Friday, November 2, 2012

Reality Check For Pensions?

James Hall, Consumer Affairs Editor at the Telegraph, reports, Pension pots to plunge under new rules (h/t, Reggie):
The Financial Services Authority (FSA) said that from 2014 the predicted growth rates used to give investors an idea of what their pension pot will be worth when they retire must be significantly lower than they are today.

Currently pension companies use a so-called “intermediate projection rate” of 7 per cent in statements to savers. This means that someone in their 20s who earns £30,000 and saves £2,000 a year into a workplace pension can expect to have a retirement pot when they reach 68 of £540,000.

However under the new 5 per cent growth rate that firms will have to use, this pot will be valued at just £335,000. The change means that the person’s predicted pension income will fall from £10,400 a year to £6,430 a year, a drop of 38 per cent.

Experts said that the lower rate will provide a “dose of cold economic reality” to savers and will give them a more accurate idea of the money they can expect to receive on retirement.

As well as pensions, the new rules will also cover the expected growth of financial products including ISAs and endowments. From 2014 all statements about existing investments will use the new lower projection rates.

Although the change will give savers a nasty surprise when they open statements, the FSA said that it is pushing through the change to give people a more realistic view of what their investments will be worth.

While the change will not reduce a person’s actual savings, it will significantly dent the paper value of their pots and could lead to millions of people changing their retirement plans.

An FSA spokesman said the regulator wants to stop companies giving savers the “false impression that they are likely to get huge returns”. The FSA said that a central rate of 7 per cent is “inappropriate” given the current economic uncertainty.

“We think that people who are making a long term investment deserve to have a pretty good indication of what they are likely to get back,” the spokesman said.

Pension experts said that the lower growth forecasts will give a “reality-check” to savers.

Joanne Segars, the chief executive of the National Association of Pension Funds (NAPF), which represents the pensions industry, said: “We are in a low growth environment and have been for some time. It is pointless letting people hope for high returns that might never materialise. This is a reality check.”

Tom McPhail, head of pensions research at Hargreaves Lansdown, the pension company, said: “This is a dose of cold economic reality for investors; the FSA is telling them to expect lower growth, which means that for a given level of pension they need to save more and that means making more compromises over how much they can afford to spend today.”

The FSA announced the changes following an independent review by accountants PricewaterhouseCoopers (PwC) and a consultation with financial firms.

At the moment, pension statements show the value of people’s funds if they grow by 5 per cent, 7 per cent and 9 per cent a year. The central 7 per cent figure is the “intermediate projection rate”.

After the changes, the rates required by the FSA will be cut to 2 per cent, 5 per cent and 8 per cent, with 5 per cent as the intermediate projection rate.

The FSA has cut the forecasts because investment returns have fallen over the course of the financial crisis. For example many pension funds have switched their investments from volatile stocks and shares – equities – into Government bonds which are safer but have lower financial returns.

The spokesman said: “Companies are moving away from equities and toward lower-yielding assets such as bonds so an intermediate rate at the lower end of the range provides the most realistic indicator of what an investor might receive from their investment.”

The NAPF’s Ms Segars said that the changes will avoid savers getting nasty surprises.

She said: “People often struggle to plan their retirement, and these new rates should offer a more helpful and realistic guide.

“The revised rates are still estimates and are not a promise of what the pension will look like. The best way for people to manage that uncertainty is to give their savings a regular MOT to see how they are faring.

“The UK is not saving enough for its old age, so it is important to help people see how much they need to salt away. A reformed simpler, flat-rate state pension will also enable people to make stronger retirement plans.”

The new projection rates will come into force in April 2014 but pension firms will be able to comply with them in promotional literature from April 6 next year.

The FSA said that it has only changed its standard projection rate twice since 1988.
The FSA is right to move forward with these changes but I fear it's too little, too late. Global pension poverty will hit Britain and the rest of the world extremely hard in the coming decades.

