The National Pension Savings Scheme
proposal of the Pensions Commission

The proposal to replace the State Second Pension

In its Second Report published in November, the Pensions Commission proposes that the State Second Pension should gradually become flat-rate:

"Earnings-related pensions should in the long-term be provided by funded private savings rather than by a state PAYG system."

State pensions will then be provided by two flat-rate pensions, the State Basic Pension and the State Second Pension, which of course may be amalgamated in due course. The State Second Pension will then have been phased out. The Pensions Commission proposes that it should be replaced by a new National Pension Savings Scheme (NPSS) for both employees and the self-employed. This will be financed by about 8% of earnings above the minimum required to pay income tax, including a compulsory 3% employer contribution.

Trends in charges

The trend away from defined benefit pension schemes to defined contribution schemes is introducing the management charges of providers where they did not previously exist. Stakeholder pensions decreased these charges. But now they seem to be increasing again. The stakeholder cap on charges was increased, in April 2005, from 1% to 1.5% of capital per annum for the first ten years. The conversion of unit trusts to OEICS, the increase in the portfolio turnover of funds, the increase in the number of closed funds; are also trends tending to increase charges.

The Pensions Commission proposes NPSS especially because of its concern with charges:

"Reductions in Yield arising from providers' charges can absorb 20-30% of an individual's pension saving ... This poses a fundamental question: in principle can a voluntary market for pensions work for low income, low premium customers?"

Does the market work for high premium customers? They still lose the 20-30% and may furthermore be a victim of mis-selling scandals like that of Equitable Life.

The NPSS choice of funds

A cornerstone of govenment policy is to increase the freedom of individuals to make choices. In the area of pensions the DWP has several "informed choice initiatives". NPSS will provide a choice of funds. Another government policy is simplicity. Perhaps a simplified advice regime will be developed to help people choose a fund, similar to the regime for Sandler "stakeholder" products.

The Swedish Premium Pension scheme (PPM) is discussed in the Second Report of the Pensions Commission. The PPM Instructions for choosing and switching funds asks: "What is your risk-tolerance?", "What type of fund suits you?" NPSS will have a choice of index-tracking and bulk-negotiated funds, so that no doubt it will have questions, such as: "What is your attitude to index-tracking.", "Will you feel comfortable with funds which are bulk-negotiated?".

The Pensions Commission considers whether the PAYE system can be used to collect contributions for NPSS. It says that without excessive delay: "It would be impossible for people's contributions to be allocated to specific funds in line with each individual's choice.". It therefore proposes a new Pension Payment System.

Five problems with having a choice of funds are: 1) It adds to costs, requiring the creation of the proposed Pension Payment System, 2) It presents people with the dilemma which fund to choose, so that they need information and education to help them make a choice, and also perhaps financial advice. 3) It is catering for people's preferences, such as for or against index-tracking funds, which may not be based on much knowledge or experience. 4) It stores up complaints from those who (with hindsight) make the wrong choice. 5) Some people may not like any of the funds.

Fund management companies

The Pensions Commission recommends that NPSS should have a First Tier of 6-10 "bulk-negotiated" funds, 3-5 or which are index-trackers, with a possible Second Tier of funds from the industry which do not have such negotiated charges. These funds are all run by fund management companies, so that "choice of fund" also means "choice of fund mangement company".

The Commission says that the bulk-negotiated funds will have low charges, like the funds of the Thrift Savings Plan (TSP) for Federal Employees in the US. On the other hand they might have high charges because they are situated in the UK rather than the US. The TSP funds are all index-trackers. In the UK index-trackers in general have higher charges than TSP.

The NPSS funds might be bulk-negotiated like the stakeholder cap on charges. This cap is being replaced by an NPSS "target". The bulk-negotiated funds will have a "target Annual Charge of 0.3% or below". But fund management companies have an incentive not achieve this target, because fund management is more profitable the higher the AMC.

The Commission says: " The retail financial services industry has lost the trust of customers." It is more serious than that for many people, who consider that they have been defrauded. Particularly unfortunate was being told that the cost for Equitable Life of losing the House of Lords court case would be £50 million, when it turned out to be £1.5 billion. Neverthless the Second Report describes NPSS as a private sector scheme. All its funds will be managed by the industry.

PPM has a default fund called The Seventh Swedish National Pension Fund. It is a government or quasi-government fund. It is invested 82 per cent in global equities, 10 per cent in Swedish index-linked bonds, 8 per cent in alternative investments.

The PPM scheme was studied by the Select Committee on Work and Pensions, which said to a Swedish witness:

"You paint a picture of thousands of houses up and down Sweden discussing whether to invest in Japan, in South-East Asia or in America."

They are no longer choosing where to invest, since 90% of new PPM members are joining the default fund. This has had a better investment performance than the average investment performance for all the about 700 funds currently in the scheme. Some funds lost particularly badly when PPM started at a market peak in 2001.

