Challenges and Choices
The First Report of The Pensions Commission ^x
Comments by Stephen Wynn

Contents

1. Something has got to give		2. Facing in two directions at once
3. The discussion of personal pensions in the First Report
4. Shifting risk and responsibility onto individuals
5. Imposing costs on individuals		6. Annuity costs	7. Mistakes
8. Explicit costs	9. Implicit costs	10. Investment returns
11. Putting the cart before the horse		12. "Choose me"
13. "Bewildering complexity"		14. Cool it!
15. "A partnership with financial services companies"
16. New institutions are needed to reduce costs
17. "Government and industry are working in partnership."			18. Efficiency
19. Governance	20. A new national pension scheme		21. Conclusion
22. More topics

1. Something has got to give top

The starting point of the First Report on page 1 is: something has got to give. It gives four rather bleak options:

"Faced with the increasing proportion of people over 65, Society and individuals must choose between four options. Either:

(i) pensioners will become poorer relative to the rest of society,
(ii) taxes/National insurance contributions devoted to pensions must rise, or
(iii) the savings rate must rise; or
(iv) average retirement ages must rise" (page 1)

If we want more people under 65 we can adopt pro-natalist policies to encourage women to have more babies. This is one of the topics not discussed by the Pensions Commission. But it does discuss other topics, such as housing, which also do not seem to come within its remit. It has been given the task:

"to keep under review the regime for UK private pensions and long-term savings, and to make recommendations to the Secretary of State for Work and Pensions whether there is a case for moving beyond the present voluntarist approach."

An alterative to (ii) is fewer people claiming the various benefits, such as housing benefit. There will then be more funds available for pensions.

"The savings rate" in (iii) is not defined in the Glossary. Sometimes, such as page 127, there are "savings rates" suggesting there is more than one "savings rate". From the text these rates seem to include only saving by individuals. What about company contributions to occupational pension schemes? The choice between (ii) and (iii) surely depends on which option gives the best pension. Should this not be determined by the Pensions Commission?

Adair Turner is reported to have said: "People are going to have to work longer." ^{x x} This implies that the fourth option above is no longer an option. There has been a long-term trend towards earlier retirement. ^x Later retirement seems like putting the clock back. The TUC is not in favour of increasing retirement ages (iv):

"There is an alternative to a 'work-till-you-drop' rise in the pension age, and that is to help those below the pension age get a job and make a full economic contribution so that there are more people in work under 65 paying taxes and creating wealth." ^x

"More people in work under 65" is an increase-the-size-of-the-cake approach to pensions, rather than how-to-divide-the-cake. The present website also has the former approach, that is how to increase benefits by reducing charges.

The number of pensioners is currently increasing at less than 1% per annum. This can surely be paid for from real GDP which is increasing at about 2% per annum, without pensioners becoming poorer relative to the rest of society or increasing the retirement age.

Many people have to retire later such as Mr and Mrs Halliwell if the alternative is to rely on their Pearl pension. ^x Colin Townsend thinks he needs to retire at "flippin' 90". ^x "Likelypauper" thinks he will need to retire at 70. His poorly performing savings "products": "I have with Zurich/ Eagle Star who have just written to me advising that the annual bonus is to be 1.4%.", ^x result from high charges (fees, levies, adjustments etc) which I estimate to amount to £500 - 1000 per head for all 60 million people in the UK. ^x

Richer people can afford to retire earlier. It is particularly lower income people who need to save so that they do not need to draw means tested benefits when they retire. But the Report suggests that encouraging people on lower incomes to save is not worthwhile:

"Reductions in Yield arising from providers’ charges can absorb 20-30% of an individual’s pension saving, even though the charges have fallen to a level where provision to lower income groups is unprofitable." (page 205)

Adair Turner is reported to consider that: "Pensioners have never had it so good." ^x In the First Report it says: "Pensioner poverty ... is higher than the EU15 average." (page 58) If short of cash the FSA has various suggestions such as: "Shop around for cheaper gas, electricity and phone suppliers.", "Take in a lodger.". ^x

Housing is discussed in Chapter 5: Non-pension savings and housing. It is implied that housing assets are beneficial. But they are not beneficial for people who are homeless because of excessively high house prices and rents. There are 100,000 officially homeless families in England. Including single people and "hidden homeless" brings the total number of homeless people to an estimated half million. ^x The Commission says:

"There is therefore no inherent reason why the purchase and sale of houses should not perform exactly the same role as funded savings via equities and bonds in effecting a resource transfer between generations." (page 190)

From April 2006 it will be possible to put residential property into a SIPP. This was suggested by the Commission:

"Savings which could be placed within the tax wrapper of a Self Invested Personal Pension (SIPP) from April 2006." (page 194)

This decreases the availability of affordable housing for first-time buyers. ^x

The return from equities is given in Figure 3.52 Distribution of Real Returns from UK Equities over 20 Year Periods: 1899-2003. There is no similar discussion of the return from pensions. There should surely be a discussion of the investment performance of personal pensions and of stakeholder pensions. What about for example: "Pensions - The worst investment of my life" ^x or "You have to laugh."? ^x

The Commission refers to the paper The Price of Retail Investing in the UK (2000) of Kevin James:

"The paper is not specifically focussed on pensions, but on retail investments such as unit trusts, but its findings are likely to be broadly applicable to pension investment as well." (page 218)

This seems to be combining together all retail investments. A discussion of investment performance and implicit charges should make a distinction between unit trusts, OEICS, insurance funds, investment trusts, personal pensions, stakeholder pensions, with-profits insurance policies. In his paper Kevin James seems to calculate "the price of investing" only for unit trusts.

According the Oxford English Dictionary a pension is a regular payment made to someone above a certain age. But the Pensions Commission does not discuss what happens after retirement such as income drawdown plans, Alternatively Secured Pensions (ASP) introduced in the Finance Act 2004, ^x the cost of annuities. The Pensions Commission's discussion of annuities seems to ignore costs or hidden charges. For example:

"Members own a capital sum which will buy them an annuity according to the life tables which exist when they reach retirement." ^x

The annuity received will be less than that calculated using life tables because of costs.

The ASP is yet another "product" which will be marketed by financial companies. An alternative approach to pensions is that of schemes. Members of defined contribution (DC) schemes should be able to leave their capital untouched when they retire and live off the investment income, instead of being required to buy a "product": annuity, income drawdown plan, or ASP.

In short, there are plenty of topics concerned with pensions that need to be researched before for example general education such as Figure 8.19 Participation in University education by sex.

2. Facing in two directions at once top

The Pensions Commission seems to be trying to face in two directions at once, for and against the retail market in pension "products". For example it refers to "mis-selling" in:

"The retail financial services industry has lost the trust of customers as the result of a series of mis-selling scandals and problems (such as pension mis-selling, endowment mis-selling, Equitable Life, split capital trusts)." (page 214)

It refers to implicit costs which may be as high as explicit costs:

"Estimating the implicit costs is difficult but vital, if as seems likely, the implicit costs are for some investors as significant as the explicit costs." (page 214)

Even though people have lost trust in the industry, and are paying "significant" hidden costs, the Commission does not want the industry to lose interest in the market:

"It is hoped that the combination of the new sales regime and the looser price cap will revitalise industry interest in the personal pension market and, in particular, in selling to lower income low premium savers." (page 220)

But it asks whether there is a level of income below which sales are not worthwhile:

"There is a segment of the pension market, comprised of lower income savers and people working for small firms, to which the free market will never be able to sell pension products profitably except at RIYs that make saving unattractive." (page 224)

This is cherry-picking the most profitable part of the market. Which "segment"? A low income in 2004 might be a high income in 2005. There is little or no reduction in RIYs for higher income customers. So that "RIYs that make saving unattractive" implies that unattractive RIYs are acceptable for higher income customers but not for lower income customers. A lower income customer may become a higher income customer as his or her career progresses. A charge of 1% or 1.5% per annum on a capital of £1000 may seem reasonable but on £100,000 it seems like a rip-off. But the Commission suggests that the market "works for" high income customers but not for low income customers:

"In principle can a voluntary market for pensions work for low income, low premium customers?" (page 205)

The Building and Civil Engineering Scheme (B&CE) EasyBuild stakeholder scheme has been successful in attracting members:

"270,000 construction operatives, most of whom previously had no meaningful pension arrangements, now have a SHP. The average contribution by individuals is £13 a week ... The answer to driving wider take up of SHPs is not, as many commercial providers seem to be presently arguing, to increase the cap on charges for stakeholder schemes by 50% or even 100%." ^x

B&CE says that the answer is an industry-wide "partnership approach":

"We believe a partnership approach like this, agreed by employers and trade unions, is a model for other industries."