And in the retail world, high return assumptions are only part of the problem. A bigger problem is that fees eat away at the performance of retirement accounts. Charlie Weston of the Irish Independent wrote a comment for the Irish Independent, High pension fees can swallow up one-third of your retirement fund:
Sky-high charges can gobble up as much as a third of the value of a pension plan, a new report has found.

And most people who are saving for their retirement are unaware of the impact fees and costs have on their fund, the report by the Department of Social Protection concluded.

High costs are particularly a problem for those with their own individual pensions, and those in smaller schemes. These are typically defined contribution pensions.

Some 240,000 people have this type of fund, with the number set to grow as the more traditional defined benefit schemes are rapidly closing.

In extreme cases charges can eat up half the value of a fund if it has been in place for two years or less.

Social Protection Minister Joan Burton, who has responsibility for pensions policy, said many people were shelling out more for a pension than they should because of high fees.

She said it was not usual for one-third of the value of a retirement fund to be eaten up by charges.

Someone who saved €250 a month from the age of 35 could end up with a fund of €200,000 after 30 years. This would leave them with an annual pension of €10,000 in retirement, if there were no charges.

But an average charge of 2.18pc a year would reduce the fund by €62,000 and this would leave a pension of just €6,900, according to the report.

The 290-page report found there are a wide range of charges, some of them hidden.

But they compare favourably with the typical charging structure in Britain.
The situation in Canada isn't better where mutual funds are raping investors with excessive fees, delivering mediocre results. Diane Urquhart sent me some comments she shared with a reporter:
Thank you for your recent column on excessive mutual fund fees in Canada. I recently updated my analysis on the impact of excessive mutual fund fees on Canadian retirement savings.

(1) Canadian mutual fund investors will likely be sharing more than 50% of their investment return with the financial industry over the next 30 year period, due to the expected low interest rates and low economic growth and the impact of excessive Canadian mutual fund fees after taking investment return compounding into account.

(2) Canadian mutual fund investors that save regularly over the next 30 years would have close to 25% higher retirement savings if Canadian mutual fund suppliers were charging the world average mutual fund fees rather than Canadian mutual fund fees.

(3) The solution is for Canadian governments to permit Canadians to buy foreign sponsored mutual funds, which charge about half of the Canadian sponsored mutual fund fees. This would involve removing the requirement for foreign sponsored mutual funds to become Canadian registered.

Alternatively, the Canadian mutual fund fees should be regulated like utility rates are in this country.


(4) If Canada intends to remove marketing boards and the quota system for dairy and poultry products, then it should surely be opening the marketplace for mutual funds to international competition first. The impact on Canadians of excessive mutual fund fees is to ensure the low income of most seniors, who are not covered by defined benefit pension plans.
I often rail against hyped up hedge fund hipsters charging institutional investors ridiculous alpha fees for pathetic returns, but the real scandal centers around fees being charged by the mutual fund industry, especially here in Canada where they are among the highest in the world.

But Diane's proposal doesn't go far enough. Instead of opening up competition, permitting Canadians to invest in foreign sponsored mutual funds, I have a simpler solution for all mutual funds: only allow them to charge 1% above the lowest cost exchange traded funds (ETFs) if and only if they beat the market that year. If they don't beat the market, they can just charge the lowest cost ETF fees, disclosing all fees to investors.

Of course, the vast majority of mutual funds underperform low cost ETFs, so no mutual fund would ever accept my proposal. They need to charge hefty fees to pay their marketing budgets, preying on clueless retail investors who think their money is being professionally managed by experts that can beat the market.

An even better proposal is for us to realize that pensions must be treated like education and healthcare, guaranteeing pensions for life. The Economist recently published an article, Marshmallows and markets:
Most people pay careful attention to their wage packets. But they tend to be much less interested in their pensions, even though their financial well-being in the last 20-30 years of their lives depends on them.

