This talk was given 30 September 2009
The text here may not be identical to the spoken text
STANDARD LIFE
THOUGHT LEADERSHIP EVENT
Royal Exchange 30 September 2009
RESTORING FAITH IN PENSIONS
I’m
Paul Lewis. I am a freelance financial journalist. I present Money Box and Money
Box Live on Radio 4, do about two spots a week on Breakfast on BBC 1 and on the
News Channel. The BBC is just one of my clients. Among other things I also write
two columns a month for Saga Magazine
– which some of you may see. As a freelance journalist, writer and broadcaster,
I am not here representing any of my clients and in particular not representing
Money Box or, God forbid, the BBC. So any views I express are mine and mine
alone.
I
am flattered and honoured to be asked to give this talk today and I’m sure some
of you are thinking what’s this two bit journalist doing here giving us Thought
Leadership. Up the garden path leadership more like.
Well, I’ve been thinking and writing about pensions since 1973 when I joined Age
Concern as an information officer. I produced this –
Your Rights – second edition in 1975.
And my latest book on pensions is this
Live Long and Prosper – subtitled pensions without the boring bits. It
threatened to be a very short book.
So
I know something about pensions and their development over the last 35 years.
And that leads me to question the title of this talk. Restoring Faith in
Pensions. Because that begs the question – did we ever have faith in pensions?
And if ‘we’ is the British public then, no, I don’t think we ever did have
faith. I think the financial services industry has had faith in pensions – and
indeed it has made a great deal of money from them. But whether the public has
had faith – or indeed made money – is not clear.
Although I quibble at ‘restore’ perhaps ‘faith’ is a well chosen word. Faith
means believing in something which can’t be proved – or believing in something
for which there is no evidence. Pensions certainly exist. But what is the
evidence for their value? is retirement heaven really waiting for us?
History
When I was at Age Concern in the mid 1970s our interest was the state pension.
Because that is what most people relied on. And if you had been in work – at
least if you were a man or a single woman – then you would at least get that. A
wife – and I use the word deliberately – could get a smaller pension based on
her husband’s work. And for those who couldn’t live on the state pension there
was a fairly primitive system of means-tested help to assist further – there was
a small means-tested supplementary pension and rent and rates rebates were just
emerging into their modern form.
Of
course, not everybody relied on the state. A minority worked for an employer
with a final salary pension scheme. Many were in the public sector but some
others worked for good companies, especially oil, banking, retail, engineering
companies who paid into what was often called superannuation. And if you worked
for an employer with one of those final salary pension schemes joining it was
compulsory – you had no choice.
There was a third option. From 1970 some wealthy and self-employed people did
take out a retirement annuity, a section 226 pension. They paid money to a safe
major insurer and they were promised a guaranteed return to top up any company
or public sector pension they had. Many judges and lawyers had these. What could
go wrong when the promise was made by a company like Equitable Life? But this
was a tiny, tiny business used by the upper middle classes and they tended to
keep it a secret. Like Queen Victoria said about sex it was far too good for the
common people.
The
Golden Age
This period – the mid 1970s on – is still seen as the Golden Age of Pensions.
Good company schemes were affordable, reliable and secure. But why, when they
are not now? Longer life and poor investment returns yes. You're familiar with
those. But the key reason those schemes worked is often ignored – they stole
money from people who left.
Remember if there was a pension scheme you had to join it. So everyone who
worked for one of these top companies was automatically enrolled willy nilly.
And until 1975 if you left the company you left the pension scheme and you got
nothing. Of course, the contributions you had made were refunded – minus tax
because you had made them out of tax-free income. But the fund kept the growth
on those contributions. And it kept the contributions paid in by your employer –
which were always far more than you had put in. And of course the growth on
those too. So early leavers subsidised the good pensions paid to those who
stayed.
Over the next three decades that unfairness to early leavers was slowly removed.
From April 1975 if you left the job you could leave your contributions in the
pension fund and draw your pension when you finally reached the scheme’s pension
age. Your pension would be based on your salary in cash terms when you left, so
still a huge gain to the fund. From April 1978 a small amount of your earnings
was inflation proofed. And then on 1 January 1985 all contributions made from
that date had to be inflation proofed – rising with prices not earnings, and
capped at 5% a year.
