Risk-sharing starts with cost-sharing

This lunchtime we will be debating pension charges at 
the Pension Play Pen lunch (50 Cornhill). 
This blog may help in organising my thinking
and perhaps your thinking too!

The terms of the debate about the charges cap that the DWP will be consulting about later in the year are not clear.

Steve Webb says that he will be consulting on the maximum charge that can be levied on the default fund of a scheme qualifying for auto-enrolment and explicitly links this to work currently carried out by the Office of Fair Trading

In January, the OFT launched a market study to examine whether defined contribution workplace pension schemes are set up to deliver the best value for money for savers. A key aspect of its investigation is whether there is sufficient pressure on pension providers to keep charges low, and the extent to which information about charges is made available to savers. (DWP press release May 10 2013)

Let’s do a little myth-busting before I launch into my triple wish-list from the investigation and consultation.

Myth one – this is not stakeholder II ; The terms of the debate are still couched in the language of pre 2000 provider bashing that led to the stakeholder pension charges debacle. The stakeholder charges cap ended in failure because it capped all funds and stopped individuals investing in a stakeholder plan and using more than plain vanilla funds. Aegon among others have been pointing this out but the same press release makes it clear that the cap is only being considered in relation to the default fund

Myth two – pension charges are too high; What’s worrying is not the general state of pension charges, the ABI and Towers Watson have both pointed out that the average default fund for the early stagers is costed at below 0.4%pa. The difficulty is that it’s pot-luck whether you find yourself in a scheme with low costs or a prey to something shockingly more expensive. The issue is one of consistency.

Myth three – Pension charges will continue to fall as auto-enrolment is rolled out; Currently there is very little information to savers about who is paying what. In the worst cases, the member of a workplace pension is paying for everything, including phantom services he or she may never see (like face to face advice delivered year in year out).

Many of the new schemes have priced out the costs of auto-enrolment and advice from the charge the member pays and they’ll have to going forward now that “consultancy charges” have been banned.

But providers are currently staging employers with a great deal of in-house expertise whose need for hand-holding is limited. There may well be something of a land-grab going on with some providers offering services at below cost to get themselves the scale and reputation they need for the rest of the journey.

Either way, there is increasing concern that offering the kind of support given to the big boys, is not going to be achievable for the smaller stagers without either the price going up or the service level decreasing.

Without the capacity to pass on these costs to the member through the consultancy charge, the provider will have to ask for fees from the employer or swallow the loss from current margins.

What we are talking about here is a risk transfer back from the employee to the employer; the first such transfer in that direction since the process of attrition against DB plans started in the late 1980s.

Member charges may not go up, but the price of operating a workplace scheme for the employer is likely to increase

Now for what I want to see from the investigation and consultation in terms of practical changes

PREFERRED OUTCOME ONE; My first preferred outcome from the OFT review and the subsequent consultation on a charge cap would be for the DWP to establish a framework that fairly apportions the costs paid by employer/members and those born from a reduced provider margin .

A charges cap must be set in this context and clearly demonstrate what it is reasonable for the DC member to pay for himself and what not. Alan and Gina Miller’s true and fair calculator (especially the advanced section) lays out all the components of the cost of a funded pension from fund charges to platform charges to contract charges.

Simplifying these charges into a bundled AMC has advantages so long as that process doesn’t simply allow all parties to lump the entire cost on members. We need a more granular approach which will have to be agreed at ABI/IMA/NAPF level and it has to start with first principles – what are acceptable charges for a member to bear ;- anything else should be born by the employer.

PREFERRED OUTCOME TWO; Stop treating this as just a contract-based problem;- let’s get tough on trustee extravagance ; no special pleading from large unbundled DC plans

A second point is this, we should not assume that because their are trustees, members are being protected.

To give one case study, the BT retirement plan was set up under trust to provide members with a blue-ribbon DC pension. It didn’t, the administration was expensive and inefficient (BT outsourced to Accenture), the fund management costly and forgettable.

