Default Investment Strategy

[Duke of Marmalade]

Now that the Bill has been published we have a better idea of what the default investment strategy (DIS) will be:

(3) Subject to subsection (7), the risk levels for the purposes of this Part are:
(a) the higher risk level, consisting of AE provider schemes with a risk rating of 5, 6
or 7;
(b) the medium risk level, consisting of AE provider schemes with a risk rating of 3
or 4;
(c) the lower risk level, consisting of AE provider schemes with a risk rating of 1 or
…
(4) Where subsection (2) does not apply [that is where the punter did not choose a risk level as over 95% do not in the UK], the appropriate risk level, subject to
subsection (5), is:
(a) where the period before the participant reaches pensionable age is more than 15
years, the higher risk level;
(b) where that period is 15 years or less, but more than 5 years, the medium risk
level;
(c) where that period is 5 years or less, the lower risk level

If the PRIIPS risk ratings are what is being referred to here, these are they:

First of all one has to say that this is a heck of an improvement on NEST in the UK with its 40+ lifestyling funds. But it is an extremely flexible description. Typically one takes the risk (volatility) of a 100% equity linked fund to be 20% or on the border between rating 3 and 4 in the above Table. Higher than 20% indicates either gearing of a 100% conventional equity index or a very racy investment strategy. (Even bitcoin with a volatility of 65% wouldn't make the cut for rating 7 ) .
So at one extreme the DIS would take a higher risk than 100% in a typical equity index up until 15 years before retirement, 100% conventional equity until 5 years before retirement and then 50% equity thereafter (for nerds 5% volatility = 1/2 of a volatility of 20% = square root).
At the other extreme it could mean 100% conventional equity up until 15 years before retirement, 50% conventional equity until 5 years before retirement and cash thereafter.

 

[Duke of Marmalade]

It can be seen that there is an awful lot of clarity still remaining on what exactly the DIS will entail.
As I said, IMHO it is better than lifestyling but it does involve a couple of "precipices" whereas lifestyling is a gradual process.
We note that the whole rationale behind the proposed DIS is a firm belief in the ERP. And yet one of the reasons for the PC to reject the smoothing suggestion was that one can't be sure of the ERP in future!
In passing note that the Bill says nothing at all about the taxation of benefits (or any tax relief on contributions).

 

[Itchy]

Annualised performance over the last 5 years for the best fund (and worst in brackets) in each risk rating category:

High (6): New Ireland Technology Indexed Fund Gross 23.46% (-3.1%)
Medium (4): New Ireland Goodbody Dividend Income 4 Gross 8.93% (-4.48%)
Low (2): Mercer Aspire Stability 0.36% (-0.94%).

Data: funds.irishtimes.com. Returns are gross.

Gives an idea of the range of returns in each category and the price of volatility. The PC have alot to answer for in my opinion. Colm's idea deserves a more thorough and respectful analysis.

 

[Colm Fagan]

Colm's idea deserves a more thorough and respectful analysis.

Thanks, @Itchy I've been feeling down today, starting to fear that they'll finally succeed in burying my proposal for good. Your comment has cheered me up a bit. It would be great if you and people of like mind could do all you can to get what you nicely call "respectful analysis".

 

[Colm Fagan]

I've had a quick look at the Bill. It seems from first glance that the drafters don't know how such schemes work. Another possibility, of course, is that I'm so dumb on legal matters that I've misread the intentions. That is very possible.
Section 72 reads that
"Subject to any fees payable under regulations made under section 35, an amount assigned by the Authority to a risk level, in accordance with section 70(1), shall be transferred by the Authority to the investment management providers."
Section 35 (referred to in Section 72) reads:
(1) The Minister may, having consulted with the chief executive and with the consent of the Minister for Public Expenditure, National Development Plan Delivery and Reform, prescribe—(a) the fees payable to the Authority in relation to the performance by it of its functions,(b) the fees payable to the Authority for the purpose of meeting the cost of services provided by investment management providers,(c) the persons by whom such fees are to be paid,(d) when such fees are to be paid, and (e) any general or specific exemptions from the payment of fees, and different provision may be made in respect of different classes or types of functions and different services or activities provided or carried out by the Authority in connection with the performance of those functions.
(2) In prescribing the fees payable to the Authority under subsection (1)(a), the Minister shall take account of the expenses incurred by the Authority in the performance of its functions.
(3) The chief executive shall determine—(a) the manner or method of payment of any fees payable to the Authority, and (b) the form in which the payment of any such fees shall be recorded, including the provision of a receipt in respect of such payment.
(4) The expenses incurred by the Authority in the performance of its functions shall, to such extent as may be sanctioned by the Minister for Public Expenditure, National Development Plan Delivery and Reform, be paid out of moneys provided by the Oireachtas.

