Topic: Government Policy

We’ve written in the past about some of the positive aspects of the Chilean pension system and what the UK can learn from how it is designed. Its approach to DC decumulation is set up to drive greater value for savers when taking an income from their fund and there is a lot to learn from this aspect of the system. The Chilean pension system has, though, been seriously challenged as it has not provided adequate outcomes to the bulk of retirees. This has led to both protests and a gradual swing back to a tax funded first pillar pension.

Replacing a pay as you go pension system with DC pension saving

Chile is one of the earliest examples of a country to embrace DC pension saving. Under the Pinochet dictatorship, it abolished its pay as you go pension system, replacing it with a system of individual DC accounts. This took place in the early 1980s, as part of a much wider programme of liberalisation and privatisation. It was retained after Chile’s return to democracy following the 1988 plebiscite on the continuation of Pinochet’s rule and the subsequent 1989 elections.

The overall results from the DC system have been disappointing. Average replacement rates from the Chilean DC system lag behind the bulk of the rest of members of the Organisation for Economic Co-operation and Development (OECD), often by some margin. Also, forecast replacement rates are projected to be low. OECD analysis suggests an average replacement rate of roughly 30% in 2060. While the system is sustainable, it has arguably achieved sustainability at the expense of delivering adequate pensions.

Why has the Chilean pension system struggled?

As usual, when a system struggles over time, there is usually more than one cause.

1. The first is that Chile completely replaced its pay as you go pensions system with individual DC accounts, rather than reforming its pay as you go system and augmenting it. This effectively withdrew the welfare safety net for retirees who were not in a position to save.
2. Second, minimum contributions totalled 10% of employee earnings, without an employer contribution. This is too low to generate an adequate retirement income, especially in the absence of state backed first pillar provision.
3. The third is broken contribution histories. With a much higher level of informal working and self-employment than the UK, it was (and is) common for working Chileans not to be contributing into a DC account for large proportions of their working lives. Coupled with the impact of lower than assumed investment returns and increasing longevity, it’s not a surprise that the system has not delivered adequate incomes.

The result of this has been protests and a move back over time to a first pillar pension, funded collectively through taxation. In 2008, the Chilean government introduced a first “solidarity” pillar pension, which operates on a pay as you go basis. It is currently payable to men over the age of 65 and women over the age of 60, who have incomes in the lowest 60%. In addition to the means test, there is a residency requirement – Chileans need to have been resident for 20 years and for four out of the last five years prior to claiming in order to be eligible.

What we can learn from Chile

We can pull two main lessons out of this. First, DC can only function as a main pension entitlement if the system covers the overwhelming bulk of the population and contributions are regularly reviewed to ensure they target an adequate income. Given that this is very difficult for policymakers to achieve, some form of combination of a pay as you go first pillar that guarantees a minimum income in retirement and a DC top up seems sensible. We think that the Chilean experience broadly validates the UK’s policy mix – a split between a first pillar set around the poverty line and a quasi-compulsory DC top up.

The second lesson is that, in a democracy, pension systems have to be politically as well as economically sustainable. If a system is not producing adequate outcomes then those affected may vote themselves a more generous pension, or take to the streets. Or, as in the Chilean case, both. This should be borne in mind by countries that are further behind on the DC journey than Chile. Pensions are boring until they become interesting and when they become interesting it’s usually a sign that something is seriously awry.

If you have ever wondered why workplace pension schemes frequently offer limited investment choice and focus on the default fund, the answer is jam, and Sweden.

In setting up pension systems both policymakers and pension schemes looked extensively at both the behavioural economics literature. They tended to take in both experimental and real-world studies. Sheena Iyengar’s work on choice showed that in both a retail environment (the sale of jam) and in pension plan design, offering many choices could discourage people from making a choice. In some cases, with US 401k plans, where investment choice could be a mandatory part of plan design, having to make a choice could put people off joining a pension scheme altogether. These studies are one of the reasons why schemes frequently offer a focused range of funds, in contrast to retail platform providers. From the way newer SIPP consolidators are put together, it looks like they’ve been reading the same papers too.

