For many IFAs, the picture of the UK pension industry painted by Hermes Focus Asset Management chairman David Pitt-Watson is second only to last October’s Who Took My Pension Panorama documentary in the ranks of inflammatory and inaccurate portrayals of the financial service industry.
While the Panorama programme charged the pension industry with taking up to 80 per cent of contributions over a 40-year period, Pitt-Watson’s Building a Consensus for a People’s Pension in Britain paper claims that a more modest but still substantial 38 per cent of retirement income is lost to charges.
But Pitt-Watson’s report is more than just another critique of the effect of high charges on pension returns. The paper is perhaps best remembered for its assertion that if a typical Dutch person and a typical British person save the same amount for their pension, the Dutch person will probably get a 50 per cent higher income in retirement.
That figure is not just as a result of charges but also because of a combination of economies of scale and a less restrictive investment approach that would crank up growth considerably if adopted in the UK.
Pitt-Watson’s figures have been attacked for using an annual management charge of 1.5 per cent, which, while common for those with active management and/or paying for advice, seems high for the man in the street. The reality is that most modern group schemes even a tenth of the size of the huge industry-wide collective DC schemes proposed by Pitt-Watson have annual charges nearer to 0.5 per cent.
Pitt-Watson says: “The way we use that 1.5 per cent figure in the report is not to say that everybody is paying that. We are saying that the difference between somebody who pays 1.5 per cent and someone who is paying 0.5 per cent can mean a difference of about 45 per cent in your pension.
“We are not trying to say that is the right number. But if somebody said ’is that so many million miles from what is typical, particularly among smaller funds?’ I think it is not. You have to multiply an AMC by 25 to understand what it really is over a 60-year period.”
He is unrepentant about the figures, arguing that there are many situations where charges exceed 1 per cent, including some trust-based schemes, and particularly where schemes are small.
’To get a collective DC to work will require something of a cultural change as well as a regulatory change’
Pitt-Watson’s comparison with the Dutch system prompted an attack from ABI acting director-general Maggie Craig. Craig pointed out that there are expensive Dutch pensions too and the ones referred to by Pitt-Watson have economies of scale as they are compulsory schemes. Pitt-Watson agrees that scale is a key part of the problem and wants to create new structures that would allow us to achieve scale in a similar way.
Whatever your view on what an average AMC is for UK pensions, Pitt-Watson’s arguments on free-ing up investment structures carry considerable weight although implementation appears fraught with complexity.
A key problem with our system is it requires investors’ assets to be invested in bonds and gilts for 30 years or more.
Pitt-Watson says: “With a Dutch system, because you are collectively invested, you do not need to move to a more conservative investment as you get older and move into an annuity, which again is very expensive.”
While the UK model sees investors moving into less risky assets in the years before retirement and then lock into bond and gilt returns through an annuity, the Dutch system, which pays pensioners directly from the fund’s assets each month or year, effectively allows a greater exposure to equities throughout the saver’s lifetime.
’Having to invest in secure assets is choking off the potential for higher returns’
Pitt-Watson does not have exact figures for how much improved return this extra investment freedom gives but points to the DWP’s review of collective DC schemes in December 2009 which said a 39 per cent increase in pension income could be achieved, a report he says he is puzzled to have seen dropped.
He says: “Having to invest in secure assets is not only choking off potential for higher returns but it is also incredibly volatile. So the poor individual in DC 10 years ago who thought they had an income of £10,000 gets to today and finds they have got £6,000 because annuity rates have changed.”
He also cites anecdotal reports from actuaries as to the actual cost to insurance companies of providing the income in annuities. “I heard a speaker from a leading pension consultancy recently say the difference between the value of the annuity and the cost of the bonds to defray it is 30 per cent. So you could have a 40 per cent uplift just there.”
One of the big criticisms of collective DC is the potential for intergenerational unfairness. The thought of pensioners being paid today out of a big pot of money that younger people are paying into is likely to put anyone with experience of investing in with-profits into a cold sweat. If not enough people join the scheme years down the line or if longevity and investment assumptions prove to be incorrect, tomorrow’s pensioners may not get what they thought they had been promised.
’Other people should be in therecompeting with an unrestricted Nest’
This was a point made by Craig in her response to Pitt-Watson’s report. In Holland, there has been uproar as managers of collective DC schemes there have had to scale back pension promises.
Pitt-Watson says: “Yes, in Holland, they had to make cuts. But the biggest adjustment I know of in Holland is 6 per cent, which plays against a 40 per cent cut in income in the UK.”
Collective DC may sound good in theory but are the people of Britain ready to hand over their hard-earned cash to pay out to pensioners today, in the hope that someone else will do the same for them when they retire? Chain letter, pyramid scheme or Ponzi investment will all doubtless be comparisons made of such a scheme.