This partnership approach means having schemes which are accepted, for which there is collaboration. They are not just imposed such as by requiring employers to designate a stakeholder pension scheme (SHP).

Under the heading Philosophical issue: should the government ensure "adequate" pensions? it says:

"An alternative point of view is that government should try to ensure that people make provision which they would consider adequate, for three reasons:

1. "A purely free market for private pensions may be severely inefficient ... " (page 129)

This seems to imply the "market for private pensions" needs to be regulated. Another philosophical issue is whether there should be a market in the first place. Occupational pension schemes do not form a market because membership is restricted. The market consists mainly of personal and stakeholder pensions.

Principle 1: Pensions should be provided, as far as possible, by membership of group pension schemes with trustees rather than by pension "products" which people buy in a pension market.

3. The discussion of personal pensions in the First Report top

Contributions

The Pensions Commission gives a considerable amount of information about contributions to personal pensions: Figure 3.37 Contributions to personal pensions in 2002 earnings terms; Figure 3.50 Components of funded pension contributions as a percentage of GDP; Figure 3.55 Investment choice for new personal pension contracts, by value of premiums: £ billion; Figure 3.56 Investment type for all regular personal pensions premiums whether old or new contract.

Assets

When discussing assets the Pensions Commission usually combines personal pensions with occupational pensions. For example: "In addition to occupational and personal pension funds worth £1,300 billion" (page 171), "Pension funds and policies" in Table 5.1 Total personal sector balance sheet end 2003: estimated to the nearest £50 billion, "Life assurance and pension funds" in Figure 5.1 Pension funds net housing and net financial assets as a percentage of GDP.

Figure 3.4 Pension fund assets as a percentage of GDP gives the assets of self-administered pension schemes as 81% of GDP. In the Note it states that if insurance company pension policies are included this increases to 120%.

The Note to Figure 4.19 Pension assets and accrued Rights: Public and private sector estimated percentage shares at end 2002 says:

"Total pension funds (self-administered and insurance companies) £1080bn (Source: ONS Bluebook and Pensions Commission estimates). Of which self-administered are £620 billion but value of liabilities is £700 billion (with £80 billion deficit)."

Therefore £1080 - 620 = 460 bn are pension funds other than those of self-administered schemes. These are occupational pension schemes administered by insurance companies, and personal (including stakeholder) pensions. Kinds of funded pension schemes are:

	Occupational pensions:
		Defined benefit
			Self-administered
		Defined contribution
			Self-administered
			Insurance company administered, and consisting of insurance policies
	Personal pensions (generic term), all defined contribution:
			Personal pensions
			Stakeholder pensions

The assets of life assurance companies are apparently not given in the report of the Commission, even as a percentage of GDP, as are those of pension funds in Figure 3.4 Pension fund assets as a percentage of GDP. Figure 5.2 Gross housing assets and mortgage debt as a percentage of GDP gives "personal sector financial assets" "insurance company policies (non pension)" £300 billion. This is not the same as the assets of life assurance companies. Figure 3.57 Investment holdings of non-linked insurance company funds gives life insurance company investments as a percentage adding to 100% but not the total amount in £s.

Charges

Figure 6.11 Reduction in yield for the average personal pension contract held for 25 years combines personal and stakeholder pensions. But they should arguably not be combined because the cap on charges only applies to stakeholder pensions.

Pensioner income

Table 1.1 Pensioner incomes as a percentage of GDP: 2002 combines personal with occupational pensions: "Funded personal and occupational pensions".

Pensioner income from occupational pensions is given in Figure 3A.8 Pensioner income from occupational pensions as a percentage of GDP. What about the income resulting from personal pensions especially from annuities?

The Commission says the people should "save more". Option 3 on page 1 is: "The savings rate must rise". When we do save what benefits do we obtain in return? What benefits have we obtained from personal pensions in practice, not just will we obtain in the future based on various assumptions. This is not discussed in the Commission's report. Why should we bother to save, if there are no benefits or at least they are not sufficiently significant to be discussed by the Pensions Commission?

In conclusion, the report of the Commission is very forthcoming about the contributions to personal pensions, less forthcoming about the assets of the funds of personal pension schemes, and not at all clear about the benefits which they provide.

4. Shifting risk and responsibility onto individuals top

The Pensions Commission uses the word "risk" about 140 times in its report. It is especially concerned with the increasing investment risk borne by individuals, who are in effect being compelled to play a game of snakes and ladders: ^x

"A major shift of risk from state, employers and insurance companies to individuals .." (page 104)

"As a result of this shift in risk bearing, individuals' income in retirement will be increasingly influenced by the investment decisions they make." (page 112)

"But handing investment risk to people with low income and limited other resources has disadvantages." (page 251)

On the same page 251 there are headings:

"3. The division of risk"
"4. Selling and administration costs"

This implies that costs are not a risk. But charges can be increased after you have bought a "product". The unit holders of unit trusts do not have to be informed if fees additional to management charges are increased. This is a market risk, and so are the implicit costs. Financial companies and funds quite often amalgamate or are taken over by other companies and funds. This is another market risk. For example:

"My concern is primarily that in common with tens, or even hundreds, of thousands of others, we are being sold on to we know not whom." ^x

The report says:

"Society and individuals must choose between four options. Either:

(i) pensioners will become poorer relative to the rest of society,
(ii) taxes/National insurance contributions devoted to pensions must rise, or
(iii) the savings rate must rise; or
(iv) average retirement ages must rise" (page 1)

A fifth option is to make the pensions industry more efficient. "The savings rate must rise", contains the tacit assumption that individuals benefit from saving. There may be only small benefits because of charges or no benefits because the financial company has lost contact with the customer, resulting in the accumulation of surplus cash. ^x

NI numbers or the proposed new identity numbers should be on all accounts and policies as a way of keeping tract of customers through the Letter Forwarding Service of the DWP or the proposed new Population Register. ^x

Principle 2: NI numbers should be on all accounts and policies.

Saving may become trapped in closed funds and not be able to leave - at least without a large MVA or MVR. ^x The value of closed funds is estimated to be over £190 billion. I could not find any reference to "MVA" or "MVR" in the Commission's report.

Becoming trapped in a closed fund is a market risk. The Commission does not discuss or even mention closed funds. The "risks" in the report are: longevity risk, investment risk, political risk, earnings progression risk. (page 104) A political risk is "governments can change the tax rules and regulatory regime for private pensions" (page 106). Providers can also change the rules, which is a market risk. It was an attempt to change the rules which led to the House of Lords case of Equitable Life. A contributor to a discussion group said:

"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." ^x

Market risks are those risks to investors resulting from the operation of the financial services market: mis-selling; changes in market costs, amalgamations, mergers, spin-offs of financial companies; changes in rules of play and so on. Market costs are chiefly selling costs, which are paid from management charges.

It is not only risk which is being shifted onto individuals, it is also responsibility. The Caveat Emptor principle is written in the Financial Services and Markets Act (2000):

"the general principle that consumers should take responsibility for their decisions." 5 (2) (d)

Chapter 6 Barriers to a voluntarist solution discusses problems faced by individuals especially: "the bewildering complexity of the UK pension system" which creates "confusion and mistrust", and "Reductions in Yield arising from providers' charges can absorb 20-30% of an individual's pensions saving." Reductions in Yield are explicit costs. There could be equally high implicit costs.

Confusion, mistrust and high charges produce dissatisfied customers. In the March 2004 Annual Review of the Financial Services Ombudsman it says:

"This year alone, the number of new complaints reaching the financial ombudsman service increasd by 57% on the previous year. (which itself saw a 44% increase)." ^x

Government is getting into disrepute with comments like that of one unhappy investor:

"There are of course a few of us in the voting population who still and persistently, in the face of all and ongoing and increasing evidence to the contrary, expect from our politicians not only cleverness, but honour, integrity, the upholding of decent values. Idiots aren't we? Positively antediluvian!" ^x

Why then is it government policy to shift risk, responsibility and costs onto individuals? The government says for example:

"In the modern world people will increasingly need to look after their own financial interests for themselves." ^x

There is a trend away from the provision of pensions by pension schemes that is by groups, to provision on an individual basis by policies. The Commission makes no reference to "affinity group". This is a group which has some common interest unrelated to insurance. Groups of employees are only one kind of affinity group and pension saving is only one kind of long-term saving. Another affinity group is all new babies. The Child Trust fund is another kind of long-term saving. The discussion of occupational pension schemes can be extended to affinity groups and long-term saving in general.

