Issue: September/November 2008
Liberty Life

From others' experience

A specialist study for Liberty Life offers a thoughtful contribution to SA’s process of pensions reform.

No one country’s retirement system can be held up as an answer to the particular challenges facing SA, but reforms elsewhere raise useful questions about aspects of overseas systems that might be right.

Compulsory or voluntary?

A fundamental consideration for any government considering wholesale pension reforms is whether contributions into a tax-qualified pension plan should be mandatory or voluntary. Singapore, Australia, Switzerland, Chile, and to a lesser extent Sweden, decided that people generally would not voluntarily save. Changing savings behaviour is tough but achievable if a government convinces them that mandatory contributions are not just another tax and that they will benefit from deferred consumption.

Failure to do this risks reputational damage for a government, poor compliance, erratic contribution patterns and loss of public confidence. Australia, Sweden, Chile and Singapore embraced major government-sponsored public education campaigns and sought industry support to avoid these risks.

What to do with the existing pension industry?

Where there is a well-developed financial services industry, it makes sense to use existing expertise and infrastructure – properly regulated by bodies with the legal duty and resources to safeguard the consumer interest and welfare. A competitive financial services market is more likely to offer low costs, higher returns and efficiencies in terms of investment allocations and distribution strategies than a bureaucratic and centralised system geared to a one-size-fits-all approach to investment.

As in Singapore with a national provident fund, transparency can often be lacking when government agencies become centrally involved in maximising investment returns and handling complex and extensive administration capacity. Singapore’s policy of using the national retirement programme to generate social development and economic outcomes is also a good example of what can happen when individual welfare is not given primacy over the macroeconomic objective.

Investment expertise is particularly important in mandated systems, given the widespread reluctance of savers to choose investment funds or spread their risk effectively. The design of default funds is important. Designers of new systems have the opportunity to look at how behavioural finance is being used in the US to automate and optimise fund choice around the life stages of plan members.

Another good reason for utilising existing industry infrastructures is to preserve the status quo for existing pension scheme participants. Care must be taken that, in improving retirement saving for the majority, no damage is caused to those who are already contributing and dependent on retirement plans.

A criticism of the UK’s proposals for “soft” compulsion is that a new, universal national scheme could cause a levelling down or closure of good private and occupational schemes. Employers making more generous contributions into existing defined-contribution structures might decide that they want the cost-contained government-backed retirement product instead.

How is the consumer interest to be protected?

Widespread contracting out of state benefits, seen in the UK in the 1990s, is a striking example of how individuals can be convinced to act against their own interest. Pension regulation must be proactive to minimise this kind of risk.

But a balance has to be struck. Oppressive or prescriptive regulation, especially around investment strategies, can lead to poor innovation and risk aversion, which negates some purpose of pension reform.

Investment return is a major factor in shaping individuals’ retirement outcomes. Maximising return is an objective of a competitive market. Through intense regulatory scrutiny, intermediated and peer review and public disclosure, a competitive market will put pressure on investment managers, advisers, trustees and financial services entities to maximise rates of return for the consumer. In Australia, since introduction of compulsion, funds management has largely been outsourced by employers to fund managers via advisers and consultants. Large parts of the administrative and operational functions are also outsourced to third-party administration entities that seek to generate return on capital by economies of scale. Life insurers and fund managers participate to differing extents in order that customer relationships with employers, trustees and employees are secured.

There can be unintended consequences of seeking investment guarantees on pension assets. Switzerland and Chile see guaranteed rate of return as highly desirable for individual consumers, but consequent conservative investment strategies and prescriptive asset allocations have tended to produce returns that are achievable rather than optimal. The UK and Australia enjoy significantly higher rates of return by adopting a “prudent person test” for investment strategies, monitored by regulators.

What can be done about fees and charges?

The subject of administrative fees and charges can be emotive. The UK, and to a lesser extent Sweden, have tried price capping and cost containment, but neither has impacted well on the industry.

Many of their financial services entities consider that the regulations and policy prescriptions, along with a price cap, make profitability and sustainability unachievable. There are negative consequences for shareholders and policyholders alike. Economies of scale and market efficiencies failed to materialise. Many financial entities refused to participate, withdrew or severely limited their offerings.

Reforms need to make commercial sense for the financial services industry to participate. Australia and Chile provide powerful lessons for SA in allowing competitive market forces to dictate the level of charges and commissions being paid on retirement products and their related distribution. Initially, both countries experienced high levels of charges and commissions. But as the systems matured and economies of scale began to occur, charges and fees fell to more acceptable levels.

Behind the Liberty Report

With debate over SA retirement fund reform in full swing, Liberty Life commissioned a study from David Harris of TOR Consulting in Australia. It examines the experiences of six countries – Australia, Chile, Singapore, Sweden, Switzerland and the UK – in the vanguard of pensions reform. This is an edited version of the report’s conclusions for SA.

In his preface, Nick Sherry (now Minister for Superannuation & Corporate Law in Australia) writes: “In some 20 years of involvement as a trustee and fund secretary, then a policy legislator, a strong emphasis on basic principles ensures the best outcome for all participants.”

What ensures a self-funded retirement?

Increasingly, reforms need to address the method by which consumers utilise their retirement savings.

Australia is criticised for allowing many retirees to take their retirement savings as a lump sum rather than convert them into an annuity or allocated pension product. The argument expressed by some politicians is that a taxation deterrent should be applied to change this trend, but it is not easy at election time to be seen dictating how retirees should use their retirement savings.

 Other countries – such as Chile, Singapore and the UK – are more prescriptive. They believe retirees should be forced into largely retirement-stream, mortality-based products for retirement savings to cover extended life expectancy. As is often the case, a balance has to be struck between allowing individual choice and ensuring collective economic wellbeing.

Ultimately, the success of reform is about sustainability and finding a system that will progressively move individuals from state-funded to self-funded post-retirement income while continuing to provide a welfare safety net. This self-funded income must be sufficient to meet reasonable, rather than merely adequate, expectations in retirement.

Experiences in the six countries covered indicate that any new system should involve existing industry in design, implementation, distribution and investment strategies to ensure competitive market pressures are applied to costs and investment performance. Investor information and education will be key in building engagement with pension plans for the new ethos of self responsibility.