“To get a collective DC to work will require something of a cultural change as well as a regulatory one,” says Pitt-Watson. “We need to set up governance structures that people trust so they can see the pension is being managed on their behalf. You need great honesty about what you are promising and what you are not. People need to understand you need discretion to reduce a pension less for the 85-year-old than for the 35-year-old if there is a shortfall because the 35-year-old has a greater chance of catching up. That discussion requires highly trustworthy governance.”
Pitt-Watson uses Nobel prize-winning economist George Akerlof’s theory, The market For Lemons, to describe what he sees as the problem with the UK pension market.
Akerlof’s theory took the used-car market to demonstrate the problem uncertainty over quality creates for markets. Because buyers do not know if a car is a good one or a lemon, prices go down. That in turn drives sellers of good cars away from the market.
“If people can’t tell the difference between the good and the bad ones, that will cause damage to the pension market. The financial services industry should be there to provide the best possible pension to you at the lowest possible cost.
“Most of that 50 per cent between the British and the Dutch pension does not have to do with anyone being bad or terrible. It has to do with the architecture of the scheme.”
For Pitt-Watson, the ideal would be a wide choice of quality structures. That would include structures such as the NAPF’s super-trusts, some of which would be collectively managed.
But for Pitt-Watson’s dream to be realised, much of the UK pension regulation of the last three decades would have to be unravelled.
He says: “If you go back 30 years, schemes were all overfunded. They were tax shelters and the Government said you can’t go more than 130 per cent funded. Sponsors were happy to take pension holidays and beneficiaries said that is fine but you have got to hard promise my pension.
Enter the 21st century, longevity goes up much more than expected, returns go down and people can no longer keep that hard promise.”
Pitt-Watson is also against what he sees as an unnecessary fettering of Nest through the annual contribution cap of £3,600.
“If it does get scale, Nest could be a real challenge to other providers. On the other hand, if it does not work and does not get scale, it could fail and be a real problem. So our suggestion is that we should try and have healthy competition. Other people should be in there competing with an unrestricted Nest.”
But surely there is nothing but economic reality stopping providers from “doing a Nest” now. Pitt-Watson’s response can sound like wishful thinking.
“What we would like is effective competition like where you go to the supermarket and there are five different sorts of jam and there is a sensible differentiation between them. A similar structure in the pension fund industry would encourage competition. Real clarity would drive costs down and ideally you would have collective pensions offered alongside individual pensions,” he says.
With online Sipps marketing themselves as ultra-low-cost, offering tracker pension investment for as little as 0.25 per cent all in, many would argue the market is already there on charges.
That said, elements of his report have received a positive response. So, where does Pitt-Watson take his theory now?
“I do not expect an immediate response from the coalition Government right now saying they will go ahead,” says Pitt-Watson. “They can’t do it on their own. It is for the coalition, the TUC, the ABI, the CBI, financial services providers and other stakeholders to reach a consensus that we need a better architecture.”
KEY POINTS FROM TOMORROW’S INVESTOR: BUILDING THE CONSENSUS FOR A PEOPLE’S PENSION IN BRITAIN
- Britain needs a low-cost system of occupational pensions based on auto-enrolment and a limited number of large suppliers whose benefits of scale allow them to offer lower costs and use collective schemes to eliminate some of the cost of administration
- Pension savings should be aggregated in a way that will give adequate returns; that suggests collective provision and trustee governance. The benefits of collective DC are huge. On the Government’s own figures, they give up to 39 per cent higher pension returns
- Providers from Holland and Denmark have expressed interest in moving into the UK market if the legislation were to allow them to operate and if there was sufficient demand
- Auto-enrolment and Nest are both fundamental to the creation of a successful pension system but Nest should not be restricted to payments of £3,600 in any year, which makes it uncompetitive and raises costs to the taxpayer
Born: 1956, Aberdeen
Education: BSc Queen’s College, Oxford in politics, philosophy and economics. MA and MBA Stanford University
Career: Worked at 3i and McKinsey
Co-founded and became managing director of Braxton Associates – bought by Deloitte, when it became Deloitte Consulting;
1997-1999: assistant general secretary to the Labour party
1999; Joined Hermes Fund Managers, where he developed focus funds. Key role in developing shareholder activism in institutional funds. Established Hermes Equity Ownership Service, a service for pension fund schemes to promote sustain-able and responsible investment;
adviser to Tony Blair and Gordon Brown, notably on the Myners report on institutional investment and the combined code on corporate governance; author of report on pensions for Royal Society for the encouragement of Arts, Manufactures & Commerce (RSA)