Automatic pension enrolment in the United Kingdom has dramatically increased the numbers of individuals contributing to Defined Contribution (DC) pension schemes in the last seven years to the delight of politicians and regulators, and the UK government has started promoting Collective DC schemes (CDC) in the hope of further boosting DC pension participation.
However, the rush for high participation statistics and flattering headlines is masking serious flaws in pension infrastructure and regulation, Professor Ania Zalewska of the University of Bath’s School of Management said on Thursday.
Pension reformers need to consider why the key benchmark scores of the UK pension system have not improved since 2009 despite the introduction of auto-enrolment in 2012 creating over 12 million new contributors, Zalewska said ahead of her keynote speech to the Westminster Business Forum pensions industry event in central London.
Zalewska said she was concerned that authorities were not paying sufficient attention to the integrity, sustainability and performance of pension funds, and in particular, to improving the asset management industry that provides advice and fiduciary management for many pension funds. She cited the Melbourne Mercer Global Pension Index, which showed the UK’s integrity score dropped to 82.9 from 86.3 in the same period while its sustainability rating fell to 53.4 from 56.4.
“Pension reformers should really give some thought to why these scores have not improved despite the dramatically increased coverage. Mandatory enrolment is in itself not a guarantee of success - The Netherlands, Denmark and Australia have it and score high but so have Mexico and Indonesia, whose scores are low. The secret of pension success is in regulation, monitoring, supervision and protection offered to contributors,” Zalewska said.
Zalewska warned that authorities, cheered by rising enrolment figures, were neglecting the importance of robust pensions infrastructure and regulation, and failing to identify poor performance. Worse still, if they did notice that auto-enrolment was not creating sufficient retirement income they tended to conclude simply that contributions were not high enough.
“They are failing to see the wood for the trees. Pensions, like any investment activities, are not just about taking money off the people (tax collectors have been doing it for millennia) but also about getting appropriate returns on these long-life savings, and building long-term relationships and trust,” Zalewska said.
“Companies are very keen to adopt a hands-free approach to pension obligations. They close defined-benefit (DB) schemes and replace them with DC schemes claiming that DB schemes are too expensive. Yet, in the period 2012-2016, FTSE 250 companies that had DB schemes paid nearly five times as much money in dividends than in DB contributions including deficit reduction contributions,” she said.
This ratio was even higher for those FTSE 250 companies that still had their DB schemes underfunded in 2016. Even worse, the cumulative underfunding of those FTSE 250 companies that had their DB schemes underfunded in 2016 was higher than in 2012 than in 2016. So, while the companies poured money into shareholders’ pockets, the employees’ pension pots were pushed into the corner, Zalewska said.
The pension industry was particularly affected by asymmetry of information, a lack of transparency, and poor accountability – all of which were to the detriment of the customer struggling to understand the relative performance of their pensions and whether their pensions were adequate or in safe hands, she said.
“The average pension contributor is easily taken advantage of as s/he often has poor financial literacy, and practically none of the specialist skills and knowledge to monitor the performance of her/his savings,” Zalewska said
“Moreover, the effects of any miss-investment may not surface for years, so when it comes to finding who is responsible for holes in pension pots, it may be neither possible to point at those responsible nor to make them accountable, even if identified. Thus, the less transparent/monitored/supervised the pension industry is, the more the asymmetry of information can flourish and wreck the markets,” she warned.
Little is understood about the long-term performance of occupational DC schemes as few of their contributors have reached retirement age. Therefore, to understand the suitability of the DC occupational pension schemes for pension provision, lessons have to be drawn from DC non-occupational pension schemes (which have a longer history) and from other countries.
Running DC schemes without employer participation poses a risk to the savers, as the responsibility of employers to ensure that the pension contributions are properly invested, and the performance properly monitored is removed. With DB schemes, the employer is left to face the consequences of underfunding, an important safety mechanism.
“However, people in DC schemes, with no employers involved in setting up contracts or monitoring performance, are vulnerable. If there is no one overseeing their investments, it will be naïve to expect that some magic market force will step in and prevent asymmetry of information taking its toll,” Zalewska warned.
Zalewska said she had studied the performance of DC investments offered through UK employers (GPPs) and ‘high-street’ providers (IPPs). After controlling for various risks, the difference between gross returns across all investment styles of the portfolios of GPPs and of IPPs was over 1% but could be twice as much for particular investment styles. When the difference in fees was taken into account, on average, IPPs underperformed GPPs by more than 2% per annum.
Zalewska said there was also an issue, with selective benchmarking, further muddying the waters for the pension contributor struggling to gauge the performance of an investment fund.
She said there were important differences in benchmarks chosen by GPPs and IPPs. Where the two types of schemes had different benchmarks, the IPP benchmarks performed better than those used by GPPs. However, investors did not benefit from these ‘fancy’ benchmarks. Indeed, the IPPs with these ‘fancy’ benchmarks performed worse than GPPs.
“This suggests that when there are no controlling mechanisms in place, asset managers promise piles of gold to their clients. Yet, they do not deliver them.”
The proposed introduction of CDC schemes does not solve, or even address, any of these issues. Moreover, the idea of inter-generational transfers can only work when the underlying system and infrastructure are sound, and savers trust the system. Given that that there is no sign of any of these preconditions being fulfilled, the idea of introducing yet another saving scheme, rather than sorting out the flaws of the existing ones, does not sound promising, Zalewska said.