Investment choice for pension savers was initially encouraged

Sweden, meanwhile, is one of the only countries that has deliberately encouraged investment choice in DC. The experiment went badly but did so in a very informative manner. The bulk of Swedish state pension entitlement is a notional DC scheme, run on a pay as you go basis, funded out of taxation. There is a smaller top up scheme, called PPM, which is a funded DC.

At its launch in 2000, the Swedish government not only allowed but encouraged investment choice in the scheme through a nationwide advertising campaign. 456 funds were offered through PPM and 66.8% of those who started saving into PPM in 2000 made an elective investment choice and chose not to use AP7, the default fund.

Outcomes for this group of self-selectors was materially worse. They tended to overweight Swedish stocks and tech stocks (during the end of the dotcom bubble) and critically, tended not to rebalance their portfolios over time. Investors in the AP7 default fund, meanwhile, received better outcomes.

Self-selection of funds was not a success

This case study has been so impactful that it is hard to think of another national DC system that has followed the Swedish route. Indeed, Sweden no longer encourages choice in the same way and has progressively shrunk the number of funds available to PPM savers.

Henrik Cronqvist and Richard Thaler, who wrote the best-known evaluation of PPM in 2004 were implicitly critical of its initial design. But their more recent work also looks at the permanence of nudges in the Swedish system. Essentially, under some circumstances, once people have been “nudged” by a pension system to do something – or not do it – that decision is quite often very long lasting.

Their more recent work shows how PPM investors tend not to react when major events happen that might affect their investments. In 2011 AP7, the PPM default fund, started using leverage in the form of total return swaps. This resulted in much higher returns but also meant that investors were taking much greater risks. This massive change in the risk profile of the fund people had been nudged into, had very little impact on investor behaviour.

Why nudging savers has its limits

They observed something similar with the Allra fraud, which unfolded in Sweden in 2017. Allra, operated a fund in the PPM system. It routed transactions through Malta, where it skimmed the transactions in the process. From a mechanical perspective, there is nothing particularly interesting about this. But from a human perspective, what’s interesting is the under-reaction by Allra’s investors. In the week after the fraud allegations came to light, only 1.4% of the fund’s investors divested. This rose to 16.5% when the fund’s auditor resigned.

PPM continues to provide actionable insights about the risks of encouraging choice and information about how to structure choices when thinking about the design of DC pension funds. Increasingly, it also provides insights about the strengths and weaknesses of policies based on “nudging” people and the responsibilities that attach to policymakers, providers and regulators once someone has been “nudged”. It remains a system to watch for anyone interested in the future of UK DC.

Like many things we take for granted, automatic enrolment was popularised in the USA.

Auto-enrolment’s origins across the Atlantic stems from attempts by large, paternalistic employers to drive up participation in their retirement savings plans. These attempts were studied by behavioural economists like Richard Thaler and David Laibson. In the UK, the Department for Work and Pensions and the Pensions Commission picked up on their research on automatic enrolment and saw in it a mid-way between compelling people to save and more laissez-faire approaches to workplace pension reform.

While the US devised and popularised automatic enrolment, it is not actually that commonplace as an enrolment technique. This reflects one of the stranger aspects of the UK’s Magpie relationship with US politics and policy. Not all of the things that we borrow are as successful or widespread in the country of origin, as they turn out to be in the UK.

Half of Americans over 55 don’t have pension savings

There are many factors at play here; as with the UK, a worrying number of Americans have nothing saved for retirement. According to a 2019 study by the US Government Accountability Office, roughly half of Americans over the age of 55 have nothing saved for retirement. But, they are in a better position than Britons.

The US first pillar pension, commonly known as social security, is much more generous than state pension arrangements in the UK.

Social security is earnings related and the average amount paid to individuals in 2022 was $1,657 per month or $19,884 per annum with a theoretical maximum for high earners of just over $40,000. Notwithstanding the fact that there is now more being paid out from the notional social security trust funds in benefits than there is coming in in payroll taxes, social security has been remarkably resistant to reform.

