If you believe the advertisements, saving money over the long term weaves a reliable safety net, allowing us to retire comfortably, afford a house, or pay for extra care in the event of ill health. Behind the hype, though, our financial system can subject that hard-earned capital to a perfect crime. Undetected, a skein of routine practices can siphon away citizen’s savings.
How Jan trumps John
One way to explain how this is done is to compare the experience of a British pension saver, let’s call him John, and a Dutch saver, let’s call him Jan.
Let’s assume they both earn £60,000 a year, intend to retire at the same age and want the same income in retirement. In the circumstances, you might assume that they would have to set aside roughly the same amount of savings every year. Wrong.
John is likely to pay 50 percent more than Amsterdam-based Jan to secure exactly the same retirement benefits at exactly the same age. So John will have to scrimp for years to afford the retirement income he wants, or face a post-work income much less than Jan’s.
These huge variances in outcomes occur because small differences in annual charges compound over the years. That, combined with a pension system in the UK that has not been designed to purpose, makes a huge difference to outcomes. Here is a simple, but realistic example of how it would work for John and Jan . From the age of 25, John contributes £6,000 a year to a savings plan. Based on a 5 percent return, he could, in theory, have a savings pot of £725,000 by the time he retires at 65. What he doesn’t factor in is fees. Because the 1.5 percent is charged every year, (some of which is not even declared to him by his pension provider), this reduces his ultimate savings by more than £200,000 to £507,000.
At 65, when he retires, John has a difficult decision. He needs to know that he won’t run out of money if he lives for a long time. On average, John might expect to live another 20 years, until he is 85. But he wants to be sure that he will still have an income even if he lives to 95 and so he takes out an annuity. As annuities are expensive and give low returns, this might give him an annual payout of £31,000.
Meanwhile, in Amsterdam, Jan has been enrolled into a giant, low-cost, nonprofit fund that will cover him for the rest of his life. Annual charges are just 0.5 percent, so at 65, he will have a pension pot equivalent to £642,000, which is used, when he retires to provide a lifetime income. That gives him an annual payout of £49,400 – far higher than John’s.
A maze of intermediaries
Why the vast disparity? Rather than establish simple, commonsense, low-cost vehicles for collective savings and retirement, such as the Dutch have, UK financial institutions and policymakers have engineered a system that has transformed worker savings into a virtual cashpoint for the financial industry. Complexity rules; one study tracked no fewer than 16 different intermediaries escorting the citizen-shareowner’s money to an investment.
For example, imagine someone in Britain who invests in a private pension, and puts their savings with a fund platform. Here is the chain of events they inadvertently put in motion. A record-keeper will make sure the correct amount is deducted from their salary to go into the platform they select. The money can then be invested in underlying investment funds, with each one specializing in different classes of assets. The platform and the funds each levies its own charge. Each fund has its own accountants and lawyers. The platform, or the funds will have a custodian. Each fund will decide what to buy partially through its own research and partially through third-party research. The third-party research, of course, has to be paid for.
When any of the funds invest, they send a buy order to a broker. The broker sends the trade to an exchange. Then the trade must be settled, money sent or received, and the results reconciled by the custodian. There will be a charge for the broker taken either as a fee, or as a “spread” between buying and selling costs.
Each agent can justify, on the basis of the complex system in which they operate, why their service is needed. And each takes his or her slice of fees. Generally we aren’t told that the agent has been hired or how much they have cost us.
People often assume that the cost of saving for a pension is low because charges are expressed as a percentage of funds under management. But of course, they are taken every year. So, if a pension provider charges a fee of one percent a year, 25 percent of the potential pension will be swallowed up in fees. If the rate is 2 percent, 50 percent of the pot will go to intermediaries.
And there is even worse news. While you may be given a number for the “cost” of administering your pension, it is likely that other amounts will be deducted from your account in the form of “hidden charges”. The most authoritative investigation into this phenomenon, conducted by the Railway Pension Scheme, found hidden costs to be nearly three times the amount of the charges declared.
Given the parlous state of the current system, what can be done to improve matters? The solution that two colleagues and I put forward in our new book* is a blueprint for what we call a “People’s Pension plan”.
The People’s Pension Plan
It takes its ethos from the first significant funded pension plan, a scheme established not by bankers but by a pair of largely unheralded Scottish clergymen. In the mid-eighteenth century, two remarkable ministers of the Church of Scotland, Alexander Webster and Robert Wallace, devised the world’s first retirement plan for the widows of their fellow clergy. It was a plan based on a clear sense of purpose, and a management approach that was both technically and morally trustworthy. It was the structure which has informed the Dutch and Danish pension systems, generally regarded as the best in the world.
Key to their success was their recognition that pensions contain two bedrock elements. One is savings and investment: money must be set aside against old age or some other contingency, and invested in assets which will give an appropriate return. The second is insurance: the pension pays out only when a particular unpredictable event occurs – in their case, of Wallace and Webster, the death of the family breadwinner. In the case of the Peoples Pension, from the time you retire until the day you die (which is unknown), and your dependents can cope on their own.
So people save into a common pool, and are able to buy a pension. For that endeavor to work at low cost, it should be done at scale. It also needs to be well governed, so that no-one has the opportunity to syphon off unnecessary fees. So it would:
- Appoint a board composed of individuals with a reputation for expertise, integrity and judgment
- Aim only to advance the interests of beneficiaries or clients who give it money to invest
- Plainly report every significant payment made to manage the fund. This would include not only the fees levied by the fund manager but the cost of services commissioned from others, such as those for trading securities
- Inform beneficiaries of what governance arrangements are in place to ensure that decisions are made in alignment with their interests. One minimum standard would involve beneficiaries being told not only who are serving as fiduciaries on their behalf but also the fiduciaries’ professional backgrounds, skillsets, potential conflicts of interest, and independence. They should also be told how to contact them to express confidence, views or concerns
- Subject these arrangements to regular independent review to ensure that they meet best-practice accountability principles
- Ask beneficiaries what types of investments they need, the ownership profile they prefer, and what else they need from the plan
- Set up feedback channels appropriate to the era of social media. These could include dedicated email inboxes for board members, fund Twitter accounts, chat rooms, and electronic surveys of member satisfaction
- Pay portfolio managers appropriately. This may well mean an end to evaluating and compensating them based on short-term bonuses
- Disclose how it or its agents used stewardship tools, such as ballots, to protect assets. This could also mean enrolling the fund in the United Nations’ sponsored Principles for Responsible Investment (PRI) or collaborating with other investors on market-wide initiatives such as the Diverse Director Datasource
- Publish how much portfolio managers and investment professionals have themselves invested in the funds they manage, how investment risk management is organized and to whom the management reports
- Ensure that the scheme was simple to enroll into and open to all
Time for change
Now you might have thought that such a plan was not so complex. Yet today, should any employer seek to create it for their workforce, or any social entrepreneur decide they wanted to do it for the population, they would find that through well intentioned, but ill judged regulation, this structure is illegal in the UK. That is despite the fact that it is the backbone of the two best pension systems in the world, and delivers much higher pensions. Each year, about 6.5% of our annual wealth is set aside for private pensions. If we were to adopt the People’s pension” system, that money could give retirement incomes which were 50% higher than those we have today.
*What They Do With Your Money: How the Financial System Fails Us and How to Fix It, by Stephen Davis, Jon Lukomnik, and David Pitt-Watson is published by Yale University Press.
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