For the foreseeable future, the UK’s new pension provision will be overwhelmingly defined contribution. DC pensions are risky. They are not just inherently risky in their own right, they are also being used in a fundamentally risky environment.
The problem that lies at the heart of the current auto-enrolment and regulatory programme is that politicians and policy makers are not building a system which can deal with the risks investors face.
These risks include (amongst others): Investment return risk; inflation risk; interest rate risk; longevity risk; regulatory risk and political risk. What’s more, these pensions have to work within individuals’ unique and changing circumstances. They have to dove-tail with cash Isas, equity Isas, mortgage redemption, children’s education costs, unexpected ill-health, long term care costs, spouse’s savings, employment patterns, inheritances and other unpredictable and personal factors.
There is more than one way we can deal with these risks. We could take the view that awareness of these risks will just put people off saving for retirement so we shouldn’t tell them about the risks – we should just to default them through the system from start to finish, ignorant of what is actually going on. This is akin to persuading someone to build a nuclear reactor on the coast of Japan and deliberately not telling them about the risk of a tsunami. You can do it, but it’s not a responsible thing to do.
Alternatively, you could try and eliminate any risk from the system. You could try and guarantee the outcomes for members by ensuring for example, that funds never fall in value. This is akin to managing a forest by deliberately and at great expense, stamping out any bush fires as soon as they start; only to find one day that because large amounts of dead wood have been allowed to build up, you get the mother of all forest fires. Trying to deliver spurious certainty is not only expensive, it will also eventually blow up in your face.
The only way to build a system which can adapt in the face of so many variable and unpredictable factors is to ensure investors can themselves adapt to the changing circumstances. What happens when they have to retire unexpectedly due to ill-health for example, as many people do, or if annuity rates fall 20 per cent in 3 years, or equities fall for 3 years in a row, or inflation takes off? No safeguards can anticipate the changes which will occur; it is an expensive, hubristic fallacy to think that we could, yet this is the myth which regulators and politicians try to promote.
Using defaults such as auto-enrolment are part of the solution but they are only the start of the solution. Rather than trying to build a defined ambition pension, or to sell deposit funds which won’t fall in value, we should be devoting our energies to progressively educate and engage investors. The better they understand what is going on, the less of a problem they will have when the unexpected happens (and it will happen).
The pensions industry and in particular insurance companies and financial advisers, can deliver the solution to the fragility problem by using our experience to engage and educate investors. We are uniquely placed to fix this problem. Regrettably, all that policymakers care about is how low our charges are.
Tom McPhail is head of penisons research at Hargreaves Lansdown