 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 constructionof 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 tensionand help individuals harvest some economies of scale.

More broadly, the industry should deliver to customers what they want:

simplicity, low costs and absolute transparency.

1Put the saver first: catalysing a savings culture , Michael Johnson, Centre for Policy Studies, July

2012. The paper is available atwww.cps.org.uk
http://www.cps.org.uk/http://www.cps.org.uk/http://www.cps.org.uk/http://www.cps.org.uk/


3/5

3

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 vyingfor 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 years 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 industrys 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

2Probability suggests 1.5625%, as 25% x 25% x 25%.


4/5

4

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 doingjustenough 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, culturalchange 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 investorsfrom the industrys 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 thenbe 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


5/5

5

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 Governmentshould lead by example, combining the Local Government Pension Schemes

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 ofextracting

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 prospectof 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 industrys 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 Labours political renewal. The articles

published do not represent Labours policy positions.

To contact political notes, email [email protected]

michael johnson - why the pension system is broken, and how to fix it

Documents