Spoiling a Good Idea
The Personal Accounts Scheme
by
Stephen Wynn

1. A good idea

Hardly anyone is opting out of the default fund of the Swedish Premium Pension Scheme:

"In Sweden, overall figures show that 58 per cent of pension savers have made an active choice, but this masks a rapid decline in the proportion doing so over time, from 67 per cent when the scheme was introduced in 2000, to 1.6 per cent in 2007. It is notable that during the period 2001-2005, the Swedish default fund performed better than an average of all funds that could be actively chosen, and was considerably cheaper." x

A 2009 study The Swedish Premium Pension: Should an investor actively select funds or keep the default option? found the default fund to be the best option:

"Our results prove that Premiesparfonden is a very attractive fund. Although the fund is outperformed by a few, the attainable return and utility gains are rather small in comparison to the effort required to identify these. Hence, we have strong reasons to believe that an investor is better off keeping the default option. ... Our analysis identifies that there are currently a large number of underperforming funds." x

Therefore the people who were persuaded to opt out of the default fund lost out.

"The first investment selection in the Premium Pension took place during the fall of 2000. The objective was to induce as many participants as possible to make an active choice and the Premium Pension Agency launched a large advertisement campaign to encourage participants to select their own portfolios. In addition to the PPM, private fund managers also put significant resources into ad campaigns to attract investors. About 68 percent of participants made “an active choice” and chose their portfolios." x

This illustrates that saving in a properly constituted fund outside the private sector (that is regulated by the FSA) is a good idea, to avoid underperforming funds. But this is spoilt by requiring savings to be locked in until retirement, and then having to buy some kind of industry "product" - probably an annuity.

2. Spoilt

2.1 Contributions are locked in

Members of the Personal Accounts Scheme should not be locked in. A contributor to a discussion said:

"I dislike systems that leave you open to rip-offs from managers because you can't move funds, or ones where Brown and his ilk can tax because they are short of cash." x

Another contributor said:

"What bothers me about pensions - all types - are the following:

1) They are essentially an expectation marketed to you by some big powerful institution. You pay in real money now and, hopefully, in 35 years they will still be about and prepared to deliver on it. If the expectation starts getting diluted, you can't do anything much about it. You can't call it a day and get what's left of your money back out.

2) The providers can and do change the rules-in-play as it suits them. Again you can't do anything to guard against such things and you can't give it up as a bad job and recover your funds.

3) Governments keep moving the playing field, let alone the goal posts. When I stared work you had to joint the company scheme by law. Then came SERPS and contracting out. AVCs can't be taken as cash any more, the retirement age can be put up faster than you can grow old ....." x

Giving a choice of funds will encourage a sense of ownership. But then investments will be in limbo land where they cannot be spent or transferred out of the scheme. Moreover when members retire they have to be "converted" into a "source of retirement income". So that people will have to buy a product from the industry. This is the advantage of ISAs:

"Many of you don’t like the idea of your savings being locked away until you reach your fifties or sixties. That’s exactly what happens with a pension scheme where you won’t normally be able to get your hands on any cash until you retire.

But with an ISA you have access to your money whenever you need it. Of course, I’m not suggesting you raid your savings carelessly, but it’s good to know there are funds available in an emergency.

The opportunity to draw on your ISA savings whenever you like gives you the freedom to vary the amount and frequency of income. It’s much more difficult to adapt income taken from a pension.

Once you retire, your expenditure is unlikely to be evenly spread throughout the year, so you can alter your withdrawals to suit your own personal spending pattern. .. Most pension savers will only be able to take an income from their pension by converting it into an annuity." x

Personal accounts should be more like ISAs than pensions. An article in ThisIsMoney says Pensions consistently disappoint x because "they are paying their fund manager for doing a half-baked job." There is a considerable literature on this topic such as Pensions not better than ISAs. x

2.2 Funds will be "passed on"

The funds from personal accounts will "passed on" to fund management companies. x This as various disadvantages. It will be difficult to change fund managers:

"Manager change can be a costly process. It requires a search for a new manager and the transition of the assets from the old to the new manager often requiring a transition manager. This will incur additional trading costs." x

2.3 Choice of funds

The PADA is proposing that the personal accounts scheme should provide a choice of a limited number of funds, such as nine. This could be the thin end of a wedge, for example:

"When Ripa originally became law, only nine organisations - including the police and security services - were allowed to use it. That has since been extended to 795 bodies. " x

Similarly the nine funds of PADA could become 795. Having a choice of funds means that millions of people will have to make a choice between the same alternatives - which seems ridiculous. Members of pension schemes do not in general want a choice of fund. How many members of the Personal Accounts Scheme will not opt out of the default fund? Tim Jones, Chief Executive of PADA, mentioned 80-90% to the Select Committee on Work and Pensions. x This seems more likely to be 90-100%. A January 2008 NAPF press release says:

"84% of DC schemes have a default fund and that 91% of all members in these schemes have left their money in that default fund." x

Less than 1% of members of the Danish Special Pensions Savings Scheme opt out of the default fund:

"Denmark has roughly the same number of members (3.2 million) in its Special Pensions Savings Scheme (SP), a supplement to its two main government pension schemes. However, less than 1% have bothered to choose from its list of alternatives to its default fund." x

Waldo Tapia and Juan Yermo say that "Participants in Australia‘s compulsory superannuation system face a staggering array of potential choices." x This is the industry promoting their funds, rather than members wanting a choice. One Australian article explains: more choice, lower returns. x The Swedish Premium Pension Scheme has a choice of about 785 funds.