Then from 1986 anyone who left with at least five years in a fund could take the
value of their pension rights with them and transfer that value into another
pension scheme. A couple of years later, in April 1988, the five year period was
cut to two years. And in 1991 inflation proofing of preserved rights was
extended to all your pension whenever you paid in. Finally in April 2006 came
the only known example of reducing the rights in a final salary pension scheme –
the cap on inflation proofing was cut from 5% to 2.5%.
Ending the practice of stealing from early leavers has played a major part in
making salary related schemes unaffordable.
These pensions were particularly unfair towards women. In many companies women
could not join the scheme. Remember that discrimination on grounds of sex was
not illegal until 1975. Even when women were allowed to join, if a woman married
she often had to leave her job – and lose her pension.
So,
yes there a golden age – if you were with the right employer, worked there for
40 years, and were a bloke. But not otherwise. In this pension apartheid most
people relied on the state pension. It was £13.30 a week –about the same as £78
today in terms of prices, almost £17 below today’s basic pension of £95.25. If
you had nothing else then supplementary pension added just 40p to make your
income up to £13.70 or £80 in today’s prices – compared with the £130 you can
get today from pension credit – £50 a week more. So pensioners were poor. Much
poorer than today. And our main campaign at Age Concern was improving the state
pension.
So
when Labour came to power in 1974 we welcomed Barbara Castle’s plans for a State
Earnings Related Pension (SERPS) that would be as good as the private sector and
better for women and low paid workers.
But
her scheme was cut the Cabinet before it was introduced. Cut again and again by
the next Conservative government. Converted into State Second Pension by the
present government which has weakened the earnings related nature of it and will
make part of it flat-rate from 2012 and all of it flat-rate from, they say, 2030
but expect that date to be brought forward.
Personal pensions
Barely a year after SERPS began, Margaret Thatcher was elected. She hated the
idea of a state copy of good company schemes. Instead she wanted to extend to
everyone that middle class secret – the retirement annuity. And nine years later
personal pensions were born along with a new system of financial supervision to
make sure they were sold fairly. And with a taxpayer subsidy to reward people
for giving up their SERPS rights and saving up in their own little pot that
would grow and grow and grow.
This happened of course at the perfect moment. We were ten years into the golden
age of stock market investment. For a quarter of a century from 1975 share
prices only went one way – up. There were just three years (1976, 1990 and 1994)
when prices fell – but in each case it was reversed – and more – the next year.
Over that 25 years London share prices overall showed a compound growth of 12% a
year.
The
financial services industry persuaded us that the consistent growth in pension
funds was due to their skill. And when experiments showed that a bunch of school
kids or in once case a chimpanzee could do as well or better than fund managers
they shrugged them off as amusing jokes. From time to time of course, to prove
that skill really was needed, the odd manager did lose money. With markets
growing at 12% a year that really did take a rare ability.
And
there was another great thing about the nineteen seventies and eighties.
Although life expectancy was growing pretty much as it is now, it was widely
believed that we were in a temporary – perhaps still post war? – phase which
would soon level off. Longevity risk was not taken seriously.
So
when the first personal pensions went on sale on 1 July 1988 the pensions
industry thought Christmas had come very early. At last they could sell this
miracle of personal pension pots to not just a few tens of thousands of the
savvy middle classes. But to the mass millions. What could go wrong?
But
instead of creating public faith in pensions, the industry contrived the biggest
financial mis-selling scandal we have seen so far – unparalleled in scale and
scope.
It
sent out teams of poorly trained, commission driven sales staff to descend on a
hapless population who believed the adverts and newspaper stories which said
that for a few pounds a month everyone could buy not just financial independence
but protection from the danger of future political cuts in state pension. The
public was gladly mis-sold £11.5 billion worth of personal pensions. Eventually
the industry had to spend £2 billion finding the nearly two million people
affected and repaying them the £11.5 billion they should never have put into
their own pension in the first place. And that is ignoring the minor scandal of
mis-selling the wrong sort of Additional Voluntary Contributions to at least
100,000 customers to top up their company pension. Another quarter of a billion
pounds in compensation.