I'm not a lawyer, so I may misunderstand it, but they seem to think that the way it works is that the member makes a contribution to the scheme, from which there is a deduction to cover the costs of running the scheme (e.g., Section 35 refers to taking account of expenses incurred in deciding how much to charge.)
They don't seem to recognise that revenues and costs inhabit different universes.
Revenues are the income from regular management charges, which the 14% contribution calculation assumes will be 0.5% of AUM per annum. Expenses are the costs of running the scheme.
In the early years, the cost of running the scheme will vastly exceed revenues. The excess will be covered by a loan from the Exchequer, which (it is hoped) will eventually be repaid when the scheme is mature and management charges exceed expenses.
That is what I have assumed in my calculations for the smoothed scheme and it is what happens for the UK's NEST scheme.
The principle should be that the taxpayers are only on the hook temporarily and that the money they advance to cover costs in the early years are projected to be repaid (with interest) eventually.
That will be a very tall order for the scheme proposed by the DSP. An indication of the scale of the challenge can be gleaned by looking at NEST.
At 31 March 2023, it had a cumulative negative balance due to the Exchequer of £918 million, having added a further £110 million to the loan in the preceding 12 months (some of which was one-off). This was despite being more than 10 years on the road and having all that time to build up a head of steam. They project to have repaid the loan from the Exchequer by 2038. NEST's charges against members' funds up to now have been higher than the 0.5% of AUM proposed for Ireland; they have around 10 times the number of members. You don't have to be a rocket scientist to work out that it will be impossible for the Irish scheme ever to break even at 0.5%. Is the government prepared to keep funding this as a loss-making venture forever? Would the EU allow it (unfair competition with private sector)? Do they plan to increase the charge beyond the proposed 0.5% in order to show that it will eventually wash its face? If so, then will they have to increase the contribution rate from 14%, which is the required contribution for an "adequate" pension assuming a management charge of 0.5%? The required contribution for an adequate pension will obviously be higher if the management charge is higher.
Am I misunderstanding what's intended?
As far as I can see, there is no indication as to whether the charge will be 0.5% or higher.
There is also a reference in Section 74 to buying insurance policies. When would an AE scheme invest in insurance policies?

 

[TheJackal]

You don't have to be a rocket scientist to work out that it will be impossible for the Irish scheme ever to break even at 0.5%. Is the government prepared to keep funding this as a loss-making venture forever? Would the EU allow it (unfair competition with private sector)? Do they plan to increase the charge beyond the proposed 0.5% in order to show that it will eventually wash its face? If so, then will they have to increase the contribution rate from 14%, which is the required contribution for an "adequate" pension assuming a management charge of 0.5%? The required contribution for an adequate pension will obviously be higher if the management charge is higher.
Am I misunderstanding what's intended?
As far as I can see, there is no indication as to whether the charge will be 0.5% or higher.

I'd say not alone will the fee start out higher than their 0.5% goal, it will also go up in time once they realise the liability to the Exhequeuer is only going one way

 

[Protocol]

I understand why there will be losses initially, as the funds will be small.

But after a few years, with 500,000+ members, surely 0.50% AMC is plenty?

I see many Vanguard funds with expenses ratios of about 0.10%:

 

[Duke of Marmalade]

I understand why there will be losses initially, as the funds will be small.

But after a few years, with 500,000+ members, surely 0.50% AMC is plenty?

I see many Vanguard funds with expenses ratios of about 0.10%:


View attachment 8729

Investment management fees are a minor element of the costs. 15bps is oft quoted as typical. The real costs, especially for this universal scheme, will be adminsitering all the employers and contributors as they opt in and out and switch around jobs etc.
Irish Life in their submission on the strawman in 2018 said 75bps were needed to take on any of the admin, but they were careful to suggest that the CPA would take on a lot of the heavy lifting. But as the department shifted the goalposts Irish Life had no problem telling the JOC that they could manage within 50 bps as the deal had altered to the providers only providing investment management.
On the metrics, the NEST fund with 12 million members has a fund of £30bn after 12 years. We will be doing well to have a fund of €3bn. 50bps of €3bn is €15m p.a.; doesn't sound enough to me.