That is a great pity, since responsibility for pension provision has been steadily shifting from the company to the individual. Around 70% of American retirement schemes are now defined-contribution (DC) plans, under which the final pension amount is dependent on investment performance. In Britain the proportion of pension assets represented by DC plans rose from 8% in 2001 to 39% in 2011.

Poor stock market performance has reduced the return that investors get on their savings. Meanwhile, very low interest rates and improved longevity mean that a much larger pension pot is required to generate a given retirement income. According to Alexander Forbes, a consultancy, the average British 30-year-old in 2000 could have expected a pension contribution of 12% of wages to generate a retirement income of 67% of their final salary; a 30-year-old today could expect an income worth only 39% of final salary.

The greater cost of providing a pension is the main reason why companies have stopped providing defined-benefit (DB) schemes, under which they promised workers a specified pension, and switched the burden to employees. But the risk also makes pensions a very unsatisfactory product for employees. They put money aside every month but have no idea how much they will receive.

Most humans have a problem with deferred gratification. A famous test for children offered them a single marshmallow up front, or two if they waited; only 30% had the necessary self-control to delay. Pension saving is even more of a test of patience: workers have to wait 40 years or more for the pay-off. Their pension pots may not even be worth the sum total of their contributions; they may have swapped marshmallows for gruel.

It would surely make pension saving more attractive if workers could be given a much better idea of the eventual rewards for their thrift. A new report from the British Institute and Faculty of Actuaries examines whether it might be possible to offer guaranteed pensions in the DC market.

There is a simple way of offering a (virtually) guaranteed pension. If investors buy index-linked government bonds, their savings will be protected against inflation unless the government defaults. But this is expensive because the returns are so low. That expense explains why most corporate and government pension funds have followed the strategy of taking more risk (usually by buying equities) in the hope that excess returns from the market will let them make lower contributions.

In theory, you could insure against equity risk in the derivatives market by buying a put option (the ability to sell shares at a set price). Over the long run equities normally rise in value (although that is not certain, as Japanese investors know all too well). Even so, buying a long-term put option is actually more expensive than buying a short-term contract.

So the actuaries examine other approaches, using sophisticated hedging techniques that rebalance the portfolio to avoid substantial losses. The idea is to take advantage of the higher returns that equities can generate but in a low-risk fashion that means the cost of purchasing a guarantee is reduced.

Although this seems a sensible way forward, a couple of caveats are needed. First, the actuaries cannot say how much a guarantee would cost. They can calculate only the maximum a pension scheme should pay for a guarantee without making the strategy self-defeating. And any guarantee will involve only the return on contributions; it will not protect the worker against inflation.

The second caveat is that a guarantee is only as good as the guarantor. Pensions are long-term products and the recent crisis has demonstrated that insurance companies and investment banks (the likely guarantors) cannot be relied upon to survive for decades.

That raises the question of whether the government should step in. Governments may not want to add to their unfunded long-term liabilities. But if a guarantee could be provided for low-risk DC schemes, workers might be persuaded to save more. And if they do not save more than they do now, they may end up relying on government benefits in any case.
I got a better idea. It's high time governments "stepped in" and bolstered defined-benefit plans for all workers, not just those in the public sector. Force people to save more off every paycheck and manage that money properly by professional pension fund managers who are able to invest across public and private markets.

And private companies shouldn't be in the pension business. They can help employees with contributions but the money should be managed by large public pension funds supervised by independent investment boards that operate at arms-length from the government. Pooling resources will lower costs significantly, as will having well paid, competent pension fund managers that can manage a significant portion of the assets internally.

Below, Senator Levin discusses how commodity related mutual funds have found ways to skirt rules to trade commodities. Apart from excessive fees, mutual funds are also guilty of excessive trading and speculation.

I also embedded a CBC report showing how the Canada Pension Plan Investment Board teamed up with BC Partners, a European private equity firm, to buy the seventh largest cable operator in the US in a deal worth US$6.6 billion. This is a smart deal, one that only a large, well-governed pension fund can engage in.