By comparison, the company negotiated a great deal with Standard Life when they switched to contract based and the members are now getting more for less under contract. The reward for employers who get great deals is earned over time but the DWP could do more (through PQM type accreditation, to encourage large and medium schemes to beat the charge and give members more for less).

I spoke with one pension manager last week whose pension AMC is in some case over 1% because the default costs 70bps (a trophy DGF) and the scheme uses a large actuarial pensions administration service. They have a huge scheme but were complaining that they would have to reorganise it using a bundled solution to .

In this case I had no sympathy. Like BT, the trustees of this company will have to go back to first principles. If their extravagant options are to be maintained, they need to be subsidised by the sponsor if the default is to get below a meaningful cap (generally taken to be 0.50%. The cost of sponsoring half a percent of the fund may be half a percent of the contributions year one but it grows exponentially from there on.

The days of paternal trustees making these extravagant purchasing decisions may be numbered. If the cost of the charges was expressed as a % of the contributions it could soon reach 10% of the contribution (the charge is on the fund not the contribution).

Even if the company did provide a subsidy on the costs of the charges, would this be acceptable when the alternative might be a lower charged scheme with a higher employer contribution?

This is the kind of information that should be put in front of members of DC pension schemes. A consultation that succeeded in getting member approval for extravagant charges based on an extraordinary investment and adminstration service would certainly get my vote under “comply or explain” but it would have to provide a balanced picture in the way I have tried to do here.

Frankly , I can’t see such a consultation happening let alone it succeeding in maintaining high charges.

PREFERRED OUTCOME THREE; No reward without cost-sharing; – let’s get companies and employees sharing the cost and value of benefits

While I don’t see pension extravagance as being justifiable under comply or explain, I do see certain circumstances where a higher AMC is justifiable.

There are times when individuals need special attention paid to them, especially when they are having to take difficult decisions close to retirement. This is not special pleading for at retirement advisers (I’m not one), but I do see a strong argument for people who choose to have the cost of their advice paid for from their funds in the later years of their pension saving, being able to have deductions made for this purpose.

There are other areas where such costs could be paid for from commissions in the fund. Since the costs are being met by a deduction from an untaxed source-this is effect the tax-payer subsidising the cost of advice (perhaps the VATman too). For this to happen through a workplace pension , the tax-payer is granting an employee benefit. I see no reason why the DWP could not make any such tax-breaks be conditional on cost sharing between the employer and employee (for instance the employer picks up half the tab and the employee the other).

In the USA, execs get pension tax incentives on their own plan where they can show that the staff 401k is being properly used -eg the individual contributions are high.

Extending this logic, it could be argued that the comply or explain model could be extended to accommodate higher than 0.5% charges when certain member benefits are clearly included within the member charge. Companies could and should be rewarded for risk-sharing by the retention of current tax-reliefs.

But this service cannot be pre-paid by an employee by an increase in the AMC over the lifetime of the plan. Value added services should only be paid for from the fund when they are used and an annual management charge should be for annual management.

Take outs

Risk sharing starts with clarity of what the risks are and cost-sharing within risk-sharing starts with clarity on what the costs are and who shares them.
High charges have to be justified, they need to have the active consent of the members who pay them and cannot be justified by trustees who think they know best
Where there is a value argument for higher charges , it should be occasional and not spread over the lifetime of the plan. For an employee benefit to get tax-breaks, the employer needs to prove some degree of subsidy of the benefit.

Pensions for nothing and advice for free (henrytapper.com)
“Fit lean pension machines” – an uncomfortable prospect? (henrytapper.com)
No learning without doing! (henrytapper.com)
MPs demand ban on ‘damaging’ pension fees (telegraph.co.uk)
MPs demand ban on ‘damaging’ pension fees (telegraph.co.uk)
Ban on pensions middlemen whose rip-off fees wipe out retirement savings (thisismoney.co.uk)
Who speaks for workplace pensions? (henrytapper.com)
Why target date funds have been slow to catch on (henrytapper.com)
Those Dutch Pensions – a Civil Servant writes (henrytapper.com)