To its credit, the United Kingdom has shown a persistent willingness to study pension reform. Six years ago, the U.K. Treasury launched the Myners Review to study pension investment trends and practices, and to make recommendations for improvement. Then, just two years ago, the Treasury launched the Turner Commission with the more ambitious aim of studying workplace pension system trends and practices as a whole and to, once again, make recommendations for improvement.
The commission has produced a report that proposes a new destination for the U.K.’s pension system, and charts a course to get there. There is much to like about the Turner report. It is thorough in its analyses, and wise in its recommendations. The broad sweep of its assessment and recommendations are relevant to all countries genuinely interested in reforming their pension systems.
Recommendations for reform
The Turner Commission’s recommendations boil down to three pillars:
•Pillar one — Stabilize public system:
Stabilize the universal part of the national pension system so that it provides a transparent, minimum income floor for all (30 per cent of the medium wage), but at the same time adapt it to the reality of workforce aging and increasing longevity to stabilize costs. (For example, raise the age of eligibility gradually over a number of decades.)
•Pillar two — Implement scheme for workers not covered by a plan:
Increase funded pension coverage dramatically through auto-enrolment in a National Pension Savings Scheme (NPSS) for all workers who are not members of a workplace-based pension plan, but include the ability to opt-out. The NPSS should raise income replacement from the 30 per cent provided by the public system to 50 per cent of pay for the median income worker. This implies an eight-per-cent NPSS contribution rate, to be split five per cent for the worker and three per cent for the employer. Total contributions should be capped at £3,000 (about $6,000) per year. There should be autopilot, low-cost investment and annuitization options attached to NPSS. Again, opt-out options should be provided.
•Pillar three — Establish pension agency:
Establish NPSS as an arm’s length pension agency with its own governance, executive and operations elements. Target an NPSS all-inclusive unit cost ceiling of 0.3 per cent per year.
These are three simple (at least in concept) but powerful recommendations. Recommendations that should be studied carefully for their relevance outside the U.K.
The need for broad review
Myners was asked to look at why U.K. pension funds were not investing in private equity, but he broadened his mandate to study pension investment practices in general. Similarly, Turner was asked to study dysfunction in workplace pensions but he broadened his mandate to study the U.K. pension system as a whole. There is an important lesson in these two broadening-the-mandate decisions.
Dark Age Ahead
, author Jane Jacobs wrote: “Science has made little progress dealing with whole systems. It tends to become arrested in the stage of singling out isolated bits, with little grasp of how these interact with other bits of integrated systems.“
Her point is clear. Trying to fix a smaller bit in a larger whole cannot be done well without first understanding that larger whole. Solving complex pension problems requires system-wide integrative thinking.
The Turner report offers an excellent example of this logic at work. One of its key conclusions was that private-sector workplace pension plan coverage in the U.K. (just like in North America) is far too low and more likely to shrink than grow in the future. So how does this disturbing trend get reversed? Turner’s answer was automatic enrolment of the entire non-covered segment of the U.K. workforce in NPSS, with an opt-out provision. This makes good sense, given people have pretty good general ideas of what is “good” for them financially, but have a terrible time turning this into tangible action plans.
However, workers can’t be forced to do the right thing. Hence the automatic enrolment in a scheme that is “good” for them, but with an opt-out provision. Human inertia will take care of the rest. Few will likely choose to opt-out unless they have a good reason.
But Turner noticed there was a catch to the NPSS auto-enrolment proposal. Eligibility to a part of pillar one (the universal system) of the U.K. pension system is means-tested, thus targeting the lowest income retirees. That in turn means this group has no incentive to participate in the NPSS, as participation would mean losing part of their pillar one payments. Stated differently, under the current system, the effective marginal tax rate on NPSS retirement income is excessively high. Thus, the Turner Commission notes, a consequence of its recommendations is that future accruals of pillar one pension rights must be universal and not subject to means-testing.
Blueprint for global pension reform
Ideally, pillar two pension plans should cover most of the workforce and address two challenges in their design:
•pension plans should be designed so workers are not left to make complex savings and investment decisions on their own; and
•pension plans should be structured so decisions are made solely in the interests of plan participants by arm’s length “expert” organizations.