A family is an affinity group. People should consult their relations about financial matters, especially if they are elderly. I understand that this is a requirement for the salesmen of some life insurance companies for elderly customers. It should arguably be a legal requirement. But it is not, for example, part of the code of good practice of Safe Home Income Plans Ltd. ^x Equity Release Plans seem to be disastrous in practice. ^{x x} It is no use saying they are acceptable provided people take financial advice. The house owners are often so elderly that sadly they may no longer be capable of behaving rationally in financial matters.

Self-administered occupational pension schemes are groups. GPP and insured schemes arguably count as individual saving, being collections of policies. Occupational pension schemes have trustees who can enquire about costs so that there need not be any implicit costs. The Commission could make a distinction between saving on a group and on an individual basis. Government encouragement for saving towards a pension should be on a group basis rather than through personal and stakeholder pensions. Groups have intrinsic advantages:

1. The group does not need to employ salesmen to recruit members.

2. Members of the group do not have to concern themselves with shopping around, gathering and reading information, comparing "products", coping with complexities, negotiating charges etc.

3. There are economies of scale.

4. The group has more negotiating weight with the financial services industry than individuals.

5. Tasks can be performed in-house rather than requiring the services of the financial industry, and schemes are able to employ people who are more knowlegeable than individual members - reducing the likelihood of mistakes.

6. Insurance provided collectively for all members of a group is inherently cheaper than when purchased separately by each member.

7. A mutual institution based on an affinity group is, it seems, less likely to demutualise than one which is not based on an affinity group.

5. Imposing costs on individuals top

Although the government says it is seeking to "promote confidence in the market" and the FSA that it is "making the market work for consumers", the retail market for long-term savings "products" for individuals, that is sales to the public, should be replaced as far as possible altogether by the development of group schemes. The development of new kinds of "product" is not a solution. Commission says that for Sandler products:

"HM Treasury has accepted that a 1.5% Annual Management Charge (AMC) for 10 years, reducing to 1% thereafter, is required to sell savings products to low income customers. At this level there is a real issue whether personal pension saving by low earners is attractive." (page 243)

But 1.5% is the (maximum) charge for the new stakeholder Child Trust Funds. A charge of 1.5% per annum is objectionable not only for low income customers. On a capital of £100,000 this is £1,500 per annum.

One per cent is apparently not adequate for stakeholder providers. One of the findings of a consultation discussed in the 2004 report of The Employer Task Force on Pensions ^x is "surprisingly harsh criticism of stakeholder providers", "with lack of support and poor service most often cited".

As discussed in page 214 of the Commission's report, stakeholder pensions have been unsuccessful, and Sandler products seem likely to be as well:

"The design of Sandler products and of the new sales regime have not delivered the dramatic reductions in costs hoped for the Sandler report." (page 243)

The Commission thinks that there may nevertheless be scope for the development of new kinds of "products":

"Radical thinking on product design supported by simplification of the legal regimes might enable some of this cost to be eliminated, building on the potential created by the tax simplification changes." (page 243)

Anything that can be done to elimate costs is welcome. But this seems to be grasping at straws. There are too many obstacles and complications for the cost of long-term saving in the retail market to be reduced to acceptable levels for most investors.

The Commission says that:

"Such RIYs and indeed higher ones appeared acceptable in the 1980s and 1990s because of the very high real returns achieved ... "

Costs tend to be concealed to a greater extent in rising market. But in my opinion such high charges are unacceptable in any circumstances. The Commission says that mortgage endowments:

"are unlikely to provide any significant financial resources once the mortgage has been repaid." (page 176)

"Repaid" by whom? Not only will they not provide any significant lump sum in addition to repaying the mortgage, in most cases they will not even repay the mortgage. I know someone whose mortgage endowment shortfall is approaching six figures. These shortfalls have not been analysed by the Commission. Many people already have savings and are concerned with hanging onto what they already have rather than saving more.

What is the total annuity payments? What are the total costs? Perhaps they could be given in the next edition of the Commission's report. I estimate total cost of the fund management industry to amount to £500-1000 per annnum per head of population. ^x

The Commission says:

"It is important to identify all the costs that stand between the rate of return in the wholesale market and the return which the individual saver receives." (page 214)

However it has not done this analysis in the case of annuities.

6. Annuity costs top

"Implicit cost" is not mentioned by the Commission in the case of annuities but exists and can be calculated from annuity rates, mortality tables and a long-term rate of interest. Where does "1.3% the rate implicit in annuity pricing" in the Commission's report (page 232) come from? Table 1 uses annuity rates of the Prudential from the Comparative Tables of the FSA, mortality tables PMA92 and interest rates 4.5 and 5%:

Table 1

Annuity costs

1	annuity bought at age:	60	65	70
2	years expectation of life for men in the UK in 2004 at above age:	23.5	19.0	14.7
3	Prudential annuity rate at age %:	6.51	7.39	8.56
4	rate with no charges %:
	I = 4.5%	7.20	8.23	9.70
	I = 5%	7.58	8.60	10.08
5	% of the premium of the annuity absorbed in charges
	I = 4.5%	9.58	10.21	11.44
	I = 5%	14.11	14.07	15.08
6	or % of capital per annum charge
	I = 4.5%	0.94	1.12	1.53
	I = 5%	1.44	1.63	2.03

A 50 year old man can purchase an annuity of £451 per month from the Prudential for £100,000 (at the time of writing), according to the Comparative Tables of the FSA. This is an annuity rate of 5.412%. Investing £100,000 at 5% and giving himself an income of £451 per month, the same as the Pru annuity, I estimate he would deplete his account when he reaches the age of 103. You can get 5% from an instant access building society account. ^x

It is better that the capital remaining when he dies goes to the other members of a scheme which distributes the capital of people who die to the living rather than being pocketed by the Pru. It is said that when annuitants die any remaining capital goes to those living longer. But does it? Annuities are very opaque. In the above example "longer" is men older than 102. Paying himself 5% he still has £100,000 left when he dies. Distributing this is a considerable benefit for the other pensioners.

A distribution of capital of people who die to other members of a scheme seems to run into the problem that the plan would then become a tontine, which is apparently illegal in the UK. ^x Distributing the funds of people in a pension plan to other people in this way results in them receiving an increase to their expected income 1/(expectation of life) = 1/23.3 = 4.3% for a 60 year old man. So that there is in effect an income of 6.5 + 4.3 = 10.9% in comparison to the Prudential annuity of 6.5%.

Annuity salesmen receive a 2% commission. Annuities provided by DC pension schemes have the problem of mortality risk. They avoid charges which could be 10% of premiums or more, but there is still the problem of low long-term rates of interest. At the time of writing:

"Ten-year gilts are yielding 4.90 percent but longer-dated 30-year paper offers only 4.65 percent."

The trend away from defined benefit (DB) to defined contribution (DC) schemes means that pensions are increasingly being paid by annuities, mostly provided by insurance companies. This is resulting in additional costs and charges and pensioners being locked into low long-term rates of interest such as "30-year paper". Indeed it even seems to be a cause of low long-term rates of interest, which will therefore persist. I am unsure the extent to short term rates of interest are better than long term rates of interest is historically usual or common.

Page 107 refers to "annuity providers (i.e. insurance companies)". But annuities can be provided in-house by DC occupational pension schemes. The Pension plan design survey 2004 of Watson Wyatt Figure 28, found that for 24% of DC schemes on retirement there is an "annuity provided directly from pension plan". ^x In another survey by Towers Perrin it was 16%. ^x These numbers must be larger as a proportion of members since the schemes providing such annuities are large.

Figure 8.7 Breakdown of annuity type purchased in Chapter 8: Women and Pensions shows that only 12% of annuities are joint life:

"For women married to men with DC pensions, survivor spouse income has often been nil or minimal because the vast majority of annuities are purchase on a single life or non-indexed basis." (page 262)

The Commission says that: "the shift from DB to DC will greatly increase the demand for annuities" (page 105) DB schemes sometimes provide annuities. From April 2006:

"Defined Benefit schemes with less than 50 members will be required to purchase annuities from an insurance company, and will no longer have the opportunity to pay the pension through the scheme." ^x

Only a small proportion of annuities are voluntary annuities. ^x From April 2006 members of personal pension schemes will no longer be required to buy an annuity by age 75. The shift from DB to DC seems likely to greatly increase the demand for income drawdown plans, and Alternatively Secured Pensions ^x rather than annuities. The ABI is expecting an increase in annuity business: "Annuity sales are set to increase dramatically over the next ten years and beyond." The Commission says:

7. Mistakes top

The Commission requested submissions to list separately any mistakes found in their report.