The Second Report also discusses the Thrift Savings Plan in the US and KiwiSaver in New Zealand. KiwiSaver is an industry-based saving scheme which will be introduced in 2007. It does not yet have a track-record. The Pensions Commission does not discuss the Danish ATP scheme which is an efficient, compulsory, and fully funded national pension scheme.

The Second Report says that contributions to NPSS can be collected "in a highly cost-efficient fashion" through a new Pensions Payment System. Should the government spoon-feed the fund management industry in this way? Why should funds not be managed in-house rather than externally?

NPSS seems like a new kind of personal pension, that is saving on an individual basis, towards a pension provided by annuities, and with funds managed by the financial industry. Who regulates NPSS? It is apparently not a regulated product like personal pensions and collective investment schemes. But in due course it will no doubt become another product regulated by the FSA.

Soft compulsion

NPSS has "soft compulsion" which is the ability to opt out. This is a U-turn in government approach away from encouraging people to do things to expecting them not to. NPSS will have default funds for people who do not like making choices. In the case of child trust funds this is perhaps a third of new parents. Only about a half of vouchers sent out have so far been invested. The Inland Revenue reports that at 20th November 2005, 2,136 vouchers had been issued, but only 1,164 accounts opened. ^x

We are living in a "floppocracy". The government introduces an endless number of schemes: stakeholder pensions, Sandler products, child trust funds; which then flop, largely because they are based on people doing things, where they instead do nothing. Soft compulsion and default funds are features of floppocracy.

A cornerstone of govenment policy is "informed choice". In the case of child trust funds the default funds are stakeholder accounts with approved organisations selected at random, "on a rotational basis", ^x by the Inland Revenue. Since as mentioned above, this is a third of all new parents, we actually have uninformed choice. An annual management charge of 1.5 per cent of capital for a stakeholder CTF, results in 24 per cent of the capital being absorbed in charges in the 18 years before the CTF is cashed.

If there is compulsion and a choice of funds, like for example child trust funds and the Swedish PPM scheme, it seems helpful to describe this as "weak compulsion". If there is no choice of funds, like the Danish ATP scheme, we then have "strong compulsion". NPSS is not even weak compulsion, since people can opt out.

Pension punters

The government encourages people to save towards a pension. When saving is long-term, people find they are investors rather than just savers. In one discussion on the web they refer to themselves as "pension punters". According to the Financial Services and Markets Act they are "consumers" and are responsible for their own decisions: "consumers should take responsibility for their decisions". This caveat emptor clause should arguably be extended to include everyone. We are familiar with our Human Rights. This is an example of a Human Responsibility: "People are responsible for their own decisions."

Savers and investors are also most often described by the FSA as "consumers" . It says that they "consume products" which are "provided by providers". The "products" then seem like manna or charity and "providers" to be acting from humanitarian motives.

The Pensions Commission describes the fund management companies of NPSS as "fund providers". But are they providing or are they selling? NPSS is a way of helping fund management companies to sell their units.

"Pensions: the worst investment of my life"

This is one of many pension stories in the press and on the web, such as: "My company put in 5% of salary, I put in 5% of salary and the pension company took out 90% in charges."

In its two reports the Pensions Commission does not discuss such particular cases, or even the overall investment performance of personal pensions. Stakeholder pensions were intended to solve the problem of the excessive cost of personal pensions. A paper of the FSA says that personal pensions "tend to have high portfolio turnover and high undisclosed charges". These continue with stakeholder pensions. The Commission finds stakeholder pensions excessively expensive, even without undisclosed charges, and for this reason proposes the NPSS, popularly known as BritSaver.

"Costs and charges for certain other things"

In its First Report the Commission discusses "explicit costs" and "implicit costs". The latter are hidden or undisclosed charges. They are the costs which the industry does not disclose. The charges of the providers of savings "products" are usually explicit such as: capital charge, contract charge, entry charge, establishment charge, exit charge, handling charge, monthly policy charge, periodic charge, preliminary charge, product charge, redemption charge, service charge, surrender charge, transfer charge, withdrawal charge. All of these charges can be found on the website of the FSA.

There are in addition levies, adjustments, deductions and so on. Other people in addition to providers may be making charges in particular: auditors, regulations and trustees. These usually appear in the small print in accounts as "fees". These are explicit costs.

Stakeholder pensions collect explicit costs into a single annual management charge (AMC), which is then capped. Providers of stakeholder pensions have been saying about their AMC: "One per cent and that's it.", "Our only charge is a 1% annual fee." "Stakeholder pensions cannot charge more than 1pc a year.". Defined benefit occupational pension schemes, are in general cheaper because they do not have the AMC. The trend towards defined contribution schemes is resulting in the introduction of this charge, which does not exist for defined benefit schemes.

