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Crazy frog

The Pensions Commission should take a lesson from a Far Eastern allegory

There are occasions in financial services when I am reminded of a rather amusing allegory from the Far East. It goes something like this:

One day, the frog from the well was visited by the frog from the ocean. The frog from the well had never left his well and the stranger’s presence was a matter for some excitement. The frog from the well was a frog of standing in his community and he was keen to find out what sort of chap the frog from the ocean was so he decided to find out how big his well was. The conversa-tion went something like this:

“Hello, welcome to my well. I am fortunate to have a big well. How big is your well?”

“Very big.”

“What? Is it as much as half the size of mine?”

“Nope, bigger.”

“Three-quarters the size?”

“Nope, bigger than that.”

“Surely it is not as big as my well?”

“Well, actually, it is bigger.”

Taken aback, the frog from the well asked: “How much bigger – half the size again, twice as big?”

“Actually, it is so big it is impossible to say just how many of your wells would fit in it.”

The frog from the well could not believe what he was hearing so he asked the frog from the ocean to show him. The frog from the ocean duly obliged and took the frog from the well to his home and when the frog from the well set eyes on the ocean, his head exploded.

I have no desire to see people’s heads explode but it would be nice if we sometimes took a trip outside our comfort zones and got a broader perspective on things. The Pensions Commission’s proposals for a national pensions savings scheme are a case in point. I am not against compulsion (or should I say auto-enrolment) per se although I would have preferred to see a matched contributions scheme. But I would like to have seen something more enlightened than what has been prop-osed. An obsessive focus on charges and the dismissal of the need for advice is extremely worrying.

As I read it, the Pensions Commission’s proposal is to offer a handful of default funds, with the option of choosing from a wider range. By its own estimates, over 90 per cent of people would make no active selection and therefore end up in these default funds which may not necessarily be suitable and might not perform particularly well.

Its recommendation that the default fund should be a lifestyle switching fund gives particular cause for concern. This is done autom-atically based on years to retirement, with no regard to market conditions. In many cases, this can work out quite well but if there was a repeat of recent market conditions, there could be a significant affect on many future pensioners.

By the commission’s own estimates, auto-enrolment would take out a big part of the cost attributed to persistency and a system with auto-enrolment but allowing for advice would reduce costs to around 0.7 per cent compared with 0.3 per cent for its recommended model. I reckon any IFA worth their salt would like to think they can outperform a prescribed fund by at least 0.5 per cent.

I really do not believe advice is the problem. In fact, by their own admission, auto-enrolment without advice, where individuals can choose from the open market, is likely to be far more expensive as competition for business would drive up marketing costs and could in all probability drive down persistency as providers vie for business.

So, what about the model on the table? As I said, I do not believe it is the best solution for individuals so who does it favour?

It seems to me that the chosen few who will manage the funds might do rather well. Based on an enrolment of, say, 10 million, with an average contribution of 1,200 (which on my calculations is actually lower than 8 per cent of median earnings above the primary threshold), this would provide the chosen few with 12bn to manage in year one alone. Even with a charge of 0.3 per cent, this looks like a nice little earner.

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