1. Annuities

"annuity provider (i.e. insurance company)" (page 106)

As reported in Section 6 above, the Watson Wyatt Pension plan design survey 2004 says:

"On retirement the cash sum is converted to pension by securing an immediate annuity either with an insurance company or within the plan." (page 14) ^x

Some occupational pension schemes provide annuities.

The Commission refers to "The 0.5 bp for stamp duty" (page 218), but does not mention derivatives which do not pay stamp duty. Unit trusts and OEICS for example use derivatives ^{x x} such as contracts for difference. Derivatives are also used by pension schemes. ^x Most of the turnover on the London Stock Exchange, in Table 4 below is associated with derivatives. It seems a mistake for the Commission not to mention them.

8. Explicit costs top

There is a trend away from self-administered occupational pensions as can be seen from Table 2 below below. The relative cost of pension schemes is shown in Diagram 1 which is Figure 6.9 An Estimate of the Overall Cost Curve Reduction in Yield in the Commission's report. A stakeholder pension is cheaper than a personal pension, but it is much more expensive than a self-administered occupational pension.

The information about personal pensions in this diagram comes from the FSA's Comparative Tables. which is for new policies. Old policies are discussed for example in the Times, Millions are trapped in rip-off-pensions, by Claire Francis, October 10, 2004. For example:

"Charges on Eagle Star's Retirement Contract amount to about 5%. If you put £50,000 in the plan and left it for 10 years it would be work just £46,922 at the end of the term because of the various costs assuming investment growth of 5% a year." ^x

The Commission refers to:

"Reduction in Yield (RIY) which results from the price charged by the provider to cover costs of selling, administration and fund management". (page 214)

The RIY measure does not take into account implicit costs and does not even take into all explicit costs, such as resulting from lapses and surrender resulting in MVRs. Or for example when the policyholder dies and premiums are returned without interest: "Twenty years' worth of growth, down the drain." ^x Or the cost of correspondence: "Companies are billing people £50 for answering simple questions about policy details." ^x

The Commission says:

"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?"

Explicit costs "cover the costs of sales, administration and fund management fees" (page 214). But how much of the annual management charge goes into each of "sales, administration and fund management? Little may be spent on fund management, shares being chosen completely at random, which could be a reason for poor investment performance. Compare this for example with the Danish ATP scheme:

"Pension activity expenses amounted to DKK 27 for each member, while investment activity expenses were DKK 16 per member." ^x

This has the advantage that a) costs are low, b) it says how much is being spent on administration and how much on investment activities. It seems that the accounts of self-administered occupational pension schemes do generally distinguish between administration costs and investment costs.

All the five funds of the Thrift Savings Plan in the US have an expense ratio of 0.1% (which seen immediately by clicking on any of the five funds ^x). This is at the bottom of Figure 7.3 An estimate of the overall cost curve include National Insurance system percentage RIY in the Commission's report, and half the "0.2% in large scale occupational pension schemes" (page 251).

Figure 7.5 Charge ratio in Compulsory Saving Schemes: 2000, lists countries rather than schemes, except for the UK when personal and stakeholder pensions are listed which are not compulsory. Excluding the UK, eight out of the twelve countries listed are Latin America. Would it not be possible for the Commission to study the Danish ATP scheme which is much nearer home?

Explicit costs are part of the wider topic of information such as in: accounts, advertisements, comparative tables, key features documents, newsletters, websites, meetings for members. Towards the right in Diagram 1 above, which is Figure 6.9 in the Commission's report, there are: a) lower costs, b) people are less on their own and more members of a well-defined scheme, c) there is better information for members of schemes, d) schemes are larger, e) members can collectively have more influence on schemes, f) there are more likely to be trustees.

9. Implicit costs top

The Commission refers to "implicit costs". But there is no reason why they should remain implicit. They could and should be disclosed. Portfolio turnover should be disclosed as it is in the accounts of mutual funds in the US. Fitzrovia have produced the first two of a series of annual reports Portfolio turnover of UK funds giving the portfolio turnover of UK unit trusts and OEICS. They think that portfolio should be disclosed (www.fitzrovia.com/ fsa-apr03.htm).

The Pensions Commission does not suggest how implicit costs can be reduced. It does not suggest that portfolio turnover and implicit costs should by disclosed, which puts it on the side of the industry and FSA. Since implicit costs are a multiple of fund turnover it follows that fund turnover should be reduced. But it has on the contrary been increasing, as can be seen from Table 4 below.

Kevin James (formerly at the FSA, now at the Bank of England), who is quoted by the Commission says that caps on explicit costs produce an incentive to increase implicit costs. In his report Waiting for Ariadne (2002) published by the Centre for the Study of Financial Innovation, ^x he says:

"Explicit charges account for only about half of true total charges. It follows that the Treasury's price cap captures only about half of the true total price of investing. Moreover, one might expect the proportion of charges captured by the cap to fall over time, as the cap's very existence creates a strong incentive for funds to devise ways to increase the proportion of the true total charges levied in the form of hidden charges. The Treasury's approach fails because it does not capture hidden charges." (page 35)

Total costs can be found by comparing the rate of return in the wholesale market and the return the individual saver receives. The Pensions Commission has not so far done this, but says:

"The Pensions Commission will do more work over the coming year to validate the results." (page 214)

These results are the paper of Kevin James (FSA, 2000, OP 6) which is quoted extensively by the Commission.

"The paper is not specifically focussed on pensions, but on retail investments such as unit trusts, but its findings are likely to be broadly applicable to pension investment as well." (page 218)

Can we be sure? The Commission says that implicit costs are 1.3% of fund value for "actively managed funds" from Kevin James' paper. (subtracting 1.40% in Table 5 from 2.71% in Table 9). These funds seem to be entirely unit trusts (from Table 3 in Kevin James' paper). They are not the same as pension funds. The paper Isaac Alfon (FSA, 2002, OP 18), states that personal pensions "tend to have high portfolio turnover and high undisclosed charges" (page 16, footnote 20) But nevertheless in spite of the billions that have been invested in personal pensions, there does not seem to be an estimate of the size of these implicit costs.

The Commission estimates 0.65% for the dealing costs of the entire stock market using the capital value of the market and turnover which is calculated from the total stamp duty paid which was £2.5 in 2002-3. From Table 34 below UK equity turnover in 2002 was £ 1,815,034.2 million. ^x Multiplying by 0.5% we obtain £9.1 billion for stamp duty. The reason for this difference is apparently the extensive use of derivatives which do not pay stamp duty.

The market includes index-trackers and shares held by private shareholders, both of whom have lower portfolio turnover. Diagram 2 is the diagram A measure of the price of investing in Annex 2 of the paper of the FSA Comparative Information for Financial Services (1999) (CP 28) ^x This shows unit trusts underperforming the market by 3.7 % per annum, of which 1.2 % is due to the annual management charge. So that total costs less the management is 2.5%. Some of this is expenses such as fees to auditors, which are an explicit cost "in the same print" since they appear in the accounts. The implicit cost is then 2.5% less expenses.

Diagram 2

Unit Trust Underperformance

This is based on a large population of funds:

"These averages were calculated over the 1987 to 1998 period for UK funds ... The sample of funds used includes all broad equity funds in existence over the sample period that were more than five years old and in existence for at least 24 months. The UK data are from Micropal."

The sample in Kevin James' paper was:

"All UK and US broad domestic equity unit trusts/mutual funds that were in existence for at least 12 months over the January 1987 to December 1998 sample period. The UK data are from Micropal." (Table 3)

This seems to be practically the same data over the same time period. But in one case (OP 6) the unit trusts are underperforming the market by 2.7% and in the other (CP 28) by 3.7%. What is the reason for this difference? It may be caused by one using geometric means and the other using arithmetic means. Geometric means are always less than arithmetic means unless all values are equal. "Index returns over a particular holding period should always use arithmetic averaging." ^x

In his report Kevin James distinguishes between "the simple average method" (3.1.1) which uses arithmetic means and "the econometric method" (3.1.2) which takes into account different market sectors and uses geometric means. The 2.7% comes from the latter. The simple average method gives an underperformance of the market of 3.16% from Table 6 of his paper. There is then not such a large difference with the 3.7% in Annex 2 of CP28.