Through its own mismanagement – encouraged by political dogma – the industry
turned the pension faithful into a bunch of disillusioned agnostics. They wanted
to believe. But the evidence to the contrary was just too strong.
Commission
I
used the phrase there ‘commission driven sales staff’. I have been speaking
about the problems commission causes the financial services industry since the
1990s. I have called it the cancer at the heart of the financial services
industry – rather a mixed medical metaphor not sure you can have cancer of the
heart – but you know what I mean. For many years my remarks at events like this
were at best greeted with a stony silence, at worst booed – once people walked
out. But slowly my view became mainstream.
In
2001 the FSA said that the financial services industry had ‘marketing practices
that led to unrealistic expectations’ and was guilty of ‘the sale of complex,
opaque products where risks are not identified’. It was also accused of using
‘jargon in literature’. Surely not!
In
2005 I did a programme for Radio 4 called Sins of Commission which looked at
this issue and alternatives to it. Which we did find.
The
next year the FSA surveyed retail firms and more than half did not obtain
sufficient information before making a recommendation and less than a fifth of
advisers gave consideration to products that did not attract commission.
Shortly after Sir Callum McCarthy, then FSA chairman, asked ‘Is the present
business model bust?’ and said
“Consumers are not always advised on transactions which fail to remunerate the
adviser, or which offer little by way of commission to the adviser….I am struck
by the prevalence of examples of providers managing demand – up or down – by
adjusting commissions which can lead to less suitable or even unsuitable sales.”
And
he warned that commission meant financial advisers have a “built in
encouragement to churn.”…“with the potential for significant consumer
detriment.”
This was the first time that commission was officially in the firing line. And
it led eventually to the Retail Distribution Review which says it will end
commission bias. It is even consulting on remuneration for bank employees and
removing incentives for bias there. We shall see.
In
its latest paper the FSA has finally come fully to my view saying that
commission “creates a potential conflict of interest that can be damaging to
consumers and undermine trust in the investment industry.” [FSA CP 09/18 June
2009]
And
that conflict of interest between the financial adviser and the customer is
precisely what is wrong with commission. The customer simply does not know why a
particular course of action is being proposed. Or within that course of action
why a particular product has been selected. It may be – it often is – good
advice. But the conflict of interest is there.
Would the major financial scandals of the last twenty years – from pensions mis-selling
to endowment mortgages to payment protection insurance have happened without
commission? Of course not. Until you get rid of commission you will not restore
faith in pensions.
Charges
Commission is not the only problem the pensions industry faces. Charges are
another. You may have seen the work published by the Royal Society of Arts last
week on pensions which claimed that over a lifetime – 40 years paying in and 20
years collecting your pension – charges of 1.5% a year would leave you 40% worse
off than if there were no charges. And by a happy coincidence of arithmetic if
charges were half a per cent instead of one and a half then your pension would
be about 40% higher. For life.
The
work was done by David Pitt-Watson the founder of Hermes Equity Ownership
Service and an ex-City investor. He assumed that growth would be 6% and
inflation 3%. Now, you can argue with the assumptions for inflation and growth,
and I have to say the calculation for the decumulation phase when you buy your
annuity still defeats me.
But
the rest of the work is accurate. Let me explain how 1.5% a year grows like
topsy. Let’s assume growth and inflation are both zero – two things we have seen
over the last few years!
The
arithmetic shows that after paying into the pension for 40 years – from say age
25 to age 65 – a quarter of your contributions will be snaffled in charges. The
reason is this. Suppose in year 1 you put in £100 a month – £1200 a year. You
will pay £18 in charges, reasonable enough. In year 2 you will have £1182 of the
first year left and you add another £1200. 1.5% of that is a shade under £36 –
in other words you will have paid 1.5% again on the first year’s contribution
and 1.5% on the second. In year three you will again pay 1.5% on what is left of
the first year’s contribution. At the end of 40 years you will have paid that
1.5% forty times on that first contribution. And twenty times on the
contribution you pay half way through.
The
result is that after 40 years a quarter – a quarter – of what you have paid in
has gone in charges. That means that out of every £100 a month you pay in £25 is
taken as a fee. Why? And where in the pensions brochures or key features
documents does it say ‘we will take at least at least a quarter of every
contribution you make in charges’. Nowhere.