These requirements led to the unveiling of The Optimal Pension Scheme (TOPS). TOPS has six critical characteristics, with the first three addressing the “human foibles”-related issues uncovered by behavioural finance research. The second three address the “agency” issues first articulated by Peter Drucker, the founding father of the study of management, 30 years ago and underpinned by a series of research-based findings since that time. (See sidebar for a list of the characteristics.)
The similarities between TOPS and Turner’s NPSS are noteworthy but not surprising. If two unbiased, deductive reasoning processes start from the same research base and try to solve the same problem (design the optimal workplace pension arrangement), they should produce similar answers. Whether dubbed TOPS or NPSS, the widespread adoption of such pension plans can revolutionize pillar two pension coverage and delivery in the developed and developing economies around the globe. For example:
•In the United States:
What would have happened if the Bush administration had followed the Turner Commission approach and had stabilized Social Security and introduced a U.S. version of the NPSS as two related, but separate, initiatives? The U.S. would be a lot closer to genuine pension reform. Meanwhile, sponsors of U.S.-based workplace pension plans in both the public and private sectors should be actively thinking about how to move their current defined benefit (DB) and defined contribution (DC) plans into TOPS/NPSS-type arrangements.
With a reasonably stable pillar one structure (Canada Pension Plan and Quebec Pension Plan) already in place, systemic pillar two problems should now be urgently addressed. The TOPS/NPSS design is the blueprint. The basic formula could be applied nationally or on a province-by-province level. As in the U.K., the means-testing element in the pillar one part of the pension system will have to be eliminated. As in the U.S., sponsors of existing workplace pension plans in both the public and private sectors should be actively thinking about how to move their current DB and DC plans into TOPS/NPSS-type arrangements.
•In developing economies:
The TOPS/NPSS design is a promising formula for developing countries ready to foster workplace pension arrangements as part of their development strategies. The Chilean reforms of the early 1980s are often held out as the “pension poster child” for developing economies. Unfortunately, the Chilean pillar two system was designed with too much of an opt-in philosophy rather than the opt-out philosophy the Turner Commission is advocating. Thus, not surprisingly, material pillar two pension shortfalls are now being predicted in Chile, with the means-tested pillar one component continuing to be an important backstop. These pension shortfalls are further aggravated by for-profit pension fund administrators that charge an average 1.4 per cent of contributions for their services. In a more recent example, India seems to have learned from these early Chilean mistakes. The implementation of a broadly-based TOPS/NPSS-type pension arrangement is currently being debated in India’s parliament.
Governance, management and investment options
The Turner Commission considered three institutional models for the NPSS:
•a government agency;
•an arm’s length agency established by statute; and
•full outsourcing to a contracted for-profit provider.
It opted for (correctly, in my view) the arm’s length agency model with its own board of directors. The commission recognized NPSS may want to outsource a number of key functions. The collection of, and accounting for, contributions is an obvious example. Other possibilities include member account maintenance and communications. The commission recognized the NPSS’s “most sensitive and judgmental decisions” would relate to investment fund choices to be offered, how an autopilot default investment strategy would be defined and how investment mandates would be allocated.
It is on these investment matters I differ with what the commission describes as its “current but tentative thinking.” The commission foresees a range of fund choices being offered by NPSS, managed by private fund managers selected through competitive bidding processes. But offering two funds — “risky” and “risk-free” — with the default strategy of assigning weightings between the two on an age-related basis, might be better. But the internal expertise should reside within the NPSS to decide which components of the investment programs it should manage internally and which to outsource to external managers.
According to published reports, U.K. Chancellor of the Exchequer Gordon Brown is not particularly enamoured with the Turner Commission recommendations. This is a pity and hopefully, upon more careful consideration, he will change his mind. Meanwhile, the rest of us should also consider the Turner recommendations carefully. They truly do represent a clear blueprint for global pension reform. Who will take the lead in Canada?
Keith Ambachtsheer is director of the Rotman International Centre for Pension Management at the University of Toronto. He is also a strategic advisor to major pension plans around the world. For more information contact (416) 925-7525 or visit www.kpa-advisory.com.
TOPS: The Optimal Pension System
Addressing human foibles
•automatic enrolment and set minimum contribution rate;
•design autopilot savings-investment process; and
•design autopilot conversion of financial capital into deferred life annuities.
Addressing agency costs
•create single-purpose pension co-operatives;
•foster good governance and organization design; and
•build economies of scale.