Portfolio turnover varies widely between different funds. Portfolio turnover, varies widely between funds by a factor of 18,617 to 1 from 0.1 % to 1861.7 % in the Fitzrovia report suggesting that implicit costs are a lottery for individual investors.

Information concealed at the time of purchase may result in further costs. For example a purchaser of an income drawdown plan from Equitable Life gives a list, with reference to a "reason why letter":

"It does not say the value of the fund can go down. ...

It does not say there are earlier policyholders who might have a claim on my fund because of guarantees given to them.

It does not say my income (Income Drawdown) comes out of the capital I gave to ELAS, and that any resulting fund earnings remained the property of ELAS and could be reduced or removed at any time.

It does not state that exit penalties could be introduced.

It does not say there wasn't a smoothing fund.

It does not say their Advisor made a mistake and my capital would not be invested in the proportions/areas he told me.

It does not state that as ELAS was a mutual investors were not just the beneficiaries of profits but also responsible for losses." ^x

10. Investment returns top

Savers and investors are interested in the returns they obtain for their savings and investments. Costs are a secondary consideration. Except that this is the same since:

investment return obtain from a "product" =
return obtained from the underlying investments for the "product"
(of the financial company usually in the stock or bond market)
- the (explicit and implicit) costs borne by the "product"

Figures 3.52, 3.53, 3.54, 5.15, 5.16, in the Commission's report and Appendix C give rates of return obtained from equities, bonds and housing. What about pensions? What is the return from personal pensions and the investments of occupational pensions? There is much available information on the former and the latter is available from The WM Company ^x (William Mercer). It would be helpful to have similar diagrams also for in particular: unit trusts, investment trusts, investment bonds. If we know the market rate of return and the average rate of return for example for unit trusts, then we can subtract the two to obtain total costs.

The return from equities is often given in sales literature for savings "products". But this seems misleading for some people who may not realise that the return actually obtained is reduced by costs and charges.

There are numerous articles complaining about high charges. For example by Kathleen Cooper in the Sunday Times (10th October 2004) Funds Take Half Your Growth in Fees. ^x There are further articles and discussions complaining about the resulting poor investment performance, such as from an article:

"Not a single unit-linked endowment would have made you money over the past ten years and very few pensions break even." ^x

"I got back just about what I had paid in - ten wasted years. Not any old ten years wasted either, what makes this even more galling is the thought that in all probability the 1990s will prove to have been the most favourable investment conditions we are going to get." ^x

The briefing report of the FSA The regulation of closed with-profits funds (2004) says:

"Every year we carry out a private survey of maturity payouts and surrender values of with-profits policies." (2.15)

I asked the FSA whether this survey could be published, with the reply:

"The Financial Services and Markets Act imposes restrictions on how we can deal with confidential information. We have passed your request to the appropriate department for consideration." ^x

This implies that maturity payouts and surrender values are confidential information. A knowledge of the investment returns obtained in practice from different categories of "product" is essential information. The discussion of returns obtained in practice should not be restricted to equities, bonds and housing as in Appendix C in the Commission's report. The report discusses the paper of Kevin James, which is concerned with unit trusts rather than pensions.

There is much information about the investment returns obtained from the long-term savings "products" of the financial industry in the press and on websites. The Commission seems to be taking the side of the financial industry and FSA rather than investors, by not including such information in the Figures and Tables in its report.

11. Putting the cart before the horse top

Figures 7.2 - 7.5 introduce and compare a considerable number of different countries including 8 from Latin America. Figure 7.5 Charge ratio in compulsory savings schemes: 2000: Total percentage reduction in accumulated pension fund lists countries which have compulsory saving schemes, showing that they are on the whole not efficient. This is putting the cart before the horse. We should instead seek out schemes which are efficient and find out whether or not they are compulsory. Figure 7.5 is not inclusive since Denmark is not included. The Danish ATP scheme is compulsory for employees. Figure 7.5 can therefore be criticised for being selective, for choosing the more inefficient of the compulsory schemes.

The Commission makes an assumption:

"Assume that there is a social interest in ensuring that people of modest or average means (e.g. those up to the 75th percentile of earnings - at present about £29,000) have made provision which they would consider adequate." (page 129)

This is again putting the cart before the horse. It assumes that it is possible for people to make "provision which they would consider adequate" without suffering from excessive costs and risks.

12. "Choose me" top

If the alternatives are identical, such as choosing a lottery number, then choice is an illusion. The Sandler Review complains about the proliferation of almost identical "products". Sandler products of the same type sold by different companies will be even more identical. The Sandler Review says that savings "products" which seem different may in fact be identical:

".. product differentiation that does not reflect true differences in what is being offered." (3.13) "Some products are fundamentally the same but are marketed as being different." (3.17)

Choice can result in costs because the alternatives compete with each other saying "choose me". If there is a choice of funds or providers they may compete for business, by increasing the fees they pay to brokers. The Commission says:

"while in theory it should be possible for a system of compulsory saving to result in a radical reduction in selling and administration costs.." (page 254)

Even if there is compulsion to save, there could still be selling costs because different funds or institutions compete with each other for business, as I understand happens in Chile with their system of compulsory pension saving.

Choice can become churning. If you do something and subsequently change your mind so you are back where you started, this can be described as churning. For example many people who contracted out of SERPS are now contracting back in again. Churning results in costs without benefits.

The Commission says that a "revitalised voluntary system" implies:

"A major increase in the level of consumer understanding of pension issues and of financial issues in general." (page 243)

We also need a major increase in rationality since currently: "very few individuals actually operate in this rational and well-informed fashion" (206). What is the definition of "well-informed"? How much do you need to know? There is the "not being told the full story" problem.

For example according to Figure 6.6 What do you think is the level of tax relief you are personally entitled to receive on your pension contributions? most people do not know "the level of tax relief you are personally entitled to receive on your pension contributions". They also probably do not realise that the income from pension annuities is subject to income tax, and therefore the tax relief will be taken away when they retire - apart from the 1/4 lump sum. The tax relief is used as an incentive for sales, but it is misleading unless people are also informed about the tax on resulting annuities and income drawdown plans. Also important is the taxation of the investment income and capital gains of the funds in which such "products" are invested.

The charges of a personal pension are on the capital including the tax relief, which is then taken away. There are therefore unnecessary charges, which benefit the provider but not the policyholder. This is in effect a subsidy paid by the government to the provider.

"What should be the role of Government in pensions? Should it be limited to poverty prevention and to making well-informed choice possible?" (page 281)

This is not realistic. Well-informed choice of a pensions "product" is not possible where there are: various kinds of risks, identical alternatives, hidden charges, obscure terminology, and above all shortage of time admirably expressed in an article in the US:

"Survey after survey confirms that the shortage Americans feel most is not information, not education, but time! ... All efforts to empower, educate and expand choice ultimately fail when confronted with this reality." ^x

Take for example the guaranteed annuity rates (GAR) which precipitated the Equity Life scandal. Following the House of Lords judgement, non-GAR policyholders complained about having to pay the guarantee of GAR policyholders. They had been unaware of this guarantee. But even many GAR policyholders did not realise that their policies had this guarantee:

"I was unaware that the first policy had a GAR." ^x "I read the documents more carefully and then realised I had something valuable. If I had known I was entitled to a guarantee ... " ^x "unaware of the GAR rights in their pension policies as these rights were tucked away ... in documents they probably signed very many years before retirement." ^x "I complained to EL that my scheme did not have the favourable GAR term, and was told that no FSAVCs had GARs." ^x

Thus it may be unclear what are the various choices. For example members of DC occupational pension schemes can request their schemes to provide annuities, if they do not do so already. But only if they are not under the misapprehension that annuities can only be obtained from insurance companies (Section 8).

The Commission asks: "How effective can financial education and informed choice be?" (page 285). I agree with the submission of the President of the Institute of Actuaries to the Treasury Committee:

"Expenditure on education aimed at helping the customer make a good financial decision is likely to be ineffective. Most consumers, including the well-educated, find it difficult to make good financial decisions. There is no self-motivation, the choices are too numerous, the education is likely to be incomplete and, most important of all, a 'good' presentation will override good education every time. (6.2)" ^x

New parents can become "educated" about child trust funds by reading FSA literature, such as CP04/10. How many will bother?