 

[Duke of Marmalade]

EY have done some calculations of final pension pots under the investment strategy proposed in the AE Bill. I attach my spreadsheet where I attempt to match their figure of €888,576 at retirement for a 23 year old, I calibrated to get €889,995. I get that they drop the net return on the fund from 4.5% p.a. to 4% p.a. 15 years to retirement and then to 3.25% p.a. 5 years out. This is "lifestyling" lite and a big improvement on the strawman. The spreadsheet also compares it with Colm's proposal below. Note that Colm's proposal really comes into its own post retirement. The independent expert calculated that Colm's approach was 144% better than lifestyling for the lump sum at retirement but 239% better for pensions in payment.

Table of Retirement Pots​
Age​	AE/EY​	Colm​
23​	€889,995​	€980,472​
24​	€838,577​	€923,401​
25​	€789,630​	€869,079​
26​	€743,042​	€817,381​
27​	€698,707​	€768,189​
28​	€656,523​	€721,391​
29​	€616,393​	€676,876​
30​	€578,224​	€634,542​
31​	€541,926​	€594,290​
32​	€507,415​	€556,024​
33​	€474,609​	€519,655​
34​	€443,430​	€485,096​
35​	€413,805​	€452,263​
36​	€385,662​	€421,079​
37​	€358,933​	€391,467​
38​	€333,554​	€363,355​
39​	€309,462​	€336,675​
40​	€286,598​	€311,360​

 

[Colm Fagan]

@Protocol
Following @Duke of Marmalade's reply to your question as to why 0.5% won't be enough, I looked at the accounts for NEST. They have something like ten times the membership that the Irish scheme can ever hope to have. Also, while their charging system is a combination of a percent of assets under management and a charge on contributions, it works out at more than 0.5% on AUM in the early years.
NEST started around 2012, I think, so it was more than a decade old at the March 2023 balance sheet date. It should have had some level of maturity by then, but was still haemorrhaging cash - a loss of over £100 million in the year to March 2023 - and owed a cumulative £918 million to the DWP (the sponsoring Department). I've shown the summary balance sheet position at that date below.
Paschal Donohoe's Department (whatever it's called) is supposed to agree the management charge with the DSP. I was told that discussions started over a year ago, but there's no word as to whether they've ever agreed a figure. I doubt it.
As an aside, NEST's loss of over £100 million in 2023 is because of a botched attempt to try to change Third Party Administrators. Without the IT cock-up, they should have been finally close to breaking even in 2023 (after which they would start to repay previous years' borrowings).
They had been with Tata from the start, but had spent a couple of years (and massive amounts of money) planning a spanking new system with some other lot, having told the world that Tata didn't cut it for all sorts of reasons. It all ended in tears and they had to go back to Tata with their tail between their legs, and had to write off the massive amounts they'd spent on the other provider.
I understand that Tata are the frontrunners to get the admin for the Irish scheme.

 

[Duke of Marmalade]

It was actually worse. DWP loan £1.132 bn vs £994m the year before.

 

[Colm Fagan]

@Duke of Marmalade Ouch! Shows why I'd never have made an accountant!

Worth adding the following from the 2023 accounts, for clarity:

 

[Duke of Marmalade]

If the PRIIPS risk ratings are what is being referred to here, these are they:
View attachment 8715

Below is what the Bill actually says. So still a lot of clarity needed. I wonder what EY assumed in their calculations. (By the way, the Bill certainly piles a lot of further work for the Minister. He or she will be kept very busy )

(6) In making regulations under subsection (5) the Minister shall have regard to—
(a) any scale and methodology applying under an enactment or European Union act
for the purpose of indicating the level of risk of a UCITS or alternative
investment fund, [I think this is the PRIIPS scale above]
(b) custom and practice in the financial industry in applying scales and
methodologies referred to in paragraph (a) or other scales and methodologies for
the purpose of indicating the level of risk of a UCITS or alternative investment
fund [this obviously refers to your Zurich PRISMAs and Irish Life MAPS etc.]

 

[nest egg]

A little off topic but the Govt's scheme was discussed on the IT's Inside Business podcast. The guy interviewed was highly sceptical AE would be introduced this side of a general election.

https://shows.acast.com/irishtimesi...ent-pension-scheme-seems-good-on-paper-but-ho

 

[Itchy]

I wonder would Ciaran Hancock have you on the podcast to speak about the alternative @Colm Fagan? Perhaps Brendan has the contact? Raising awareness of the alternative, now that its been validated, would be a good way to stoke the conversation (which is external pressure on the PC).

 

[Colm Fagan]

Thanks for the suggestion, @Itchy I'll leave it for now, as I have a couple of other irons in the fire. I'll see how those pan out first. I'm also heading off for a short break. My wife asked me to promise that I'd go easy on smoothed AE while we're away. I gave her a vague answer!!!