"Over 90 percent of new participants, most of whom are young people entering the labor market, do not choose a fund on their own (Sundén 2004). This high rate may reflect in part that many observers recommend participants to 'choose' the default fund." x

"After the initial enrolment period, the government significantly reduced its advertisement expenditure. Interestingly, the proportion of member choosing their own portfolio fell as well. During the last four years, investment choice among first time choosers fell dramatically to less than 10%.

Later, participants who did not make an active choice may have also been attracted by the higher investment return and lower management fees of the default fund During the period 2001-2005, the Premium Saving Fund (default option) has performed better than an average weighted of all funds that can be actively chosen in the PPM system (PPM Index).

The default fund is also considerably cheaper than other funds. By the end of 2005, the net fee for the default option was 0.14% while the average fund fee for participants who made an active choice was 0.39%." x x

Share of first-time chooser that made an active choice in Sweden:
2000 2001 2002 20032004 2005 2006
Total number of first time
choosers		 4,420,003 492,934 195,851 150,151 128,991 116,800 113,450
% of first time choosers
who made an active choice 		67% 18% 14% 8.4% 9.4% 8% 7.5%

2.4 Obligation to buy annuities (or ASP x Appendix 3)

Many people will accumulate savings in personal accounts from earlier jobs, producing a retirement income which they do not actually need. The PADA discussion paper Building personal accounts: Securing a retirement income (2008) x says:

"Retirement savings can be converted into a number of different sources of retirement income, including annuities, income drawdown and alternatively secured pensions."

"Securing" and "can be converted into" are euphemisms for buying. "Sources" means industry "products" such an Income Drawdown Plan:

"If a member wants to take out an income drawdown product, they will be able to do this by transferring their funds out of their personal account to another registered pension scheme."

"The Government has decided that members of the personal accounts scheme will be able to transfer their investments into a different pension fund, for the purposes of securing a retirement income."

"Will be able to transfer their investments into a different pension fund" seems like a euphemism for "will have to buy an Income Drawdown Plan from a life assurance company". The Personal Accounts Scheme should itself provide annuities and income drawdown.

Retirement savings abroad are most often taken as a lump sum on retirement, or the savings remain in place with a "programmed withdrawal". "The private annuity market in the United States of America (USA) is small." x The Swedish Premium Pension System does not require members to buy annuities, on the open market when they retire. (It provides the choice of an income drawdown arrangement "fund insurance" x or annuities "traditional insurance". x) Nor do Individual Retirement Accounts and 401(K) plans in the US. x They have "minimum distributions". x "Lump sum is the standard form of retirement distribution for profit-sharing, 401(k) and stock bonus plans," x The discussion paper says:

"Despite the theoretical benefits of annuities, they remain unpopular in most countries."

Because "theoretical benefits" are outweighed by both real and theoretical disadvantages. They are unpopular everywhere, including Ontario:

"In Ontario, a life annuity had to be purchased by age 80, but this restriction no longer applies. An individual in Ontario can now continue programmed withdrawals until death. From age 90, the entire remaining balance can be taken in lump sum cash, but this is not mandatory; programmed withdrawals can continue." x

Problems with annuities:

They are a gamble on: 1) annuity rates when you retire, 2) the value of pension savings when you retire, 3) the future rate of inflation.

They are based on bonds, which have no capital growth and a lower yield than shares. There is no longer a reverse yield gap:

"The 4.8 per cent paid on the UK share indices is about a percentage point above the yield on long-term government bonds." x x

They are dissaving rather than saving.

They are irrevocable.

They have opaque charges and money's worth calculations.

People may not need an income from an annuity, and prefer to receive investment income, or the cash.

They destroy capital.

2.5 Income drawdown

PADA recommends that person accounts should not provide an income drawdown option when people retire. This will encourage the sale of Income Drawdown Plans. The discussion paper says:

"If the personal accounts scheme were to manage such products, it would need to provide the necessary investment management infrastructure, and a payroll system. This would add costs for all members to service a minority."

This seems feeble and heavy weather. Switching from investment income being reinvested to being received as a pension income can hardly be described as a "product" which requires an "investment management infrastructure". Surely "a payroll system" is for employees rather than retirees. Life assurance companies always seem to have a drawdown facility. Perhaps if a PADA income drawdown were properly formulated, there would be a majority rather than "a minority", and in any case why should the minority not pay for itself?

2.5 Money's worth values

The PADA has various money's worth values for annuities in its discussion paper. But they are published values, which seem unacceptable, because they do not specify the annuity rates and interest rates used in the calculation. I have a computer program which calculates the money's worth, given an annuity rate, interest rates and mortality.