"This paper will be of interest to consumers who have parental responsibility for childen born on or after 1st September 2002." (page 5) ^x

Another problem with choice is that people have to actually do something namely make a choice. The Commission says that a reason for not saving is "inertia" and "procrastination" which it mentions respectively eight and four times. Most people are busy with work, family and community responsibilities. They may have more important things to do, "shy away from complexity" (page 209) or do not trust the industry (page 204).

A choice between a limited number of funds with different levels of risk such as the Thrift Savings Plan in the US ^x (www.tsp.gov/rates/ monthly-history.html) has the useful purpose that choices can reflect attitude to risk.

Principle 3: ^x Pensions should be provided, as far as possible, by membership of group pension schemes rather than by pension "products" which people buy in a pension market.

Principle 4: A funded pension system should not:

13. "Bewildering complexity" top

The Commission refers to "the bewildering complexity of the UK pension system" (page 205):

"The private system has meanwhile developed, for a set of historical reasons, a complex set of legal and tax forms (COSR, COMP, GPP, APP, Stakeholder, AVC, SAVC, etc)." (page 212)

In general employees only have a choice of one employer's occupational pension scheme. The existence of other schemes does not make a difference to the choice. Complexity is only a problem for individuals when they need to make a choice or some action such as "combine different pots of pension savings" (page 212). "The UK has introduced a unique complexity at the interface between the state and private pension systems." (page 212) This is because there is a choice whether to opt in or out of SERPS now the State Second Pension.

The government has an emphasis on simplicity. It is simplifying the taxation of pensions. It is introducing the new suite of simple Sandler products. The FSA is on the contrary introducing new complications. For example we now have the new kind of "multi-tied" financial adviser, adding to tied and independent advisers. Collective investment schemes are becoming more complicated because: "the regulator is introducing new classes of authorised funds to be sold to investors." ^x

14. Cool it! top

This website is particularly concerned with churning. Table 3 shows that the turnover of shares on the London Stock Exchange has been increasing.

Table 3

Turnover of UK shares on the London Stock Exchange

Source: London Stock Exchange
Market Information and Analysis, ^x
Tables: UK - number of companies and market capitalisation, UK Equity Turnover

This is a world-wide problem. Diagram 3 shows the turnover of mutual funds in the US.

Diagram 3

Portfolio turnover of mutual funds in the US

Source: John Bogle ^x

The Commission mentions: "buying", "choices", "decisions", "dealing", "opting-in", "opting-out", "selling". A new system should arguably be based on as little going on as possible per unit of benefit provided, because all this activity results in financial costs and also costs in time and worry to individuals. Suppose for example you write to obtain policy details:

"Savers with thousands of pounds locked up in pension and endowment companies which have closed down in recent years are facing £50 bills to find out policy details." ^x

If you have accumulated funds in a DC scheme, should it not be possible to leave these funds where they are rather than then purchase an annuity (until age 75) or income drawdown plan? This is possible in the case of a self-invested personal pension (SIPP) ^x and Individual Retirement Accounts in the US. The Watson Wyatt survey found that DC occupational pension schemes have three alternatives for members when they retire: "annuity purchased directly from pension plan" (24%), "annuity purchased from an insurance company" (90%), "income drawdown from within the pension plan" (1%). Should this income drawdown option not be possible for all occupational DC plans?

According to the Oxford English Dictionary a "pension" is an income in retirement. Personal pensions are not pensions in this sense. Income drawdown plans are pensions in this sense, but are not discussed by the Commission. Annuities, income drawdown, equity release schemes are called "decumulation products". The FSA says that the market in these kinds of "products" is set to expand "to meet consumers needs throughout retirement". ^x

Rather than compelling people to opt in to a pension scheme, they can be enrolled and then be able to opt out. This is automatic enrolment rather than compulsion. There seems to be so much inertia that automatic enrolment can be relied on as an alternative to compulsion. This is discussed by the Commission and an example given from the US in Figure 6.1. But there are examples as near as House of Commons Staff Pension Scheme in the UK!

"The remaining 53% were not turning down this free money because of altruism - but because the whole idea of 'pensions' was freezing them into inaction. The scheme has recently reversed its operation - now you have to 'opt out' instead of opting in. Takeup is now 100%." ^x

In this example with automatic enrolment in the scheme there is 100% particiption and without automatic enrolment only 53%. New institutions could be established, and for example employees who are not members of self-administered occupational pension schemes made into members, with the option of opting out.

Stakeholder pensions are referred to as a "savings scheme" in Figure 7.5. What is the difference between a "pension scheme" and a "savings scheme"? The stakeholder regulations refer to "schemes" (rather than "products"). A "savings scheme" is then a collective consisting of many "schemes" which form a market. The term "scheme" may or may not be referring to a collective.

Child trust funds are compulsory, where the compulsion is to invest in a collective scheme. The compulsory Danish ATP scheme ^x is a single scheme whereas the compulsory Swedish Premium Reserve scheme ^x is a collective. It seems helpful to distinguish between "strong compulsion" and "weak compulsion". The latter is compulsion to invest in a collective scheme If employers have to join the pension scheme of an employer, this is strong compulsion. I am not in favour of weak compulsion. It also seems that:

Principle 5: Automatic enrolment combined with incentives results in high enough participation rates to make strong compulsion unnecessary.

15. "A partnership with financial services companies" top

Stakeholder pensions were introduced as an improvement on personal pensions, as something new and different. The DWP said in its green paper A new contract for welfare: Partnerships in pensions (1998) ^x for example: "Individuals can find personal pensions difficult to understand and nearly impossible to compare." (page 48) It says that stakeholder schemes have a collective structure like occupational pension schemes:

"The costs of stakeholder pensions will be kept low by:

- using a collective structure, like occupational schemes to get the best value-for-money for scheme members" (page 50)

"As collective schemes with bargaining power, we would expect stakeholder schemes to be able to offer good value access to other arrangements, such as life insurance cover to provide for survivors and 'waiver of premiums' cover which allows contributions to the pension to continue if the member becomes ill or disabled."(page 62)

Stakeholder schemes divide into "trust based" and manager based. ^x The latter cannot have a collective structure since they are not permitted to restrict membership to members of affinity groups. The Commission mentions "trustee and contract-based" forms of pension system (page 212). The former have genuine trustees, at least if associated with affinity groups, like occupational pensions and unlike unit trusts. The contract-based forms are "products" sold in markets. The chief executive of OPRA, Caroline Instance, said in 1999:

"Contract law and policyholders' "reasonable expectations" are not enough, as the recent Equitable Life case shows. ... Having two forms of governance just adds unnecessary complexity. Opra believes that all stakeholder pension schemes should be set up under trust, or an independent board of management with equivalent duties." ^x

Stakeholder pensions are now being described as personal pensions. "Stakeholder pensions are a subset of personal pensions." (page 80). The Inland Revenue says:

"From 6th April 2001 the list of people who can provide personal pensions has been expanded. The new categories include, for example, employers, trade unions or other affinity groups, such as membership organisations." ^x

6th April 2001 was the date when stakeholder pensions were introduced. This is referring to stakeholder pensions as a kind of personal pension. It seemed in 1997 that they were going to be more like occupational pensions with trustees and based on affinity groups:

The green paper said:

"We expect schemes to fall into three main categories:

Those based on representative and membership organisations

Those set up by financial services companies

Those set up by employers" (page 59)

All stakeholder schemes are listed on the OPRA website. ^x They are nearly all manager based, the second of the above categories. The providers are nearly always financial companies, not associated with affinity groups, such as the Prudential and Legal and General. The green paper said:

"Stakeholder schemes will evolve in a number of ways. All are likely to involve a partnership with financial services companies.." (page 59)

The B&CE EasyBuild Stakeholder Pension and the Police Mutual Stakeholder Scheme are associated with affinity groups, building and civil engineering and the police force. The TUC Stakeholder Scheme is arguably an extension of the Prudential Stakeholder Scheme. Are there any category three schemes? The Printing Industry Pension Scheme which is a group personal pension, now has a stakeholder scheme. ^x But this is not listed by OPRA and is therefore not really a stakeholder scheme in its own right. It is a subset of the Legal & General Stakeholder Scheme.

