Second mover advantage – UK can trump US 401(k)

Blue Skies Ahead

Blue Skies Ahead

Here’s an analysis of what’s going on in yankee-doodle-land, especially with their workplace pensions. Once again I’m grateful to Per Andalus for the prompt

Commentators often point to the US 401K and IRA markets as models for the UK to follow.

But if this research by the respected analysts Cerulli shows, the fee market approach adopted by successive US Governments has left USA DC with major structural problems,

In this article , it’s possible to see the direction of travel in the UK as altogether more focussed on consumer value.

For anyone trying to understand what happens if you offer pension freedoms without regulating products the report makes for alarming reading.

America’s sprawling 401(k) pension system will turn cash flow negative in 2016, threatening disruption for asset managers and selling of equities, according to analysis by Cerulli Associates, a research house.

“Disruption” in this context, means “lower profits and job losses”, selling of equities means the loss of long-term finance for the engines of American growth- its corporations. This is lose-lose to Cerulli and should be sending alarm bells to UK fund managers and policy makers betting on DC!

The $3.5tn system attracted fresh contributions of $300bn in 2012, with $276bn either withdrawn as cash by retirees or rolled over into individual retirement accounts (IRAs), Cerulli estimated.

So we’re still seeing growth in the workplace bit (401K) but the money’s leaking out of the system in retirement almost as fast as its coming in from contributions

However, by 2016 it forecasts that inflows will be $364bn and outflows $366bn, with the deficit only widening year on year after that as the core of the baby-boomer generation retires.

And within a couple of years 401K will be in decline

“This has significant implications for asset managers and other financial services providers,” said Bing Waldert, a director at Cerulli. “It is going to be a disappointment for a lot of fund managers that have put a lot of effort into the DC [defined contribution pension fund] market.

Bless! You’ve got to ask why they haven’t put more effort into clinging on to assets into retirement.

“For asset managers, the consistent contributions are particularly appealing and provide a source of positive flows even in poor markets when a firm may experience outflows from other segments of the industry.”

This is why DC is referred to in asset management circles as “sticky”. Unlike DB, fund managers in 401K plans are rarely fired. DC is a nice-little earner

The largest managers in the 401(k) market are Fidelity Investments; Canada’s Power Financial, which owns Great-West Financial and Putnam Investments; TIAA-CREF; Vanguard; ING of the Netherlands and Prudential Financial of the US.

Funds run by such managers are typically among 10-20 options available to 401(k) savers, but when money is rolled over into an IRA, they face far stronger competition.

This makes it sound as if 401k funds are a cushy little number, in fact, the protection that members get within a 401k is from the plan fiduciaries who keep things simple and minimise choices (though we’d find 10-20 options probably 9-19 too many!)

“In IRAs you are not just competing against asset managers, you are competing against the world. There are insurance-based products, ETFs [exchange traded funds] and individual securities. There is more freedom and flexibility,” said Mr Waldert.

This is the retail free for all that worries Steve Webb and it’s one of the reasons that he wants CDC. Whether on a “to and through” scheme like ATP or simply a collective drawdown scheme, it looks like the Government are doing their best to provide an alternative to the US IRA free-for-all.

Fidelity and Charles Schwab, which run direct-to-consumer platforms, are significant providers in the IRA market, alongside wealth managers such as Merrill Lynch and UBS. Vanguard also has a strong foothold.

You’ll have noticed Fidelity having feet in both camps; as in the UK, the Fidelity funds you access through a workplace plan are very different from the funds you are offered in retirement.

Amin Rajan, chief executive of Create Research, a consultancy, said IRAs tend to have a 20-35 per cent exposure to equities, compared with 45-60 per cent in 401(k) plans. This suggests equity-focused houses could lose market share to bond-based rivals such as Pimco and Principal Global Investors as the demographic changes mean the 401(k) system shrinks relative to the IRA market, which is already larger at about $5.4tn.

Here’s an important lesson for the UK. Given the freedom, US savers “go to extremes” and rush to a reckless conservatism! Blimey- perhaps there’s hope for annuities yet!

Sue Walton, director at consultant Towers Watson Investment Services, agreed, saying: “People go to the extremes. They get to retirement heavily weighted to equities and they make this shift to go too conservative”, buying low-risk fixed income and money market funds.

But it’s not just that 401k is losing out to the retail scrimmage, Towers Watson are predicting that overall savings in what we call “approved pensions” is likely to fall from 2020. It’s not quite clear why but  presumably because of demographics and a disenchantment with DC outcomes

Mr Rajan believed the wider US DC market, encompassing both 401(k)s and IRAs, would turn cash flow negative by 2020, following in the footsteps of the defined benefit pension market.

So what’s the recommendation from Cerulli?

Mr Waldert said that regulators could intervene to slow the transition from 401(k)s to IRAs, given concerns that the costs of managing assets in an IRA tend to be far higher than the institutional pricing levels secured by 401(k)s.

Bingo- market intervention!

Without sounding too smug, the American 401K system looks to be on the ropes. What has for decades been hailed as a standard-bearer for free-marketeers, is now subject for calls for market intervention.

The pension freedoms offered to Americans, are based on contributions from plan sponsors well below those in the UK (even under auto-enrolment post phasing minima)

What Americans haven’t learned- which we have – is that the freedom to choose investments does not result in good decision making. In fact the decision making has become so poor that market commentators are called for an end to this free-market.

Our system of nudge and default with the options throughout to “opt-out” seems altogether better organised than the rag bag and bobtail of the 401K/IRA continuum.

We have a less mature DC system , but it looks like we have the second mover advantage!

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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