1.5% is the level of the annual cap on stakeholder products and many providers
do say they charge it – on stakeholders certainly and often more on other
products. But this is just the annual management charge. Nowadays there is more
interest in the Total Expense Ratio or TER which includes registrar’s fees,
marketing fees, secretarial fees, custodian’s fees, audit fee, professional
fees, director’s fees, and other expenses. Now that list of charges on top of
its annual management charge is from Fitzrovia Financial Services and it admits
they raise its quoted 1.3% Annual Management Charge to a TER of 2.27%.
Co-operative Investment Services is also very open about its charges. All have a
standard 1.5% AMC. But on top there are ‘extra management charges’ ranging from
0.1% to 1.68% – so up to a possible 3.18%.
Skandia too has charges ranging from 0.5% to almost 3%. But in Skandia’s case
those charges are only shown to IFAs not the public.
And
the TER is not the only cost. There is the cost of dealing, of buying and
selling shares which active management requires, and the spread that is taken.
That is not even in the Total Expense Ratio – total being a technical term in
financial services meaning not quite everything. It is hidden in the reduced
performance of the fund. The FSA itself published a paper in 2000 which said the
dealing costs are hidden and suggested they might be as much as 1.82% a year if
the whole portfolio was turned over. One correspondent tells me that typically
funds do turn over 98% of their portfolio in a year.
And
that is on top of any annual management charge. One major pension provider
charges an AMC of 1% to 1.67% for its own funds and allows people to invest in
166 funds with charges ranging from 1% up to 2.73%. Now at 2.73% over 40 years
out of every £10 you put into your pension £4 would go in running the
investment. And with inflation at 3% and growth of 7% almost half your fund –
48% –would go in charges over 40 years.
And
remember the investor is taking all the risk. But the contributions and the fund
are divided almost fifty fifty. The investor gets £195,000 and charges use up
£180,000.
So
if we have a pension pot that we fill up at the top each year, the pensions
industry has its own little tap at the bottom which it uses to drain out our
money year in year out, how ever well or badly the investment performs. It is
the only retail business where if the product you buy does not do what it says
it will do you cannot take it back.
We
have Savile Row made-to-measure pensions when what we need is Primark value
pensions.
Cutting charges is the second vital thing to restore trust in pensions. And as
important is to make the charges clear and upfront.
Investment
Many people in the industry react to high charges by saying you pay more for
better investment performance. Although a lot goes in charges you are getting a
bigger reward so you get more money in the end. If only. there is not a single
piece of research that shows paying more for investments boosts the return over
the long term. All the research I have seen shows that in the long term all
funds and all managers revert to a bit less than market growth. Spot the Dog
will be published next week by Bestinvest. I haven’t seen it yet. But in its
2008 edition the dogs charged 1.65% a year to underperform their benchmark by
10% over three years.
The
industry though still believes in its maxim – if you want a bigger reward you
have to take a risk. But a risk doesn’t guarantee a bigger reward. If it did it
wouldn’t be a risk.
The
three largest public sector pension schemes in Canada lost 19% or C$72 billion
off their C$385 billion assets in the last year because their active managers
prefer to put the money at risk in shares rather than keep it in safer bonds.
Defending this approach Jim Leech, the CEO of the Ontario Teachers' Pension Plan
which lost C$20 billion, said ‘The fact of the matter is we have to take on risk
to meet our pension promise.’ Oh Jim! If taking a risk guaranteed those extra
returns you need so badly it wouldn't be a risk would it? The risk is you may
lose another C$20 billion. Perhaps he should have listened to Toronto teacher
Kelly Alles ‘A high return is great’ she told the magazine
Canadian Business in July ‘but when
it comes right down to it I'd rather have a guaranteed lower return’.
And
that is what is missing in pensions. Genuine options that allow people to be
invested in cash – something that does always produce a return year after year
rather than shares which do not.
Personal Accounts
Investments will be simple and charges will be low in personal accounts. From
2012 ish auto-enrolment will mean that everyone in work – almost – will
automatically be put into the company pension scheme and if there isn’t one into
what the Government is calling Personal Accounts.