The Commission says: "The vast majority of small company Stakeholder schemes are empty shells with no contributing members." (page 92) Category two schemes have been unsuccessful at least unless associated with affinity groups like the B&CE scheme, which is by far the largest stakeholder scheme. ^x

The B&CE scheme has apparently been successful. "Partnerships" with the financial industry such as stakeholder pensions, are likely to be viewed by the industry as an opportunity to sell more savings "products". The Commission asks:

"What is the appropriate risk-sharing balance between the state, employers, the financial services industry and individuals?" (page 284)

The role of the financial services industry should be to provide a service rather than "risk sharing". This assumes that state, employers, the financial services industry and individuals, are the only alternatives. A fifth alternative is to set up new institutions to provide pensions.

16. New institutions are needed to reduce costs top

The Pension Protection Fund ^x and Financial Assistance Scheme ^x have been forced on the government to compensate members of failed pension schemes. Perhaps there will in due course be a scheme to compensate the policyholders of Equitable Life.

The Pension Protection Fund and Financial Assistance Scheme will be providing pensions directly rather than by the purchase of annuities. New parents are being provided with vouchers for baby bonds. But the Pension Protection Fund and Financial Assistance Scheme will not be saying to members of failed schemes: "Here is a voucher. Go and purchase an annuity."

Thus various new institutions or schemes are being forced on the government to provide pensions. Why not set up new institutions to provide funded pensions rather than waiting until this is forced? The First Report of the Pensions Commission ^x refers to institutions such as the government, employers, insurance companies. These are existing institutions. But it does not mention the possibility that new institutions could be set up to provide pensions.

It says "the shift from DB to DC will greatly increase the demand for annuities" (page 105). Annuities are provided mainly by insurance companies. Table 4 shows that the assets of pension funds, which are self-administered occupational pension schemes, has been declining relative to those of insurance companies and unit trusts.

Table 4

Assets of institutions (£ billion)

year (end)	unit trusts	investment trusts	insurance companies	pension funds	% pension funds
1993	88	29	434	480	46.6
1998	163	47	776	699	41.5
2000	223	60	933	765	38.6
2002	190	38	854	610	36.1

Source: Financial Statistics , ONS x, April 1966, April 2000, September 2002, August 2004.

The First Report does not discuss annuities in general such as the (implicit) cost of annuities. It does not address the problem of churning, which is a main concern of my website. ^x It does not suggest that portfolio turnover should be disclosed. It discusses "implicit costs" but does not suggest that all costs should be disclosed. Implicit costs are just those costs which have not been disclosed.

It says "many compulsory saving schemes round the world do not achieve" a reduction in costs because of compulsion (page 254). Figure 7.5 Charge ratio in compulsory savings schemes: 2000: Total percentage reduction in accumulated pension fund lists countries rather than schemes and does not include Denmark and therefore the Danish ATP scheme. Compulsion does not necessarily reduce costs. Child Trust Funds have compulsion, but the management charge (for stakeholder funds) is 1.5% of capital per annum. Costs are reduced when everything is automatic and computerised, that is by automation.

The report to the Secretary of State on Work and Pensions (2004) of The Employer Task Force on Pensions says:

"There will always be some companies that won't provide pension benefits unless compelled to do so." (page 7) ^x

Such companies if compelled to provide pension benefits are most likely to do so through a GPP, which is expensive. New institutions need to be established as an alternative.

The Report of The Employer Task Force on Pensions ^x (December 2004) discusses multi-employer schemes. It says that the "majority" are restricted to particular industries or sectors . It does not give any examples which are not.

The Employer Task Force particularly likes 401(k) plans in the US

"The Task Force reviewed the pensions models of Australia, Netherlands, Singapore, Sweden and the USA. ...the USA's 401(k) system is the most interesting from a UK perspective." (page 41)

The formulation of Individual Pension Accounts was influenced by 401(k) plans. They have been very unsuccessful. The Treasury says:

"While the new investment instrument is not a direct copy of the 401k, it does - deliberately - share a number of features with it." ^x

The Task Force describes 401(k) plans as "low-cost". But there are numerous articles complaining about the high cost of 401(k) plans, such as Savings With Real Pensions, ^x Hidden costs and high fees eat into 401(k) plan benefits. ^x There are links to many articles about 401(k) fees on the 401(k) Help Centre website, ^x starting with:

"Industry braces for 401(k) fee fallout
Attorneys anticipate 'a flood of lawsuits'" ^x

One affinity group is members of pension schemes which are wound up. The Commission does not mention "wind-up" "discontinue" or "discontinuance". OPRA says that there were 1575 schemes "being wound up" in the year to March 2003. ^x There has been considerable discussion about the proposal for the creation of a Central Discontinuance Fund (CDF).

A CDF would take over the assets and liabilities of pension schemes which are wound up. This is not the same as the Pension Protection Fund proposed in the Pensions Bill. This provides benefits for members of DB pension schemes which become insolvent. A problem with the CDF is said to be that it requires a government guarantee which is not forthcoming. Is the Pension Protection Fund different in this respect?

The Commission is particularly concerned with the topic of compulsory saving. There would probably need to be a new organisation to administer a new system of compulsory saving. This new organisation would need to be independent, and not part of the state, employers or financial services industry. Perhaps it could be "risk-sharing"? It will be unacceptable to compel people to save through insurance companies such as the Prudential and Legal and General. The term "compulsion" on its own, leaves unclear who it is proposed will be compelled to do what. The Commission says:

"Detailed consideration of the advantages and disadvantages of compulsion in general and, if appropriate, of specific scheme design will be key aspects of the Commissions work over the next year and are therefore not presented here." (page 252)

Members of DC schemes are more on their own than members of DB schemes because there tends to be less employer involvement. The units of funds of a DC pension scheme are financial assets. But employers are not in the business of looking after personal finances, unless part of the financial industry. Mike Wadsworth a partner of Watson Wyatt said in an article (Financial Times October 16/17 2004, page M29)

"Employers are surprised to discover that they have become quasi insurance companies, financial services providers that they have become an extension of the welfare system and are expected to operate as if they were non-profit making."

The Commission says that both the government and the financial industry are not trusted (page 214). Yet they are deciding policy. The government says:

"Government and industry are working in partnership to deliver public policy, for example in the recent Green Paper on pensions." (paragraph 20) ^x

This is a problem with pensions in the UK. Too much policy is decided by the government and industry. New institutions could provide pensions and give the public more influence.

There have been changes which disadvantage savers, such as a shift from unit trusts to OEICS which according to Fitzrovia have higher charges. The FSA is permitting charges to be taken out of capital rather than income. Building Societies are permitted to have subsidiaries which are life assurance companies. This is arguably too risky.

New Labour has had a large number of enquiries on different topics. A problem with these enquiries is that they disband. For example Lord Penrose is reported to be no longer interested in further investigation of Equitable Life now that his report has beeen published. He will therefore not be helping policyholders beyond his report.

There need to be strong representative organisations to represent the interests or savers and investors. There is the Consumers' Association and in particular, the Investors' Association and the United Kingdom Shareholders' Association. The former is interested in all kinds of consumers in addition to consumers of financial services, and the latter have limited resources. New institutions could help to give savers and investors more influence.

18. Efficiency top

The entire economy is becoming more efficient so that the existing workforce has a greater output. The Commission refers to "GDP per capita growth of 2% per annum" (page 149). But the percentage of the population over 65 is only increasing at the rate of about 0.1% per annum. The ONS says:

"The percentage of people aged 65 and over increased from 13 per cent in mid-1971 to 16 per cent in mid-2003." ^x

That is 16 - 13% = 3% over 32 years. This suggests that the resources required to support an ageing population can come from higher productivity in general. Government economic policy has an emphasis on "growth". What does this mean? What do we need more of? Better pensions are surely preferable to yet more motorways and multi-storey car parks. Ron Sandler said in evidence to the Treasury Committee that the industry is inefficient:

"Improving the efficiency of the industry presents a considerable challenge. Consumer weakness and the absence of meaningful incentives from within the industry to address inefficiencies mean that, without some form of external intervention, persistence of the status quo is inevitable. Such intervention is unlikely from the FSA, whose remit as regards consumer protection does not, in practice, extend to a concern about industry efficiency considerations and levels of charges." ^x

By "the industry" Ron Sandler means the retail financial services industry regulated by the FSA. He is not optimistic that the efficiency of this industry can be improved. This is a large part of the case in favour of establishing new institutions. People should not be compelled or even encouraged to do something which is inefficient, that is save with inefficient institutions.

