Today we expect a discussion paper from tPR/FCA on the measurement of value for money. This is not so much a blog but an essay about measuring value. I’m trying to write about what I hear people saying and thinking when they consider their workplace pensions and SIPPs.
“I can see what I’m paying but I don’t know what I’m getting..”
I had one of those light-bulb moments yesterday lunchtime, when I heard this statement. I was with a group listening to some feedback from people saving into a workplace pension. The conclusion from the evidence was that people understood charges when they understood their money was invested. If they thought of their pension pot as “savings”, they considered not the charge but the savings rate. The apercu was that people recognize they have to pay to get a good investment and they want to understand the link between how much they pay and the outcome of the work they are buying.
Expectation and trust
If I put my money in a savings account, I expect to get a declared rate of return which I can reject by moving account or accept as representing value. The rate is declared and if it changes I expect to be told.
But if I put my money in an investment account, I have no way of knowing the rate I will get so will trust in the investment manager to give me a good outcome. I don’t get told how my rate changes and am told my rate can go down as well as up.
One of the reasons that people get so confused when asked if their money is in savings or investment is because for generations , people were not given a return linked to their return but to a declared rate of return with a guaranteed element and an element linked to the investment return (but not the investment return).
This confusion led to the problems people had with low-cost endowments , which they saw as savings problems (typically because they were sold on “rate” but which were actually investment linked. When investment returns fell behind what was required , the value of these low-cost endowments was insufficient to pay off mortgages and savers were asked to top-up their policies. Some people thought they had been sold a savings plan and not told it was investment linked and some people realized they had been sold an investment plan which had broken trust by not delivering on a promise.
Savers, especially mature savers, still think in terms of rate and are confused that they don’t get a rate of return on their money.
It’s all in that “rate”.
Most people now know that savings accounts are not a good place for long-term money and are prepared to have their money invested. They do not say, “I want to invest my money”, instead they are passive and put their trust in an investment manager.
And when they realize that is what they are doing with their pension pot, they are in a position to consider how much they are paying and whether this represents value.
But the pensions industry jumps ahead of itself and assumes that people take this as read. They don’t.
The default position for people who aren’t in our bubble is built upon generations of adverts in building society windows advertising savings rates. For my generation this sense of a “rate” was reinforced by with profits bonus rates and annuity rates. All were defined and distanced the saver from the money in their accounts.
Although “unit-linking” has been around for well over 50 years, the rate of return many people expect on their money is still expected to be declared by a financial institution rather than linked to the value of investments.
And so long as people intuitively relate to a declared rate, the idea that they have to pay for investment management and administration is counter-intuitive as they already consider that payment is “in the rate”.
Measuring the “rate”.
The rate of return people get on their savings is not the same as the rate of return declared by an investment manager or even what regulators call “net performance” (the rate adjusted for costs and charges experienced). This is because people’s rates of return are governed by the timing and incidence of contributions, by the vagaries of the single swinging price and by the accuracy of investment administration and record keeping. What you get can only be measured by what you put in relative to what you get out – measured by time.
Your rate is known as your “internal rate of return” or IRR and the IRR includes everything that has happened to your money – all of the above.
One of the common themes of conversations with those saving for retirement is that what they value is the outcome of their savings. This is not just the end of the journey but what happens on the way and we know that most people are prepared to sacrifice a little at the end if they know that their money is being put to good use (people use words like “ethical”).
So it would be wrong of me to say that all that matters is the outcome in terms of the net asset value of a pot on the day a measurement is taken. But the “net asset value”, e.g. – the amount of money available for transfer or encashment, is the “value” of a pension, so far as most people are concerned.
But even if we know the “value” of our pot, we don’t know our internal rate of return unless we pay someone to do that calculation (or have a very good head for maths).
And even if we do know our rate of return, we have to have a benchmark to consider whether we have done well or badly.
What is the right benchmark to decide if we’ve done well?
There are two types of benchmark. There is an absolute benchmark such as Cash + 2% or CPI +1%. This kind of benchmark suggests that doing well is by beating the return you might get by putting your money in a savings account or buying Government debt. Here you are asking whether your investment is doing better than if it were in savings and the answer is generally “yes” at the moment as we have benign investment markets for longer than most savers or investors can remember. This is why everyone is claiming to be giving value for money (at the moment).
The second kind of benchmark is called a “relative” benchmark and this is a much more contentious approach. Here you aren’t comparing yourself with an absolute rate – like what you get from the building society, here you are comparing your IRR with that of other people like you, people who have had their savings invested by a manager who has been paid to do a good job with investment and administration.
This is more contentious because it implies that not everyone can be winners. While everyone can beat an absolute benchmark, only 50% of people can be in the top half of a league table meaning that 50% are doing worse than average.
This of course implies that we can define “average” and this is no easy thing to do. Because everyone has an individual rate of return, we need to have an investable index that represents the rate of return the average person would have got for the contributions made, we can call this a benchmark index as it gives a benchmark return.
Is this too complicated for people to understand?
For a long time, I thought that people would need to get what they were given by way of returns on their savings and investments.
Then along came a bunch of people demanding transparency about what we are paying for the services we are getting and we started taking apart the returns to see how much was going in costs and charges. This important work, led by Dr Chris Sier and supported by the FCA and other parts of Government has led to improvements in institutional disclosures and almost certainly, greater efficiency as fat has been taken out of the system.
However the complex tables that are found at the back of IGC, GAA and Trustee reports showing the minutia of costs and charges relative to the gross and net performance of funds are quite beyond the grasp of all but the most dedicated statisticians and fund analysts. They leave the ordinary saver clueless as the value they are getting for their money.
But intuitively, people get how they have done compared with average – when average is personal to them. “My average” is the benchmark return for my contributions and my pot value (NAV). I’m really not interested in a deconstruction of all the elements of my return, just an answer to the question “how did I do?” and hopefully “what good have I done with my money?”.
It’s easy enough to turn a comparison with “how I did against other savers” into a score. Here’s an example.
We need people to find a way to get interested in their pensions. We know that people find pensions important but they don’t find them interesting. We know that people are interested by what their money does and that when they’ve worked out that they are invested, they want to know “where and how”.
But many people don’t get as far as thinking their money is invested because they are preconditioned by savings rates into thinking they will get a given return (reinforced by the with profits and annuity products of the past).
People still think of their saving into a pension as giving them a savings rate and we need to get it across that they are actually getting an investment rate and that this rate is peculiar to them (their IRR)
And we need to make that IRR relevant by comparing it to something that matters (a benchmark).
Giving people a comparison with their savings (an absolute benchmark) is ok but it risks confusing savings with investment.
Better is to give people a relative benchmark (how am I doing against average). My light-bulb moment came when I saw yesterday a group of people struggling towards this conclusion.
Why are we prioritizing the disclosure of pension charges, when people don’t know what they’ve bought? Perhaps, when people know their investment rate (compared to others) they will they become interested in what they’re paying .
To get there , we need people to have access to their personal investment rate – properly benchmarked.