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Tom McPhail: Avoiding a pensions black swan

Engage and educate consumers to prepare for pension upheaval

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


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There are 14 comments at the moment, we would love to hear your opinion too.

  1. But are would-be investors prepared to pay for the time it will take to educate them?

    Responsibility for delivering solutions lies with the government, firstly by effecting the desperately needed reforms to the pensions framework promised by the Conservative party in its pre-election manifesto (on which we never hear anything at all from Steve Webb, who’s just the Treasury’s glove puppet) and secondly by adding personal financial management to the school curriculum in place of the hugely expensive (at our expense) and ineffectual quick fix that the MAS was expected to deliver.

    The industry can only do its best within the framework by which it’s governed and if all the public ever sees and hears about that framework they simply won’t engage. And they aren’t, are they? Quite the reverse.

  2. Lest we forget…pensions are long term investments not bank accounts.
    The value of our pension pots will go up and down but over the longer term it is the responsibility of all involved, including the pension member, to do what they can to make sure it goes up.
    We are breeding a society that takes no responsibility for their future and expects a rosy ending to be handed to them on a plate in so many different fields.
    Educate children in schools, educate kids at home, educate parents in the workplace of the benefits of taking responsibility for such things and not only will we get better pension outcomes but we may just produce better, more rounded and responsible people!

  3. The concern is not low charges but that the total costs to investors are largely unknown. The suspicion is that the total costs of investing in the stock market could be around 3%-4% of the fund per year on average across any actively managed fund in the retail pension sector.

    The firms who know how much these costs total are fighting a determined battle to keep that knowledge private. There are concessions being offered in the face of sustained pressure in some quarters.

    If you save for the long term in equities then you might hope for a 3%-4% return above a risk free rate. It is clearly inequitable for the investor to have to pay this 3%-4% risk premium away in expenses.

    The Government has changed the landscape for long term pension saving by introducing auto enrolment. The industry will see reduced sales costs and increased persistence levels. It needs to urgently reform its business models and reduce its costs. There are some difficult and unpalatable decisions for it to take.

    A recent academic study pointed to the dangers of using past economic growth data for the basis of predicting future returns. Commodity resource is becoming increasingly scarce and past economic growth may not be achievable in future. It is quite possible that real economic growth slows down to well below recent historical levels.

    The financial services industry has to guard against trying to charge too much for its work. Regulators need to work with the industry to minimise frictional costs.

    No sane politician could sanction a lightening of financial service regulations in the current climate. The industry has much to do to clean up its act after LIBOR; PPI; packaged debt and many retail investment product mis-selling.

    The parts of the industry which continue to try to hide its costs is doomed to a painful death.

    We need a leaner, fairer financial services industry truly based around delivering value to the consumer.

    As an adviser, I see my role to try and understand
    the investment products’ benefits, risks and their costs. There are many products that are potentially attractive but when I cannot understand the risks or their costs then I cannot blindly recommend them. I’m aware that there are other advisers or sales-houses that will take a different view and use the laxity in current regulations to sell such products and make nice profits.

    There are a good number of investment firms who understand the need to reduce costs, be clear about the investment risks and deliver value. The gradual decline of the sales’ driven culture will allow such propositions to succeed.

  4. Tom –

    So true and what many of us have been trying to say (although with less erudition) since the inception of the plans for AE. You are in a special position as an undoubted ‘guru’ in the field, but who will listen?

    In my view the real solution (as I have often repeated) is to have a decent State Pension – properly funded – if Governments are truly serious about ensuring a decent retirement income for most. Personally I don’t think either the Government of the ‘pensions industry’ are to be trusted with this. Neither has covered themselves with glory. A new way has to be found.

    This should definitely not be a PAYG system but underpinned by something along the lines of a Sovereign Wealth fund, ring fenced and protected against the sticky fingers of Westminster. There should then be an undertaking that any future changes or tweaks should only result in universal benefits (agreed by an independent board of Trustees) – if not no changes should be made at all and anyway limited to a minimum of (say) 7 year reviews. If taxes have to rise – so be it. Better than enforced contributions to AE.

    We need to get those who know what they are talking about – you, Ros Altmann, Robin Ellison and others to guide the numpties at the DSS, Treasury and Government in the right direction. Is this all hot air and vain hope?