There are in addition implicit costs. These are explained in a DWP booklet Stakeholder Pensions - Your guide:

"As well as the yearly management charge, the law allows pension providers to recover costs and charges they have to pay for certain other things. For example, when they have to pay any stamp duty or other charges for buying and selling investments for your fund, or for particular circumstances such as the costs of sharing a pension when a couple divorce. These expenses are found in other pension schemes, not just stakeholder pensions."

"Stamp duty or other charges for buying and selling investments for your fund" are dealing costs which are implicit costs. They are also outside the cap on charges for CAT standards for ISAs. The Treasury said on its website, before these standards for ISAs were withdrawn:

"Our CAT standards get rid of the small print and hidden charges that worry people so much."

The law for collective investment schemes and conduct of business regulations, allows the providers of other savings "products" to recover dealing costs. They are also not included in the total expense ratio and reduction in yield measures of costs.

The amounts being concealed, especially stockbrocker commissions, are not inconsiderable. A report by Oxford Research Associates, published by the FSA in April 2003, says that "total broker commission revenue .. increased by 18% annually from £1.5 billion in 1992 to £5.7 billion in 2000." If this has continued, then total stockbroker commissions are £13 billion in 2005.

This report says that the funds under management in the UK were £ 2,857 billion in December 1999. A 1% AMC is £28 billion per annum. These funds include defined benefit occupational pension schemes (£985 billion) which do not have this explicit AMC. On the other hand AMCs are often higher than 1%, and we should consider TERs and RIYs which are in general higher than AMCs. Dividing total charges by the 60 million population of the UK, suggests that charges per head of population is at least £500 per annum.

The government has been encouraging the trustees of occupational pension schemes to pay attention to dealing costs. Therefore it is discouraging retail investors from looking at dealing costs, while simultaneously encouraging occupational pension schemes to do so. This paradoxical situation has reach a new level with the unbundling of soft commissions and commission recapture. In its report Bundled Brokerage and Soft Commisions, the FSA proposes "investor representatives" for the industry which it regulates. They are intended to be concerned especially or entirely with dealing costs. Will NPSS be capable of restricting the dealing costs of fund management companies? This a reason for managing such funds in-house. .

Dealing costs are highly dependent on portfolio turnover. This has to be disclosed as a percentage in the accounts of mutual funds in the US, but not in those of UK-based unit trusts and OEICS. However UCITS-approved funds have to give this in the Simplified Prospectus, using a different formula. It would be helpful to investors if stockbrokers' commissions were given in the accounts of unit trusts and OEICS.

Many funds have a remarkably high portfolio turnover which has been calculated by Fitzrovia for most UK-based unit trusts and OEICS. It finds the average for funds investing in UK equities is about 65% and the median about 55%. The exact figure depends on the year, and has been increasing over the years. The turnover of shares on the London Stock Exchange is now over 100% per annum. This higher value reflects the use of derivatives by hedge funds, which can have high turnover because they do not pay stamp duty.

Pensions should not be provided by annuities

The Oxford English Dictionary says that a "pension" is a regular income in retirement. In order to obtain a pension NPSS requires members to buy an annuity from the market in annuities supplied by insurance companies. PPM members do not have to buy annuities when they retire on this way, since PPM provides annuities itself.

The trend towards defined contribution schemes results in more people having capital sums when they retire with which they have to buy an annuity on the market, perhaps preceded by an income drawdown plan. There is then the possibility of making mistakes and not getting the best deal.

The cost of annuities is implicit or hidden and is not discussed by the Pension Commission. I estimate this to be in the range 10-15% of premiums. The Commission says only that annuities are "transparently priced". A further problem with annuities is that they rely on government gilts, which may have an inadequate supply and provide poor returns.

A bleak future?

Without a new properly designed national pension scheme, the future for pension savers is likely to be bleak. There are continuing problems: closed funds, poor annuity rates, mis-selling and so on. Above all the problem of high charges needs to be solved. Otherwise saving is just throwing good money after bad.

Discussions about pensions seem to divide into dividing-the-cake issues, and size-of-the-cake issues. Retirement age comes into the former category. High charges are in the latter category, which is more serious.

In this area there are constantly improvements, but which do not solve underlying problems. Stakeholder pensions were described as "low-cost" and were an improvement on personal pensions. They were therefore widely welcomed. But now, on the contrary, the Pensions Commission finds them unacceptably expensive - at least for lower income savers. A new system, such as NPSS, must be an improvement on what exists already. This is necessary. But it is not sufficient.

NPSS is designed especially to collect contributions efficiently. But this is not sufficient. There is a need to set up a new national pension scheme, which not only collects contributions efficiently, but also manages funds internally and provides pensions.

28th December 2005.