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The cost of compulsion

Despite being squeezed by foreign policy developments, pension reform remains a critical issue for most governments in the developed world. We regularly hear of new initiatives aimed at getting people to save for themselves, aimed at allowing governments to unwind public provision over time.

But these initiatives never seem to work as they have been built up to do, leading some commentators to conclude that compulsion is the only solution.

Analysis by Oliver, Wyman & Company suggests that not only is this a dangerous conclusion but it also reflects a misunderstanding of the lessons to be learned from the industry&#39s experience of pension reform so far.

The first lesson is that compulsion does not provide a complete solution, except in extreme cases. Singapore, for example, has compulsory contributions of around 36 per cent of salary (split between employer and employee). While the funds built up can be used for other things besides retirement provision – such as house purchase and higher education – we can safely assume that the Singaporeans can look forward to a comfortable retirement.

Not so for those with compulsion at less drastic levels. With a compulsory contribution rate of 9 per cent, Australians face a retirement pot 50-70 per cent short of their needs, according to various studies.

Part of the problem is that compulsion does not make people take ownership of their own situation. Governments are trying to move away from “the state will provide” to “you must take care of this problem yourself”.

Compulsion adds on “…and to help you, we will make you save£x a month”. People&#39s natural reaction is to see this as a technical change: “They used to tax us to pay our pensions, now they tax us to build a fund to pay our pensions.” Introducing compulsion, therefore, does not transfer ownership of the problem from state to individual.

Evidence for this can be seen most clearly in Australia, where the savings rate actually went down upon the introduction of compulsion.

We applied the underlying data from Australia and the US, where just 25 per cent of 401(k) contributions are genuinely new savings, to the UK.

We found that, in order for compulsion to almost close the retirement savings gap in the UK, a compulsory contribution rate of around 15 per cent of salary would be required – a figure well above the levels being suggested by lobbyists.

Proponents of compulsion argue that non-compulsory schemes do not work. They cite the poor take-up of stakeholder pensions in the UK, or of Riester products in Germany, and the mixed success of 401(k) in the US.

They are right that none of these vehicles completely solves the savings gap problem.

From our own analysis of the UK savings gap, it is clear that there is no silver bullet. Instead, a number of initiatives, some of them radical, will be required to ensure that people save enough for their retirement.

One of the main problems experienced in the US has been how to encourage employee take-up of 401(k). Current 401(k) legislation offers two solutions.

First, in order to make 401(k) a topic to talk about around the water-cooler, investing in the employer&#39s shares is encouraged. This certainly has had the desired effect, much like share save plans in the UK and elsewhere, with around 17 per cent of 401(k) assets invested in company stock. However, Enron showed the downside to this and we expect some moves away as a result.

The second solution, introduced some time after the original bill, is to incentivise senior management to improve employee take-up by linking their personal 401(k) tax relief to the level of take-up. To relieve pressure on smaller employers, the trigger levels of take-up depend on the size of the employer.

The result has been spectacular for bigger employers – more than 90 per cent of big employers (those with 1,000-plus workers), have a 401(k) scheme in place. However, still less than 20 per cent of smaller employers (those with fewer than 100 workers) have one.

Another key lesson to be learned from the States relates to cost. The US is an extremely competitive market, although average fees for 401(k) plans are 1.35 per cent a year, well above the 1 per cent cap imposed in the UK. For small plans, the average fee is 1.6 per cent a year.

The US experience has shown that scale benefits are largely illusory in terms of the number of plans – having lots of small plans on your books does not make you materially more efficient. This has led to a focus on more affluent customers, resulting in poor penetration of low-income households (just 6 per cent of households with an annual income less than $10,000 have any retirement provision at all).

This focus on the more affluent population is also the big issue with stakeholder in the UK, where the average premium exceeds £80 a month. The US experience suggests that the key to tackling the issue in the UK is to reduce the cost of the sale. A current worksite sale costs around £75. With a 1 per cent a year charge, it takes a £40 a month policy around six years to recover that cost – ignoring all other costs. At 1.5 per cent, the picture is little better – perhaps five years. And in reality, of course, only a fraction of the annual charge is left to cover the sales costs after taking set-up and ongoing administration costs into account.

It is now clear that what needs to change is the £75 sales cost. Our research suggests that the saver agent approach to regulation would produce a cost of sale of around £25 with payback in around three years at 1 per cent. At a sales cost of £25, there is a significant benefit – 75 per cent more savings from low-income to middle-income households – associated with allowing a 1.5 per cent charge rather than 1 per cent.

International experience of pension reform shows it is a complex problem which can only be solved by progressively adapting solutions to reflect the realities of the market. In the UK, a heavily regulated and advised market, this means reducing the cost of a sale to make it attractive for advisers to sell into the target customer segments.

In the US, the current big issue is how to attract smaller employers with lower-income workers. This may mean tinkering with employer incentives or perhaps more radical action, such as direct government subsidy of plan administration costs (some 40 per cent of total costs) for these target customers.

What remains abundantly clear, however, is that compulsion – be it compulsory contribution or merely compulsory availability – does not appear to improve employee take-up significantly at all.


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