Irish Times opinion piece by Colm Fagan: "Auto-enrolment plan seriously flawed"

[Colm Fagan]

Hi @Zion2022. Fantastic post.
The answer is that my approach only works for auto-enrolled pensions, and with the constraints set out in the paper in relation to how much and when members can contribute and withdraw funds That restricts the scope considerably. For example, it excludes people who don’t work for a wage or salary, it excludes the portion of people’s earnings which is highly discretionary (the low upper limit on qualifying earnings is an important element). The low upper earnings limit also limits the scope for more affluent workers who can decide when to ‘retire’ to play the system, etc. All these requirements- and others in similar vein - ensure that smoothing will never take over the world. What it will do is allow lower paid workers compete in investment terms with their richer colleagues- and win.

 

[Duke of Marmalade]

@Zion2022 I agree that you make excellent thought provoking points. Colm has addressed them in the Irish context. Still you provoke a thought piece around what if the UK followed Ireland and then US, EU, Japan etc.
There could then be significant geo macro effects like a big shrinkage in the ERP and the other knock-on effects you talk about. As I say, a very interesting thought piece which could be part of the remit of a review by say the ESRI albeit not likely to be significant in an Irish context.

 

[NoRegretsCoyote]

There's a long and interesting thread with @Colm Fagan's ideas on auto-enrolment from 2019 here. He explains his ideas in great detail and it's worth a read.

My proposal for one fund with a smoothed return

I nearly wept this morning, hearing Regina Doherty on RTE with Rachel English, going over old ground of people having to decide whether they want to be low, medium or high risk; what happens if markets tumble on the day people retire; the carousel (probably one of the most ridiculous concepts...

www.askaboutmoney.com

 

[Colm Fagan]

Thanks @NoRegretsCoyote
I had forgotten about that.
My thinking has evolved. The proposal is now more robust theoretically.
At that time, I was relying to some extent on community spirit and inertia for workers to keep contributing if smoothed value exceeded market value. I’ve realised since then that it makes sound economic sense to keep contributing even if smoothed value exceeds market value by a considerable margin from time to time in order to capture the long term benefits of the ERP and lower costs, particularly post retirement.
I’ve also strengthened the logic around what happens when/if the fund eventually starts to decline.

 

[Itchy]

There's a long and interesting thread with @Colm Fagan's ideas on auto-enrolment from 2019 here. He explains his ideas in great detail and it's worth a read.

My proposal for one fund with a smoothed return

I nearly wept this morning, hearing Regina Doherty on RTE with Rachel English, going over old ground of people having to decide whether they want to be low, medium or high risk; what happens if markets tumble on the day people retire; the carousel (probably one of the most ridiculous concepts...

www.askaboutmoney.com

And his SAI presentation is available on YouTube

A New Approach to Auto-Enrolment. Higher pensions for half the cost

Colm Fagan has published a paper so that recipients can study its proposals in detail and form a judgement on their merits.The paper can now be accessed here...

www.youtube.com

 

[mtk]

I heard colm Fagan on newstalk this morning ( pat kenny show) talking briefly about his concerns

 

[Colm Fagan]

@Zion2022 I agree that you make excellent thought provoking points. Colm has addressed them in the Irish context. Still you provoke a thought piece around what if the UK followed Ireland and then US, EU, Japan etc.
There could then be significant geo macro effects like a big shrinkage in the ERP and the other knock-on effects you talk about. As I say, a very interesting thought piece which could be part of the remit of a review by say the ESRI albeit not likely to be significant in an Irish context.

The insightful contributions above by @Zion2022 and @Duke of Marmalade spur another thought.
The planned AE scheme for Ireland will not be as attractive to higher-rate taxpayers as a conventional pension, because workers will only get tax relief at 25% (€300 net contribution get a €100 government top-up), compared with relief at the marginal rate for a conventional pension.
However, the better value under AE under my proposal could cause some higher rate taxpayers to opt to forfeit the higher tax relief in return for a higher pension and greater peace of mind with the AE scheme.
This could reduce further the net cost of the scheme to government (on top of the lower contribution): they wouldn't have to give away as much in tax reliefs to higher earners.
Of course, workers could 'only' opt for the AE scheme in respect of the first €80,000 of earnings.

 

[Duke of Marmalade]

@Colm Fagan The tax proposal is a coc k-up pure and simple on behalf of the DSP. Their initial strawman was nigh eve to the point of embarrassment. It was to be a SSIA type initiative with tax incentive on the way in and no tax on exit. When it was pointed out how illogical this was, not least by comparison with the State Pension which is taxed, they simply decided that pensions would be taxed without thinking it through. They totally ignored that this was a less generous arrangement than conventional pensions and have left a ridiculous conflict at the interface of the two regimes. I suspect they will fix this before final commencement. It is symptomatic of one enormous blind spot in their thinking - they decided to ignore post retirement altogether and simply follow the NEST Pied Piper. In fact, at least subconsciously, that seems to be still their aim.

