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Diminishing returns

The Government has a stated aim of increasing the proportion of self-responsibility for financial provision during retirement. This has been its goal since before the last election and the proposal for stakeholder pensions was supposed to be part of the grand design.

The first Budget of Chancellor Gordon Brown, however, took positive steps to reduce by about £5bn a year the value of pension funds by the abolition of dividend income tax relief in pension funds. This is just part of the political doublethink/doublespeak process which governs us nowadays.

Maybe we should be looking beyond the political statements about pensions and investments and consider the future opportunities for investments and likely future investment returns, particularly in the light of stakeholder pension charges restricted to an unprofitable 1 per cent.

It follows that the implications of RU34 from the FSA, requiring that all pensions sold must, in effect, broadly replicate stakeholder charges, indicates that all pension plans are affected.

Let us consider a number of associated issues. Where will this money be invested? Are there the opportunities for this hoped for, all of new money, to be profitably invested and if so where? What returns are likely to be achieved?

What will be the cost of investing this money to achieve good investment returns? What is defined as suitable investment returns relative to inflation to provide retirement income?

Have there been any trend changes recently which need to be considered over investment opportunities? Can stakeholder achieve what the Government feels is the desired effect in reducing dependency on the state in retirement? Are there perhaps alternative approaches which might be more suitable?

In this context, it is worth noting that New Zealand is turning its back on fully funded pensions based on future investment returns and is considering state funding, very much on a pay-as-you-go basis.

First then. Where will the money be invested? The majority of funds are invested in UK equities and property. Funds with mature liabilities have a larger proportion in fixed-interest bonds and gilts.

The problem is if the public is to be persuaded to save more for retirement they will have to cut consumption and increase investment. Such an action is likely to reduce company profits and investments returns on UK equities.

We have been spoilt by ever increasing equity returns over the last 20 years, with profits taking an ever increasing share of GNP. How much further can this go?

If returns on equities level out as a share of the GNP, the returns will reduce and the amount of investment needed to achieve retirement security will increase, leading to an increasing need for higher pension contributions.

The time has come to accept that the mature economics of the UK will force us to look abroad for investment opportunities. Future growth opportunities are likely to be found in the newly emerging countries which have a greater need for capital for infrastructure and where expensive capital equipment will be installed to take advantage of lower labour costs with fewer anti-industry restrictions and red tape which are going to choke off investments here.

If our pension funds will need to be invested abroad, this will require active fund management, not index trackers – which have been found wanting. Unfortunately, with charges stuck at a ridiculous 1 per cent a year, active fund management will not happen.

The apparent model for stakeholder is the US 401(k) plan, which has considerably higher charges. Indeed the managers of such plans have warned our Government that their plans would never have got off the ground on stakeholder terms.

It seems to me the new investment opportunities for pensions will be found outside the existing areas and where active fund management will be have to be paid for.

Analysis shows that 60 per cent of successful investment growth stems from stockpicking and 40 per cent fromgeographical or sector-picking. Both features are vital but if this is the case, then UK index trackers are now looking like last year&#39s solution.

Sadly, stakeholder must direct pension fund investments down the “pile it high, sell it cheap” path rather than focusing on paying a little extra for quality fund management. It seems that once again Britain gets it wrong.

First, we should make retirement funding more, not less attractive. We should abolish the absurd 1 per cent annual charge on stakeholder pensions which will ensure passive investment management, bypassing best investment opportunities.

Abolish the savage tax on pension funds. Abolish the enforced purchase of annuities which results in loss of unused funds on premature death of the annuitant or the dependant where a joint-life annuity was taken. Allow the unused fund to be left to the next of kin, perhaps in a generously tax-treated fund to escape inheritance tax.

Take account of the inc-rease in the number of single pensioners who retire without a spouse, who can on death have an estate that might be subject to a significant tax charge from the Capital Taxes Office on the value of thepension fund in the event of death before retirement or while in drawdown.

Is it surprising that, under New Labour, we have seen savings drop to an all-time low?

Look again at the terms in the US for 401(k) pensions, which provide for good pension deals for company managers being dependent upon offering a good deal for all employees.

The Government is on record as saying the target market for stakeholder is the £12,000 to £20,000 earner. These people are unlikely to be significant contributors but, as standard-rate taxpayers, this group may be better off placing their money into an Isa – at least it is accessible in emergencies like needing a life-saving operation.

A significant development recently has been the rapid growth of funds which have lock-in guarantees to protect them from sudden stockmarket falls. The significance of these and their effect on the performance of the related indices are affecting the market mechanism itself.

The derivatives&#39 dealers are now, effectively, closing their positions each quarter on many indices and acting as latter-day speculators who smooth the market and, effectively, remove the risk of falls such as the crash of 1987. Their charges have to be paid for, which I believe in the long term will have the effect of reducing investment returns.

We have seen many indices move within narrow limits recently with little overall market obsession with index trackers.

I believe these two trends, while ironing out risks of big falls, are responsible for reducing potential equity returns. The difference, however, between the best and worst active fund managers seems to be widening and in America far more fund managers are delivering value and beating the index.

The restrictive cost approach on pensions is precisely the wrong policy at this time and will be totally self-defeating, especially as advice is inevitably going to be actively discouraged – hence, decision trees and no tax relief on advice or premium waiver permitted within the plan.

Stakeholder and individual retirement plans, coming on top of an incredibly complex web of inter-reacting plans built on a multiplicity of regimes introduced by a succession of Governments over the years will make advice even more important. But access to advice has effectively been denied because of an obsession with cheapness.

Could it be that the New Zealand approach might be better – thinking the unthinkable of funding pensions by the state on a pay-as-you-go basis?

I suspect if the real truth were known, demographics will require that older people will retire later, continuing gainful employment well past the present retirement age.

Increased longevity, falling birth rates, increased basic living costs, increased cost of health care for the over 60s, are all likely to take their toll.

America is an example of where balding grey-haired or blue-rinsed heads are numerous in the labour market, assisted by a legally enforced anti-ageist philosophy.

The cost of fully funding an inflation-proof pension of 50 per cent of final salary, plus 1.5 times salary as tax-free cash and full spouse benefits, is variously estimated by actuaries at about 25 per cent of salary throughout 40 working years. Clearly, the available investment opportunities, the gilt supplies, the cost implications and the demographics all make this look absurd.

I know I have done nothing to quantify the above. It is macro rather than micro analysis. I am not an actuary. I suggest that stakeholder pensions will at best scratch the surface of the issue, are likely to be invested in the wrong place and sold to the wrong target market.

The likely truth is that stakeholder will make little change. What is could happen however is a wholly undesirable shift from high-quality actively managed pension funds and final-salary-related pensions into cheap and not very cheerful passively managed defined-contribution funds invested in the wrong place to provide a poor future for the masses who have been led to believe that £20 a month should suffice for adequate retirement funding.

Suppose the Government designed a specification for a car which was fixed and not negotiable and was to provide a profit maximised at 1 per cent a year for the manufacturer and distributor over a10-year life of the car. I wonder what the reaction would be. How much investment would there be in the UK motor industry?

Are pensions any different? It is quite clear that stakeholder pensions pose a threat to the cashflow, profitability and, indeed, very existence of the financial services companies which are meant to – but are not compelled to – manufacture, market and run them.

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