I
try to be very positive about personal accounts. Because deep down, and despite
the evidence of a lot of the arithmetic, I do believe in pensions. I have faith.
But could a dafter name have been thought up than personal accounts? I am told
it was a working title. Pensions Ministers – plural because they last on average
14 months (it’s a sign of how seriously the Government takes pensions that it
has had 11 pensions ministers in 12 years) – a couple of them have told me it
will change. The Chief Executive of the Personal Accounts Delivery Authority
told me in an interview for Money Box that the name was being reviewed and his
“hunch is it will not be called personal accounts when it eventually comes
through.” And this week PADA told me ‘working on branding’ and ‘an announcement
would be made in due time.’ I don’t know about faith. Let’s just pray…
One
thing I do like is low charges. Lord Turner in his Pensions Report thought it
could be done for about 0.3% a year. Now it seems likely it will be at least
0.5%. Comparable with similar funds in other countries. Low charges are good.
0.5% takes less than 10% in charges over a forty year pension – before growth
and inflation have done their work. The industry of course is lobbying hard for
higher charges to avoid embarrassing comparisons with its own expensive schemes.
Auto enrolment
Another thing I like about it is auto-enrolment – it means that more than five
million people will start paying into a pension.
In
fact I go further. I don’t like the opting out bit. Because there is no
guarantee that the ones who come out will be the ones who should come out. And
no guarantee that the ones who stay in will be the ones who should stay in.
Remember the changes in 1988 which forced companies to stop compulsory enrolment
has left millions of people opting out of good salary related pensions.
And
if membership was compulsory that would create its own immense pressure to turn
it into a scheme that was pretty much guaranteed to be worthwhile. And even if
some people end up worse off, for society it is better if we all pay into a
pension. We pay the price of 3000 people dying a year for the convenience of
being able to drive our cars where and when we like. We put our children at risk
by vaccinations for the greater good of elimination of disease. The advantages
of everyone being in a pension are worth the price of a few people ending up
worse off.
There is a danger though that employers will try to evade their auto-enrolment
obligations. And I don’t mean the kebab shop that slips employees a few quid to
say they want to opt out. No. There is a bigger danger. Some employers with a
good pension scheme are considering setting up a parallel auto-enrolment
personal accounts scheme. To avoid the expense of enrolling all employees into
their main scheme. That would be a retrograde step. Even worse of course would
be closing an existing scheme and using personal accounts as the only company
scheme in future. That would dumb down money purchase a level so low they would
be useless.
Contributions
So
we come to the real, fundamental and perhaps fatal flaw in personal accounts.
The amount that will be paid in. I’ve often accused your industry of being
experts in describing things in ways that are true but misleading. But I have to
say the government propaganda around personal accounts runs it a close second.
Eight per cent contributions. Not true. Time to feed some more figures into a
spreadsheet. This time one which works out how much is actually going into the
pension.
Because the 8% is in fact of a band of earnings between in 2006/07 terms about
£5000 (£5035) and about £33,500 (£33,540). Income below one or above the other
is not used in the calculation. So the maximum that can go in is in fact 6.8% of
total earnings. And that is for someone on £33,540, which is about 1.4 times
average pay. On average earnings the contribution going in is 6.25%, and on low
earnings, the bottom third where the higher child tax credits are claimed and
where personal accounts are aimed, it is a little more than 5%. Altogether.
Between employer and employee.
And
these contributions let the employer right off the hook. Total contributions
into a salary related pension average 20.5% – with the employer putting in 15.6%
and the employee 4.9%. With money purchase pensions the average contribution is
9.1% shared 6.5% employer and 2.6% employee. So in both cases the employer pays
two and a half to three times as much as the employee pays. But in personal
accounts it is the opposite. The employer pays only 3%, half the average paid
into a money purchase scheme, a fifth the amount paid into a salary related
scheme. And the employee pays 5% – double the contribution normally made.
Incidentally, employers have a role in restoring faith. Those with salary
related schemes but who plan to switch to a money purchase scheme should put as
much into the replacement as they did into the salary related scheme. They are
already transferring the risk to the employees. It is not fair to save money as
well by halving the amount they pay in.