 

[Nermal]

'Smoothing' necessarily involves assumptions on future returns. Who's taking on the risk embedded in those assumptions?

 

[Colm Fagan]

Hi @Nermal
An assumption on future returns plays a minor role in the smoothing process, particularly at the start, but it really is minor, and becomes more minor over time. The smoothed graph can be viewed as a line cutting through market values, reducing the magnitude of the humps and hollows of market value movements. I've tried to append the graph of smoothed and unsmoothed indices if contributions were invested in the UK index between 1990 and 2019 to show how it looks pictorially. I hope my stupidity in all things technical hasn't stymied my efforts.
In case that hasn't worked, I attach the paper I submitted to the UK Institute and Faculties. That shows the same graph on the bottom of page 10. I suggest you also run through the numbers in Table 1 on page 9, calculating smoothed returns for the first six months of 2020, assuming a scheme start date of 1 Jan 2020 (just before Covid struck the stock markets). The calculations should answer your question. They show monthly unsmoothed returns spanning a 20% range (from -15.1% to +4.9%) while smoothed returns span a 0.2% range (0.13% to 0.33%).
I'm sorry if the answer to your question is a bit long-winded, but if it were child's play, it would have been done years ago. I think you'll get the hang of it quickly though if you just take 15 minutes or so to put the numbers of table 1 into a spreadsheet. It could actually be a bit of fun!

 

[Colm Fagan]

Hi again @Nermal I didn't answer the second part of your question. The "risk" when smoothed value differs from market values at a particular date is taken by members joining and leaving at that date. If smoothed value exceeds market value, contributors are paying more than "fair value". My claim is that they'll be happy to pay extra because they know that smoothing will also apply when they're getting out so that, if markets fall suddenly just before they're due to retire, and they're invested 100% in equities, it won't be of concern to them, because smoothing will save the day. That safety net allows them to remain invested in equities forever, both before and after retirement. That delivers a heck of a lot of extra value (which is quantified in Appendix 1 of the paper).
The converse is that, if smoothed value is less than market value, members exiting the scheme are getting a raw deal. That's what they've signed up for. Of course, they would prefer to hang on, and not to have to sell at an artificially low price, but they won't have an option, because their employer has turfed them out, having given them due notice, etc. I do make the point in the paper that, if employees have a lot of discretion on when they "retire", that could cause problems, but AE is aimed primarily at the lower paid, who don't enjoy the luxury of being able to specify their retirement date and, even for the more affluent who may enjoy that luxury, they can only avail of AE for earnings below the limit and even in their case they still have to give notice of intention to retire. The markets can move a lot between giving notice of intention to retire and actual retirement date. There is the further consideration that they can only claim a portion of their benefit at retirement (25% is mentioned). The balance is paid out (at prevailing smoothed values) over many years into the future.

 

[Duke of Marmalade]

Developing an earlier point.
Tax incentive for AE: 25%
Tax and PRSI relief for a PRSA: 20% up to the Standard Rate cut-off; 40% on the balance.
Auto enrolling will set up a field day for brokers who will easily argue that folk should opt out at the first opportunity and go for the much more tax efficient PRSA.

 

[Colm Fagan]

The tax proposal is a coc k-up pure and simple on behalf of the DSP.

Duke, for once, I have some sympathy for government and the DSP. Once the political decision was taken to give something to non-taxpayers, they had little option but to go down that road in terms of tax relief. If government opts for my proposal, it will be much easier to manage the two systems of tax relief because the two approaches to pension provision will be so different. That's not saying it's ever going to be easy! Financial advisers will earn their oats advising higher paid workers and employers which option to choose!

 

[Duke of Marmalade]

@Colm Fagan I too have some sympathy for the DSP; for their utter incompetence
The strawman included, amongst other things, four providers and their adviser hangers-on touting for business from low income groups; a carousel for allocating undecideds (estimated at 95%) to one of the four at random; and an SSIA type tax incentive.
All three were bonkers, and there was no straw left on the man after consultation.
The industry may be sitting smug that they have nothing to fear from AE undermining their market at the higher end of the income spectrum because of the huge distortion in tax incentive in favour of conventional arrangements. But it is as plain as a pikestaff where this is going - the much called for (by lefties) reduction or even abandonment of pension tax relief will need to be partially implemented by reducing the maximum relief to 25% to put it on a level playing field with AE.
You might be right that your approach will make comparisons of such an apples and oranges variety that tax incentives will be a side show, but the DSP were not (and probably are not) thinking along the lines you are proposing.