The paper by Edmund Cannon and Ian Tonks, Money's Worth of Pension Annuities (2009) x seems to be a dishonest paper in favour of annuities, such as:

"We may illustrate the welfare benefits of an annuity, with recourse to a simple example which is explained in more detail in the Appendix."

This "simple example" is illustrated by Figure 2.1. It can be seen that it is far from "simple". The "more detail" in the Appendix is horrendous.

The money's worth values in the paper are impossible to check. The interest rates used in the calculation of money's worth in Chapter 6, are not specified in the same tables. The reader is apparently expected to derive this from a discussion of interest rates in Chapter 5 Data for money's worth calculations. But it is not immediately clear exactly what interest rates are being used. The calculation of money's worth is highly dependent on interest rates. Similarly they do not specify exactly which annuity rates they are using. The "data for money's worth calculations" needs to be given in tables corresponding to the tables of money's worth values. There is a mismatch between the tables in Chapter 5 and Chapter 6. They do specify which mortality tables they are using, such as in Table 6.1.

2.6 Hidden agendas

There is a possibility for secret agendas. The PADA discussion paper is promoting annuity sales, without saying so explicitly. "Association of British Insurers" or "ABI", is mentioned 41 times. Perhaps a further reason PADA likes annuities, is that they help to finance government debt. Perhaps insurance companies do not only buy bonds to back annuities. They may include some property investments, in the expectation that these will be more profitable. Funds which are locked in are liable to hidden agendas, such as the government wanting to promote particular projects.

Appendix 1
Reasons for not having a choice of fund

1) Only a small minority of members will want a choice of funds.

2) It is expensive, requiring the creation of the proposed Pension Payment System.

3) It is difficult or impossible to change the fund manager.

4) It will result in competition between funds to attract money, resulting in extra costs, and members being influenced to choose the wrong funds.

5) It presents people with an unhelpful dilemma about which fund to choose, perhaps requiring financial advice.

6) There will be inadequate criteria for making choices, especially when the funds are new, that is without a track record.

7) It is catering for personal likes and dislikes, such as for or against index-tracking funds, which may not be based on much knowledge or experience.

8) However many choices are provided, some people may not like any of them.

9) It is storing up complaints in years and decades to come from those who (with hindsight) make the wrong choice.

10) Switching between funds will increase costs.

11) The number of funds is very likely to increase over time.

Appendix 2
"Bounded rationality"

PADA commissioned a report Individual investment behaviour: A brief review of research (2009) by Sharon Collard, x which says that people are generally hopeless at investment decisions, such as:

"There is also evidence that consumers lack the understanding and knowledge to make pension investment choices themselves."

This follows the discussion paper of PADA on securing a retirement income x which says: "Retirement savings can be converted into a number of different sources of retirement income, including annuities .. ", but people have problems deciding what to do because: "individuals have what is known in economics as ‘bounded rationality’", "individuals have limited cognitive abilities" and "often virtually non-existent" "awareness and understanding". This seems to be saying; "You are hopeless at looking after your own money, we should look after it instead." The paper by Sharon Collard "draws heavily" on Waldo Tapia and Juan Yermo Implications of Behavioural Economics for Mandatory Individual Account Pension Systems (2007) x who say:

"in reality several obstacles and behavioural challenges compromise good investment decision making. Many individuals are not particularly good at the retirement savings problem either because they lack the necessary cognitive ability to solve the optimization problem, because they have insufficient will power to execute it, or even sometimes because they are overconfident."

They say that people a subject to: "procrastination", "inertia", "overconfidence", "bounded self-control", "illusion", "heuristics":

"The problem of procrastination and inertia is closely related to that of bounded self-control .. there are two factors that can contribute to overconfidence: the illusion of knowledge and the illusion of control... heuristics may result from individual being unable to asses risk in terms of probabilities."

People should not be required to make ridiculous choices. They have better things to do with their time. The report of Sharon Collard concludes:

"The review highlights that consumers generally lack any detailed knowledge or understanding of pensions and investments, even though they are increasingly expected to make their own financial provision for retirement."

There is a long history of people being ripped off when they "make their own financial provision for retirement", such as:

"My 'Managed Pension' has in practice proved to be a wholly mismanaged one, with 'income drawdown' being a misnomer for 'capital drawdown'. Their 'With Profits' operation too has been neither a low-risk nor a smoothed fund, and they have added to my problems by ensuring that their 'Investment Bonds' have proved to be anything but an investment. Moreover, I have every reason to believe that they have in fact been neither honest or equitable in their dealings with me. First they removed my Gar without my knowledge and then, more recently, they took away my Gir by another quick sleight of hand." x

Appendix 3
Alternatively Secured Pension

"While it is technically possible to avoid the purchase of an annuity by using the Alternative Secured Pension (ASP), tax disincentives make this route problematic. Indeed, the Government has noted that this is not a 'mainstream product' and would not allow it to be used 'to get round the annuity rules'. For its part, the FSA commented that ASPs were “only intended for a small group of people who have a principled religious objection to buying an annuity.

Unlike the United States, Australia or Canada, where income drawdown solutions for retirement are widespread, the UK regulatory regime still makes annuitisation of at least 75% of an individual’s pot effectively compulsory." x


April 2009