It
was announced last week that personal accounts will be phased in over five years
from October 2012. Already six months after the April 2012 date envisaged by the
Pensions Minister in parliament in January last year. Turner wanted 2010. Last
week we learned that for the first three years the contributions will be pegged
at 2% – 1% each from employer and employee. And of course that nominal 2% is
little more than 1.5% for those on average pay and barely 1.25% for those on low
pay. It will rise in October 2015 and then in October 2016 to 2017 will it rise
to the full – I use the word reluctantly – 8% or as we know in fact no more than
6.8% of total earnings.
So
the initial contributions to personal accounts are going to be a complete waste
of time. £20 a month for someone on average earnings.
Means-testing
And
here we hit the real problem with pensions and having faith in them. If you have
very little money the state does provide. We have a complex but sort of adequate
system of means-tested benefits. At its heart is Pension Credit. That makes your
income up to £130 a week. And if you have more than £96 a week of your own it
makes it up to £130 and gives you a bit more as well. You can get some pension
credit if your income is below £181 a week. (All the amounts I quote are for
people living alone. Amounts for couples are about 60% higher.)
On
top of pension credit there is money off council tax. At 65 you get all your
council tax paid if your income is £150.40 a week or less. And you can get some
help with average council tax on an income up to £251 a week. Again, add 60% for
a couple. And if you are a tenant – and a quarter of people over 65 are – then
you get help at similar levels with your rent. Average rent is about £75 a week
so that is worth a lot of money.
The
result is that saving up enough to give you a small pension is not worthwhile.
Briefly if you have a state pension of £120 a week – which will soon be pretty
normal with only 30 years contributions needed and contracting out of State
Second Pension ending for money purchase schemes – and you get a personal
pension of £75 a week on top – pretty good by most modern standards – then you
will lose many of those means-tested benefits and, believe it or not, you will
also pay tax. So your £75 a week pension will leave you better off by around £39
a week, you will keep about half of the gain. And the ratio is not much
different even if you have £100 a week or £120 a week from your pension. You are
effectively taxed at between 40% and 50%.
If
you are a tenant the position is much worse. You end up keeping less than 10% of
your extra pension. Because if you did not have it you would get £24.40 from
pension credit, all your £75 a week rent paid and ditto all your £20 odd a week
council tax. About £120 a week in means-tested benefits – doubling your state
pension. If you simply replace that with a pension you have paid for you end up
about £8 a week better off.
This is not just a problem for personal accounts. Many people are sold personal
pensions that will leave them little better off. For example, paying £100 a
month in for 40 years with 1.5% charges and assuming 3% growth on top of
inflation would get a pension pot – after charges – of £93,000. Enough to buy a
65 year old an index-linked pension of less than £80 a week. Of which they would
keep about half compared with doing nothing.
So
we are back to the start. Looking to the Government to provide a decent
non-means-tested pension. It is easy to imagine one at pension credit levels
£130 a week. But not so easy to imagine one at £180 a week to stop any pension
credit being paid. And much more difficult to imagine one at £250 a week which
would end the payments of most rebates on council tax and rent. That is almost
three times the current pension. And even allowing for the savings on
means-tested benefits and sacking armies of civil servants who work all these
benefits out, the cost would be prohibitive, Especially at a time when
politicians are thinking of ending universal non-targeted benefit such as child
benefit. However logical, however you fiddle with the figures to make it
affordable, trebling the state pension for everyone is just not going to happen.
Summary
So
how do we restore – or create – faith in pensions?
Get
rid of commission and the conflict of interest that undermines trust.
Keep costs down. They are quite out of scale with the real costs of running a
simple low risk pension plan.
Make the price clear and compete on price. That will drive down cost and raise
efficiency.
Stop believing that you can beat the market. You can’t. Offer the market. And
offer something safer in cash or index linked bonds for those that do not want
any risk with their retirement money.
Turn down customers. When someone on a low income comes to you wanting to put
£20 or £50 a month into a pension tell them not to bother it is not worth it.
And
employers, show your faith in pensions. Go for the NAPF new gold standard
Pension Quality Mark Plus with 15% of contributions going into it. And say ‘no
personal accounts rubbish here. We give you a decent pension’. And then use your
pension scheme as a recruitment tool.
You
can restore faith in pensions. You just have to believe.