 

[Duke of Marmalade]

Sir, – Colm Fagan’s excellent analysis of the draft heads of a Bill for a national auto-enrolment pension scheme (“Auto-enrolment pension plan seriously flawed”, Opinion & Analysis, January 4th) must be taken very seriously and acted upon immediately. He makes the very strong case for workers who retire from such schemes to have their accounts kept in the scheme, rather than be obliged to withdraw their savings at retirement and buy a life annuity or approved retirement fund (ARF) from a private-sector provider.

Colm Fagan demonstrates how this disadvantages workers financially. First, they lose the investment benefits of being in a large, well-structured scheme. Then, to make matters worse, because the cap on charges is being removed, as in the UK, “there will be no constraint on what private sector providers can charge”. He calculates that if retired workers could continue to benefit from remaining in the auto-enrolment scheme, this “would ensure more than 50 per cent better value to members, on average”. And he greatly regrets that by removing the cap on charges, “the Irish Government is following the UK’s lead” which, he says, “left private sector players with an open goal when workers’ pension pots mature”. All those who are concerned with improving the position of future pensioners in Ireland must take heed of the careful calculations and conclusions of this actuary – a past president of the Society of Actuaries in Ireland – and unite to ensure that our Government does not “go down the UK road” on this important issue. – Yours, etc,

ROSHEEN CALLENDER,

Blackrock, Co Dublin.

@Colm Fagan , she seems to agree with you.

 

[Duke of Marmalade]

Sir, – Your article on pension auto-enrolment didn’t go far enough in its review of the draft heads of the recent Bill. Colm Fagan is quite correct in urging the draft scheme to allow members to keep their accounts post-retirement as a way of reducing the inevitable fees and charges that the pension companies will apply. But the other major flaw in the proposed scheme is that the employers’ contributions of up to 6 per cent of pay will be subject to matching employees’ contributions. This will result in the hidden incentive for employers to discourage employees from continuing in the scheme, thereby reducing the employers’ payroll costs. The purpose of the auto-enrolment scheme is to grow and encourage the employee participation in an occupational pension scheme. But some employers will be tempted to downplay the benefits of the scheme, particularly when their short-term interests will be met by employees withdrawing their ongoing participation.

To make a level playing field for all employers, and to maintain the growth of an employee’s pension fund account, the employer’s contribution should not be subject to a matching employee contribution. – Yours, etc,


Cllr DAVE QUINN,

Social Democrats,

Dún Laoghaire Rathdown County Council.

@Colm Fagan He also agrees with you (does anybody disagree?)
However his own point is faulty for if employees were entitled to the employers' contribution irrespective of their own contribution it would be a big incentive for them to opt out.

 

[Brendan Burgess]

Hi Colm

Most people who have looked at this see the merit in it. Most people agree that equity investment is the way to go during working years and into retirement. The conventional wisdom of lifestyling seems to be losing its allure

You have won a big prize from the UK Actuaries Society

So why are the people who count not convinced?

In practice, proving someone is wrong doesn't get you any support. No one likes to be proven wrong.

You need to identify where there is agreement - e.g. that 100% equities is right.

You need to identify the problem areas - but don't tell those of us who see problems that we are wrong. Listen to the points and look at the pros and cons,.

The big issue that I see is the political risk. Rather than dismiss it, you should acknowledge it and see can it be minimised.

From the punter's point of view, I get a statement in 2030 saying the smoothed value of my account is €100k and I have had a return of 4% a year. I am very happy. at the end of 2031 , the smoothed value has gone up to €110k with my €6k additional contributions. I am very happy.

But what has happened in the background?

the actual value of the fund was €100 billion compared to a smoothed value of €90 billion and "emergency measures" allowed the government to take/borrow €10 billion. I don't care as I see my fund rising anyway.

Or the fund had a surplus of €10 billion and Joe Duffy has a whole week of programmes about how the fund is robbing people by not giving them the actual value of their underlying investments.

Or there is a deficit in the fund, and Joe runs a whole week about people are forced to buy units at a price in excess of their real value.

Your technical arguments will get nowhere with the baying mob.

I want to see your proposals implemented. If they are not implemented from the start, they will be very difficult to implement later.

But if you dismiss everyone who supports you, who sees difficulties about how it will work in the real world of populist politics, then you won't get support for the proposals from the people you need to support it. I have a thick skin. I don't mind if you tell me "Brendan you are wrong , so totally wrong " But senior civil servants who will make the decisions, are much more likely to just want to get the AE implemented and to hell with anything innovative which they don't understand.

The civil servants don't want anything new. If it was such a good idea, they would have thought of it themselves. They completely dismissed my proposal for allowing home owners to borrow from the fund to get on the housing ladder. They didn't even discuss it in their proposals. They are only interested in this scheme and can't see the problems it will cause for first time buyers.

But Ministers change and maybe a new minister will see the merits of your proposal and mine. When I eventually convince someone of the merit of my ideas, they can be added on. But it will be very difficult to add yours on if AE is up and running.