This means that while the first pillar will not afford American retirees a luxurious retirement, support given to almost all retired American workers is, for the most part, well in excess of that provided by the UK’s state pension. Second pillar savings are, obviously, highly desirable but the base level of support provided by social security is much greater.

No nation-wide AE for Americans

There have been successive attempts to roll out automatic enrolment at a federal level, which have not met with success. Meanwhile a variety of states have brought in variations of automatic enrolment at the state level. Illinois was the first to bring in its programme in 2015, followed by Oregon, California, Connecticut, Maryland, New Jersey and Virginia. Pennsylvania and Hawaii are currently considering the issue. While there has been some bi-partisan support for automatic enrolment, both at a state and at a federal level, these states are predominantly wealthier than average and lean Democrat.

At the federal level, last autumn, all the proposals in the Biden administration’s flagship Build Back Better bill were removed from the bill’s framework. Those included proposals to require established employers with more than six workers to begin automatically enrolling employees into either individual retirement accounts. In some ways, this is emblematic of slow progress at the federal level.

An important year for US pension savers (possibly)

2022 could, potentially, be the year this changes. HR 2954, dubbed the SECURE Act 2.0, which is currently in front of Congress, contains provisions intended to mandate that businesses of more than 10 employees, which have been trading for more than three years automatically enrol their workers in a retirement plan. The initial contribution rate is 3% of pre-tax earnings but this escalates automatically by 1% every year to a minimum of 10% and a maximum of 15%. Individuals can select a different contribution rate if they want.

We are watching this with interest. There have been many attempts to bring in significant reform of workplace retirement saving at the federal level, but none have yet succeeded.

That alone tempers enthusiasm in the experiment. But the provisions on automatic escalation are interesting and, should they work wholesale, could provide an example for the UK to follow. It would be a pleasing development if the nation that pioneered automatic enrolment managed to extend its benefits to the bulk of its own citizens.

This Australia Day, we take learnings from Down Under and look at how UK pensions could benefit from the advancement of the country’s superannuation system.

This is highly relevant to the UK because the Australian Superannuation system is roughly 10 years ahead of the UK in its DC journey and policymakers often, but not always, look to Australia for inspiration.

The Your Future, Your Super policy package follows on from a series of inquiries into the performance of the Superannuation system. These, especially the final report of the Productivity Commission, made serious criticisms of parts of the Super system and have forced a heavyweight response from the Australian government.

The performance element of Your Future, Your Super, implemented last year, subjects funds to a pass/fail test based on investment performance. The regulator (APRA) examines 7 years (changing to 8 from 2022) of a registerable superannuation entity’s (RSE) investment performance and compares it to a benchmark portfolio. The benchmark is put together using the RSE’s asset allocation and a series of benchmark indices for each asset class.

If the RSE’s performance is more than 0.50 per cent lower than the benchmark, then it fails the performance test. If the annual test is failed more than two years in a row, then the RSE is banned from accepting new business into the product. This strongly incentivises “failing” funds to merge.

Australia’s Superannuation was already consolidating rapidly ahead of this regime coming into effect. Some analysts expect further consolidation and a dramatic shrinking of the market to far fewer funds. We see that as likely but are cautious about estimating how may funds Australians may have to choose from.

Value for money is key

There are both positives and negatives from this for the UK. We think the main lesson for the UK is that if the regulator, in this instance TPR backed by the Department for Work and Pensions (DWP), wants to increase the pace of consolidation in workplace DC then binding value for money tests are one way to achieve this. The current approach UK to driving consolidation based on value for money is focused on DC smaller schemes and allows trustees of the schemes in scope much more discretion in compliance than the Australian version.

One potential outcome of the recent TPR/FCA consultation on value for money metrics would be the strengthening of this regime and its application to more schemes. The Australian audit applies to all regulated funds, not just smaller ones.

Too much focus on past performance can be a negative

We do, though, see negatives to the Australian approach. The approach focuses only on past performance. There are two problems with this. First, past performance is not a good guide to the future. Poor past performance tends to persist while good performance may not. This limits its use as a decision-making criterion, even for regulators and professionals. The real value in a pension scheme is driven by the decision making around a scheme’s default fund, which is impossible to capture quantitatively. But it is also the key thing you would want to understand if you were trying to judge which funds are more likely to show value for money over the long term.