19. Governance top

The Commission does not mention "governance" or "director" in its report. It mentions "trustee" in: "An occupational schemes is one with trustees and governed by trust law." (page 80). But there is no mention of "member-nominated trustee". It seems surprising that the Commission has so little to say about governance and trust law.

Paul Myners is at present chairman of a Review of the Governance of Mutual Life Companies. He has also written about the governance of pension schemes. In evidence to the Treasury Committee he said:

"At the heart of the system, we often make wholly unrealistic demands on pension fund trustees. They are asked to take the most crucial investment decisions setting objectives, selecting benchmarks and appointing advisors and managers yet many lack the necessary resources, expertise and capacity to challenge effectively the advice they receive. They are often unsupported and are normally unpaid." ^x

It is reported by Simon Targett in the Financial Times:

"Ministers are concerned about the failure of trustees, who oversee pension funds and charities to sign up to the government's code of best practice established three years ago by Paul Myners," (15th March 2004, Fund Management section page 1)

The reason why the trustees of pension funds are not signing up to this code of best practice ^x may be because is makes "unrealistic demands" because schemes are too small to have the resources to comply with the code. This is an argument in favour of large schemes.

Financial companies look after savings as a business. The charges of the savings "products" of the industry are like payment on a fee-for-service basis. This method of payment is expensive.

Dealing (or transaction) costs are concealed from purchasers of these "products". However the government does think dealing costs are important for occupational pension schemes and should be understood by trustees. It says on the Treasury's website:

"Transaction costs are an important cost to pension funds. For trustees to fulfil their duty to act in the best interests of their beneficiaries, trustees must ensure that these costs are properly managed." ^x

"Despite a great deal of controversy over Mr Myners’ proposals on commissions, few responses to the Government’s recent consultation disagreed with his central proposition, that these costs 'which are substantial' are 'subject to insufficient scrutiny' and that 'clearer and more rigorous disciplines could be applied'. On the contrary, the clear message from the consultation responses is that the problem is, if anything, greater than Mr Myners originally suggested. ..... Trustees, or those to whom they have delegated the task, should have a full understanding of the transaction-related costs they incur, including commissions. ^x

Dealing costs are also important for individual savers but they do not have trustees to look after these costs which are mainly hidden. Savers are not even being informed that they are important. They are being treated as second class citizens, in comparison to the trustees of occupational pension schemes. Retail investors are at a disadvantage. For example Martin Dickson asked in the Lombard column of the Financial Times:

"The unbundling of commission payments from fund managers to brokers - a long time aim of the Financial Services Authority - grows closer, and a good thing too, since it will give investment clients much greater transparency about the use of their money....What remains unclear is how this disclosure will help investors in retail funds." (4th November 2004, page 22)

Paul Myners is conducting a Review of Mutuals ^x concerned with governance. It is not clear for example from the websites of B&CE ^x or the Police Mutual, ^x who are the directors and how they are appointed.

20. A new national pension scheme top

Various people such as the trade union Unison have recommended the formation of a new funded national pension scheme. Such a scheme could:

- be based on the English regions, Scotland, Wales and Northern Ireland,

- be independent of government,

- require small compulsory contributions from employees such as 1% of 2% of pay, or have optional contributions with an incentive to stay opted-in (Principle 5 above),

- provide pensions.

Further considerations for the new scheme are for example:

- whether there is a choice of funds,

- how the trustees or board members are appointed,

- how the pension is calculated.

Stakeholder schemes have not been successful. As discussed in Section 16 above they started out looking like occupational pension schemes but have ended as a kind of personal pension. Most are "empty-boxes". But they might not remain empty. Since they have been designated by employers with five or more employees, they are in a good position to receive contributions in the future. A new national scheme would counteract this possibility. Otherwise funded pension schemes seem likely to be increasingly run by The City of London rather than being self-administered with trustees. The Commission says:

"When DB schemes are closed they are usually replaced either by DC occupational or by GPP schemes." (page 84)

Group personal and stakeholder schemes are more expensive than occupational pension schemes as can be seen from Diagram 1 above. This is therefore a general cost increase. Figure 6.11 Reduction in yield for the average personal pension contract held for 25 years shows a reduction in explicit charges for personal pensions. The Pensions Commission says that:

"It is likely that at present price levels the financial services industry cannot sell profitably to lower income, small premium savers." (page 220)

The stakeholder 1 per cent cap on charges is being increased to 1.5 per cent for the first 10 years, from April 2005. This is again a cost increase. A further cost increase is the expected expansion of the annuity market, because of the cost of annuities.

Retail investors do business with financial companies who promote themselves in the market. Hugh Osmond the entrepreneur who is taking over Pearl Life said:

"In life assurance, customers are generally called and treated as 'liabilities'." ^x

Policyholders of non-mutual companies are liabilities because they do not own the underlying assets. They only have a right to payment as specified on policies. A new national pension scheme would be a mutual organisation, so that investments belong to the members.

21. Conclusion top

The Commission does not make specific recommendations in its First Report. It says that "provision to lower income groups is unprofitable" (page 204), which implies that the financial industry should be allowed to cherry-pick the most profitable part of the retail pensions market. This is an advantage of group schemes. All members of the group are members without leaving the poorest and most vulnerable out in the cold.

The report of the Pensions Commission has a section Revitalised voluntarism? (page 242), discussing whether pension saving can be revitalised. In particular it wants to "revitalise industry interest in the personal pension market" (page 220). But it should arguably not be revitalised because of the poor investment performance of personal pensions, which is not discussed by the Commission. The Commission will hopefully study this in the next edition of its report:

"The Pensions Commission will conduct more work over the next year to validate results." (page 216)

Pension funds should be looked after by trustees rather than by businesses. The latter gather in savings by selling pension "products". Trustees represent affinity groups, and pension schemes should be associated with groups, so that the members of a scheme are the members of the associated affinity group.

22. More topics top

Three topics I would particularly like the Commission to study are:

1. The Danish ATP scheme

The Danish ATP scheme is mentioned in Appendix D "For Denmark, the results include the statutory labour market supplementary pension schemes (ATP, SAP and SP)." (Note to Table D.2 page 107). SP is administered by the ATP organisation. In one of the ATP Annual Reports it says by only three employees, which is amazing efficiency for a national scheme. SAP is voluntary. ^x ATP is an example of an efficient scheme. It is (strongly) compulsory for employees. It could be studied by the Pensions Commission to explain how and why it is so efficient. This is seeking out best practice from abroad to find out what would benefit the UK.

The ATP scheme is not a partnership between the government and the financial services industry, but a partnership between parties to the labour market, like the B&CE scheme mentioned above.

2. The costs of annuities

The Commission discusses implicit costs but not the implicit cost of annuities. This can be calculated using a) the annuity rate, b) mortality tables, c) an interest rate assumption.

Contributors to discussions on this topic bring up various issues especially smoking and adverse selection. It is suggested that annuities are so complicated that it is hopeless to try to calculate costs. I do not accept this at all. For example looking at annuity rates for the Prudential on the Comparative Tables of the FSA, these are the same for smokers and non-smokers. The rates are slightly smaller for annuities for large sums, which seems to be caused by adverse selection. But this difference is tiny.

It would be interesting to compare the annuity rates of annuities provided by insurance companies, with those provided by self-administered occupational pension schemes. Table A.3 should arguably contain the difference whether or not schemes are self-administered.

3. The investment return of personal pensions

I would like to see diagrams giving the overall investment return obtained from personal pensions.

My approval of the B&CE EasyBuild scheme is modified by the observation that the B&CE Foundation Personal Pension Scheme had an investment performance of -22.81% over the last five years. ^x B&CE Contracted Out Pensions had an investment performance of only 4.07% per annum over the last ten years. ^x The performance of personal pensions is surely more within the remit of the work of the Pensions Commission than house prices. Figures 5.15 and 5.16 of the Commission's report give rates of return resulting from the increase in house prices.

Stakeholder pensions were introduced in April 2001. The return from stakeholder pensions is becoming increasingly interesting, so that perhaps this could be given as well and separately. The return from personal pensions needs to be separated from that of stakeholder pensions.

The Commission assumes "a real rate of return of 3.8% for occupational pensions and 3.5% for personal pensions" (page 154). This is a difference of only 0.5%. Figure 6.9, Diagram 1 above, suggests that it should be higher, as does:

"0.2% in large scale occupational schemes and well over 1% in most personal pensions" (page 251)

I would also like to see a diagram giving the investment return of the funds of occupational pensions.