Brendan

 

[Colm Fagan]

@Duke of Marmalade. Getting back to your earlier point on tax relief, my high-level conception, assuming government finally opt for the smoothed approach to AE, is that it will be seen as the poor man's (or woman's) pension. No bells or whistles. Everyone in the same smoothed fund, before and after retirement, no choice on where their money is invested, no chance of shooting the lights out by choosing wonderfully performing investments, by jumping in and out of the market to take advantage of irrational booms or busts, etc.. No. All they have is something that looks just like a deposit account and that pays an average interest rate of 4% more than the post office.
The more sophisticated, high-earning employee won't want to be stuck with such a simple concept. They'll want all the bells and whistles and the freedoms that go with it. They'll also want the higher tax relief. So they opt for a more conventional pension, typically a unit-linked one, either through their company scheme or an individual arrangement.
Things change though when people see the smoothed fund deliver higher long-term returns than the pension with all the bells and whistles, and with extremely low variations in quarterly returns to boot. Then, some of the higher earners may decide that, to hell with the higher tax relief and the exciting ride through the markets, they'll be happier to take the pain of lower tax relief (implicitly) and move to the smoothed fund.

 

[Colm Fagan]

the actual value of the fund was €100 billion compared to a smoothed value of €90 billion and "emergency measures" allowed the government to take/borrow €10 billion. I don't care as I see my fund rising anyway.

Brendan.
I don't know what you mean by "emergency measures". I never mentioned anything of that nature in anything I ever wrote. It's a complete fiction. Giving readers the impression that there's a possibility of government taking something called "emergency measures" to rob them of their money could be classified as scaremongering. Those of us who occupy positions of trust should avoid scaremongering.
The directors/trustees have an obligation to look after every cent and ensure that it's accounted for correctly to members - and to the auditors, regulators and the world at large. The fund's market value and cash flows are calculated every quarter (or more frequently) and a smoothed return is calculated every quarter based on that market value and those cash flows. If someone takes money from the fund, through "emergency measures" or otherwise, the market value falls and the smoothed value falls, and the smoothed return falls. It's all completely transparent and auditable.
As you know from your own investing experience, the value of an investment only matters when you're selling it. Only a small proportion of the members are selling their interest in the fund in any given quarter - those who are retiring, or have already retired and are drawing a pension, or those who die in that quarter. The value at which they sell is the smoothed value. The value for everyone else will be the smoothed value when they eventually take a gratuity, a pension instalment, or die. I've shown that smoothed value will always track market value on average. I've also shown that members can rest assured that they will always get the smoothed value when their time comes. Smoothed value will be calculated in exactly the same manner for everyone, irrespective of when they take their money. There is no bias in favour of early or late leavers. The "exit value equals market value on average" mantra works even if the scheme closes completely to new entrants and assets eventually fall to zero. That should reassure everyone.
If smoothed value is above market value at a particular date, smoothed returns for the next quarter, possibly for the quarter or quarters after that, will be lower than if smoothed value was below market value at that date, and vice versa, but the smoothing mechanism - which is completely objective, to such an extent that apps will be made available to enable members to project what smoothed returns will be over the next month, six months, year, whatever, based on whatever projected market movements they put into the app - will always bring smoothed values back to market values eventually.
That "eventually" can happen very fast, especially in the early years. The example of table 1 on page 9 of the paper shows that, even after markets have fallen by 15.1% in March 2020 with a smoothed return for that month of +0.13%, smoothed returns for the next couple of months are lower than market returns as expected (while still positive) but smoothed and market values are back in sync by end June.
It really is worth taking a few minutes to work through that example.

 

[Colm Fagan]

@Brendan Burgess
I should have added that retirees and deaths in the early years will "sell" their investments to incoming and continuing contributors. The transaction will be completed at whatever the smoothed value happens to be at that time. Both parties will see it as a fair transaction. It may be below market value, in which case those exiting are "losing" and those joining or continuing to contribute are "winning", but everyone can see the fairness of it all in the long-term.
The key concern is whether new and continuing contributors will be happy to buy from leavers if the price at which they're being asked to buy (the smoothed price) is greater than market value. What I'm saying is that it will still be worth their while, even if they have to pay up to 150% of market value, possibly more, because the peace of mind provided by the smoothing mechanism will allow them to remain fully invested in equities forever, in the lead-up to retirement and all through retirement. The resulting higher long-term returns make that (temporary) 50% (or whatever) extra cost on that particular contribution date well worthwhile.
So, taking your Joe Duffy question, it can be explained to him as A selling their assets to B at a price agreed between the two of them, which differs from market value, because they're both happy to deal at that price, because it eliminates all the distortions caused by crazy market movements. They both realise that it's in their mutual long-term interests to deal with each other at those prices rather than at volatile market prices.