Stuffing guarantees into DC pensions is a recipe for disaster warns Teresa Hunter
Pensions minister Steve Webb wants to offer private sector workers with defined contribution pensions some underlying security in retirement, possibly through a guarantee.
And a very noble aspiration it is too. There is nothing more soul-destroying than “doing the right thing” and saving for retirement, only to watch your hard-earned cash consistently fall in value, thanks to a combination of volatile markets and high charges.
But guarantees are a bit like sausages. It helps if the consumer doesn’t see what goes into them – and when they go bad they cause a disgusting stink.
It costs money, a great deal of money, to provide any form of viable guarantee. Doing it on the cheap with an eye to a fair wind is a recipe for disaster, as the demise of final salary schemes, Equitable Life, with-profits and a host of other failed guarantee options testify.
The result of those failures has led to substantially increased regulation. Indeed, the minister may be powerless to press ahead with his “guarantee” scheme, without first unpicking some of this armour-plating, which, as a Liberal, he will be loathe to do.
Pension lawyers are already warning that any pension with a guarantee is legally a defined benefit scheme, and must be regulated accordingly. If they are correct, Webb’s proposal is dead in the water.
Insurers too, if “invited” to offer these guarantees would face a capital mountain hurdle. Some already warn of the moral hazard. If fund managers know their underperformance will be picked up by an insurance guarantee, where is the incentive to outperform?
It’s hard to ignore unpleasant echoes from the mortgage market, where indemnity insurance picked up the bill for poor lending decisions.
All of that said, guarantees do already exist, and sales are soaring, expected to top £1.3 billion this year. The public like them and they are an easy to traumatised investors who have lost all appetite for risk.
MetLife, Axa, Aegon and MGM are among companies already offering a range of income or capital guarantees. Aviva has a guaranteed fund on the drawing board, although details have not yet been hammered out.
Companies already operating in the arena are at least honest about how much such guarantees cost, adding anything up to 2.25 per cent annually in additional charges.
So you need to make some heroic assumptions about growth to be able to justify recommending them. Hargreaves Lansdown has estimated that you need growth of more than 8 per cent for investor to be quids in, if an adviser takes maximum commission, although this figure will fluctuate between different contracts and commission rates.
The minister has something more modest in mind, such as a simple money-back guarantee. He believes this could be done for a charge of 0.75 per cent. Cue snorts from the experts.
But let us accept he is correct. Stakeholder pensions, thought to be cost effective, allow for a management charge of up to 1.5 per cent in the first ten years. Add 0.75 per cent and a 2.25 per cent charge is going to swallow a hefty chunk of any return these days.
Or to put it another way, why reduce your return by anything up to a fifth each year, to “guarantee” that in 40 years time, you get your inflation-nuked money back? The OECD has calculated a 24 per cent annual cost of an inflation-linked guarantee.
But with any form of retailing, it is incumbent on the provider to give customers what they want. As with sausages, the consumer will be entranced by a well-packaged item, that has plenty of comfort on the wrapper, as long as no one explains what it is made of.
It is only if you clearly spell out to mum that she will be serving her children blobs of fat, blood, gut, ears, and any other left over parts swept up off the butcher’s floor that she holds her nose.
Even Nest, the ultra cautious pension provider, balked at guarantees. It modelled thousands of approaches, but decided a low risk investment approach to avoid disillusionment in the early years would produce a higher return than a guarantee.
Guarantees only seem to work when they are backed by a bottomless pit of cash. Money trees don’t grow in private sector gardens.