Second, performance next to a reference portfolio creates quirks. A conservative fund might outperform its benchmark and pass the test. A more aggressive fund might outperform the conservative fund but underperform its benchmark and find itself, effectively, out of business.

We look forward to seeing how a tougher value for money regime plays out in Australia and whether a consolidated market really delivers the benefits promised.

The eagerly anticipated report of the Department for Work and Pensions (DWP) working group on small pots, which was published in December, sets out potential ways forward for resolving the problem. It will be tough to fix but the size of the problem is growing, meaning that it’ll be harder to solve the longer it’s left.

Small deferred pension pots have been considered a significant problem since the inception of automatic enrolment in 2012. It has always been the case that employees switching jobs would leave behind stranded pots. The phenomenon has multiplied under auto-enrolment because the policy brought in workers who shifted employment far more frequently and whose salaries were lower. The Pensions Policy Institute estimates that as a consequence of this combination of deferred pots and a mass workplace pension system, there’ll be 27 million dormant small pots in circulation by 2035.

Small pots are an issue for providers, particularly the master trusts which serve the auto-enrolment market, because they may never generate the fees required to cover the costs of their administration. Regulatory levies are currently also calculated by number of members rather than assets. This has the consequence that regulatory costs have fallen disproportionately on schemes with large numbers of deferred small pots. These are the schemes which have picked up the bulk of the millions of employees brought into pension saving by automatic enrolment.

Cross-subsidy

Higher financial burdens for schemes becomes a problem in turn for active members, since a cross-subsidy is required from the fees charged to them to cover the cost of administering the unprofitable pots. The problems for savers don’t end there. A trail of small pots makes it difficult for those employees with small pots to keep track of their pensions and to keep on top of what they need to save in order to generate a reasonable retirement income. Both members and providers have a strong interest in fixing the problem and both will benefit from removing unnecessary costs from the workplace pensions system.

Potential solutions

The working group’s report is a reasonable first step and gets a lot right – both the working group and DWP have done well in a short time to synthesize diverse views and come up with a way forward.

The first thing they got right is that there’s a need for an automatic solution to consolidate small pots held by different providers. The experience of Australia and small dormant super accounts is that the number of pots an individual has grows early in someone’s working life and they aren’t voluntarily consolidated until people approach retirement. Having a dashboard that facilitates voluntary consolidation, like Australia, hasn’t been enough to solve the problem.

The second thing they get right is the importance of administration reform. Again, the main lesson of the international experience is that transfers need to be cheaper, exchange of data needs to be rendered easier by an industry-wide standard and there’s a need for a rock-solid identity verification process so that automatic consolidation can be done securely.

The key insight here is that fixing known administration problems might enable quite a wide range of different options for consolidating small pots. Administrative reform creates a pitch on which more than one game might be played.

The second insight is that there are a lot of potential overlaps between the administration changes needed to power a consolidation solution and the components of the pensions’ dashboard. It seems likely that the data standard to be used by the dashboard might be used as the basis for a standard that might power a consolidation system.

There’s a lot more work to be done on consolidation models as well. The report recommends further work on pot follows member and on “consolidators”. The former would consolidate dormant pots to the active pot, while the latter would establish a single destination for all an individual’s deferred small pots. Both DWP and industry will need to look in more depth at how these consolidation options might work. Ideas that initially seem attractive can rapidly seem much less attractive as work progresses and technical difficulties emerge.

Member exchange

The report also recommends that the industry take forward work on “member exchange”, a variant of pot follows member. Member exchange is attractive as it might be possible to consolidate small pots using the bulk transfer regulations. This would obviate the need for further legislation and might enable master trusts to make faster progress on the problem.

Conclusion

The amount of work required now is, frankly, gargantuan. There needs to be a durable partnership between the pensions sector and the DWP in order to reconfigure a large part of how workplace pensions work.