Thomas Philippon – economist and financial explorer

Of all the orthodoxies within pension insurance, the concept of “lifetime pricing” is the most sacred. What Lifetime pricing means for an insurance company is the promise of a stable stream of profit from an insurance policy over a fixed duration.

Back in the seventies, when unit-linked policies were being introduced by Abbey and Hambro Life, the starting point for pension pricing was that a full set of premiums (contributions) were between the outset and maturity of a contract. The insured paid the premiums and the insurer managed the money.

Anything less than a full set of premiums meant less money and higher charges on the reduced money paid. The concept required a stable working pattern and was ideal for self-employed partners of professional practices. It didn’t work for much else.

So, over the years, this old model has been tweaked to reflect the fact that people’s circumstances change and it’s not fair to expect them not to. People change jobs and as jobs are linked to pensions, they change pensions. People go on maternity, suffer voluntary and involuntary period when they earn less. People retire earlier or later than can be supposed at the outset of a lifetime contract of insurance.

But this “pound of flesh” principle has never quite gone away. Even today, the concept of shareholder value – and it’s understated cousin – executive pay –  dominate internal pricing discussions in the finance departments of insurers.

It was partly to break this anti-consumerist hegemony, that the concept of multi-employer occupational schemes (aka master-trusts) became popular in the 21st century. Master-trusts might take from insurance but they did not have to give an insurance-type pricing structure. Master-trusts could price on the basis of profitability.

This concept was openly avowed by BlueSky, one of the first DC master-trusts; it’s claim was that it would price on the basis of what it needed to meet its costs, not on a projection of a lifetime of premiums. It created an expectation that advances in technology and growing economies of scale would give scope for reduced prices over time. I hope that BlueSky’s management stand by this approach!

But then came NEST.

NEST’s estimated debt by 2026 of more than £1.2 bn, means that it expects to keep its prices static till 2038 – simply to remain solvent. Put another way, NEST will have between 2026 and 2038, a spare £1.2bn to repay debt. Put another way, NEST’s profitability post 2038 will be quite huge (unless it passes on profits to its members by way of lower prices). NEST is fixed price to 2038 and that is good news for the shareholders and executives of all its rivals.

The collective sigh of relief from insurers can be heard from Edinburgh to Kingswood. What NEST has told us is that lifetime pricing is not only acceptable, it has a Government endorsement. This pricing model is acceptable to the DWP but also to Parliament.

140 years of failure

The French-American economist, Thomas Philippon, has mined data to show that the fundamental price of “intermediation” – the total cost we pay for pension services, does not come down over time – it remains level. It remains level at around 2% pa of funds under management.

Philippon does not tell us why, he just points out that over 140 years of data this is an empirical fact.

I measure the cost of intermediation on the one hand, and the production of assets and liquidity services on the other. Surprisingly, the model suggests that the finance industry has become less efficient: the unit cost of intermediation is higher today than it was a century ago. Improvements in information technology seem to have been cancelled out by increases in trading activities whose social value is difficult to assess.

Philippon’s discovery is the basis on which lifetime pricing works. It assumes that there is a tolerance within society to pay intermediaries (whether fund managers, providers, advisers or a combination of the three) a fixed percentage of monies managed.

This of course is totally counter-intuitive. The cost of financial services should fall with technology taking over manual processes. It seems that pension providers see the NEST model- where pricing remains static over a 28 period (NEST opened its doors in 2010) as quite natural. Pension providers are – in following NEST down the lifetime pricing route, simply following a well trodden road – trodden for the last 150 years. But it is a cul-de-sac for consumers.

If consumers knew what they wanted, which they generally don’t – due to the nature of financial services, they would want to pay less rather than more for the management of their money. As their pension pots grew, they would demand that annual management charges fell, as technology improved, they would demand this fed through to prices- rather than shareholder profits and executive pay.

I include both shareholders and executives in this equation as in not for profit organisations such as NEST, People’s Pension and Royal London, the amount paid to executives is a good proxy for the fat in the process. Famously, Phil Loney’s £4m + remuneration package at Royal London is taken before Royal London declares its policyholder’s dividend. The accounts of  “for profit” and “not for profit” organisations should be scrutinised by those looking at “value for money”. The amount leaking to shareholders and through excessive exec. pay, should be considered in any such calculation.

(I know the remuneration of NEST and People’s Pension executives and happily exclude them from this criticism).

Nonetheless, I see no notice published by People’s Pension that it intends to share its future profitability with its members. People’s Pension’s profitability is “owned” by B&CE – a mutual insurance company. I see no notice from B&CE that it intends to share People’s Pension’s future profitability with its policyholders (of which the Trustees of People’s Pension are one).

If we are ever to break free from the “Lifetime Pricing” principle, where pension providers mint it at the back end of contracts, then we must make a pricing commitment to members (master-trusts) and policyholders (GPPs), that prices will be linked to profitability.

The transparency dividend

This can be called a “transparency dividend” and it is what the IGCs and the trustees of master-trusts must be striving for. It is critical that these fiduciaries can both understand and explain the business models of their providers in a transparent way. It is critical that they understand pricing, the impact of lifetime pricing and the impact of pre-determined “embedded value”.

The transparency dividend is the mortal enemy of “embedded value” (the idea that a contract of insurance will pay the insurer a fixed value over its duration). Embedded value requires secrecy and works through obscure charging structures. It is a holy grail for shareholders and senior executives, it is a value destroyer for ordinary people’s workplace pensions.

The transparency dividend erodes the old concept of embedded value – where the shareholder and executive comes first. It replaces it by a different value, where consumers are treated as equal stakeholders and benefit from the growth in revenues and reduction in cost from a provider’s success and from technological advances.

So , when I go to see B&CE this morning, to talk to their IGC about value for money, I will talk to them about where they expect pricing to go , as People’s Pension moves into profitability and whether they subscribe to lifetime pricing or the stakeholder principles of a transparency dividend.

In my view the lifetime pricing model is broken. It persists with NEST because of the debt overhang created by NEST. But People’s and other master-trusts do not have this overhang, nor do the insurers. If they are serious about challenging NEST’s supremacy, they should point out that the NEST pricing model is broken and that if ordinary people want long-term value for money, they should be shopping around.

But that will take a break from a 150 year old tradition, and that won’t happen overnight. But it will happen – so long as we keep pushing and asking the right questions.

BROKEN