  5. That was an honest piece from Tom McPhail.

    However, there is a air of unreality surrounding the whole issue of DC pensions.

    Your bog-standard PAYE employee is stiffed every month by the Goverments extractive taxes and most of them don’t even realise (because it is not usually shown on pay-slips) that the employer has had to pay an extra employee tax i.e. employers NI on top of around 12-13%.

    Therefore, when, by default, the hapless employee sees more being taken through auto-enrolment, then they are going to opt-out and any spare savings will find their way into ISA’s.

    That will be the case for the vast majority of working private sector people.

  6. Oh dear, the normally sensible Harry Katz has drifted off into Alice-in-Wonderland.

    Norway has a Sovereign Fund of some £250Bn or so.

    The UK has a Sovereign Debt of £1.11Tn.

    Dream on Harry, a Sovereign Fund in the almost bankrupt UK?

    You’re having a giraffe.

  7. @Anon 12.19

    Yes I realise this is cloud cuckoo land. No I haven’t quite lost my marbles and yes I know how deep in the manure the UK is and I also appreciate what Norway has done.

    But let us start from the premise that current and past remedies are rubbish and that some new thinking is needed.

    It really isn’t that different from ‘kitchen sink’ economics. First you have to have the will, then then the discipline. Let’s start by stopping all foreign aid and tipping that into the ring fenced and sacrosanct Sovereign Wealth fund. That’s £11billion p.a at current figures. Next all revenues from what remains of North Sea oil (That’s how the Norwegians built their fund) and all potential future revenues from Fracking – goes in the pot. Then we have what NI was supposed to be there for in the first place – that’s another few billion a year. We could have a financial transaction tax – say 0.5%.

    It wouldn’t take that long to build a decent fund. It may mean that expenditure elsewhere would have to be curtailed (and isn’t that about time!) and taxes may have to rise – but at least let them be honest taxes and not of the stealth variety.

    Unfortunately we have 600 odd people who govern us who are far more concerned with their own incomes and pension than those of the Nation as a whole. Perhaps this is the main and major stumbling block.

  8. Ros Altman? She hates pensions and tells savers to use ISAs.

    I agree with above. The usual solid HK is having a bad day. O)

  9. Stop all foreign aid? Oh Harry, you’ve gone down in my estimation : (

  10. @ Richard

    She is critical of Private Pensions – with some cause. Agreed not all the making of the industry – the Government’s constant meddling is a very big issue.

  11. @ Toby Lerone

    It would be better for us to get our own house in order and look after our own first, surely?

  12. Just think pensions are great now.

    If I transfer my pensions without any advice I can get up to a grand as well as entered into a prize draw for a car.

    who said pensions were nonsense?

  13. I don’t think we can stop ALL foreign aid given the calamities we left behind in some countries. I guess that bad karma will be with us for many years.

    As for building a sovereign wealth fund…we should drastically cut military expenditure and stop being America’s poodle. That’d be a start. Fat chance of that happening with politicians always thinking about a reelection and their own pensions.

  14. Plainly cabin fever is rife bring on the summer!

    Let’s put this into perspective shall we.

    The target audience for AE presently has zero pension provision.

    They’re about to get some pension provision, providing they don’t opt out of course.

    They didn’t know much about the stuff of Tom’s article when they didn’t have a pension and they won’t know much more when they do have a pension.

    What they will have is a pension.

    Moving forward what they won’t get is any means tested top ups to add to their flat rate State Pension.

    Awareness of this more than anything will focus people’s minds tremendously and just might get ’em motivated to find out what on earth is happening with their money.

    It’s not beyond the bounds of human imagination to envisage quite a powerful NEST policyholder’s group that could apply considerable pressure without relying on the pontifications of a few old style industry ‘talking heads’, some of whom are concerned mainly with preserving the status quo.

    So yes the government’s approach is sometimes silly, frequently far from joined up and occasionally just plain perverse but, and it’s a big but, they’ve managed against all odds I might add, to put a workplace retirement savings scheme in place that will, in my opinion, reach millions of people previously disengaged entirely from the subject and that, combined with the other changes I’ve mentioned, is probabably the best way of engaging their interest thereafter.

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