The specifics might be arcane, and the topic (pensions) might be boring, but the promise is huge: double the size of your pension for the same amount of contributions.

That’s what Colm Fagan, a former chairman of Standard Life International and former President of the Society of Actuaries in Ireland, thinks is doable. 

Last week Fagan presented a paper to the Society of Actuaries in Ireland entitled “A new approach to auto-enrolment — higher pensions for half the cost”.

The background here is that the government is working on a new plan for the pension system. It foresees people aren’t saving adequately for retirement, and it wants to put things right.

The government’s solution is still being worked out. But it’s going to involve some kind of scheme into which workers will be automatically enrolled. And it’s going to involve the government kicking in about a seventh of the contributions, with employers and employees covering the rest. The government estimates we’re going to need to save 14 per cent of our income each year to build up a reasonable pot.

According to Fagan, we can get the same result for half the price. If he’s right it could save government billions, and make our retirements much more comfortable.

Risk and reward

If you’ve sat down with a pensions advisor before, they’ll have told you about how your pension pot changes over the course of your life.

When you’re young, you won’t need the money for decades. So the pension provider invests the pension in riskier stuff that returns more. Stocks, in other words.

When you’re older, you need the cash you’ve built up in order to pay for living expenses. As a retiree, you definitely don’t want the value of your pension pot to drop by a quarter in a month, as happens in the stock market from time to time. So you want your savings parked in something whose value is stable. Bonds, in other words. 

So as you get older, they gradually move your pension over from stocks to bonds. There’s a rule of thumb called the hundred-minus-age rule that says the right amount of stocks in your portfolio is equal to 100 minus your age. So when you’re 30, it’s 70 per cent stocks. When you’re 70, it’s 30 per cent stocks. There are other rules for deciding how much to allocate, but that’s the general principle. 

This is a sensible approach, because at age 70 you don’t want your ability to cover your health insurance bill to be tied to the stock market. But it’s undeniably annoying. The return on bonds at the moment is close to zero. Even at the best of times, the return on bonds is in the low single digits. Having 70 per cent of your money parked in bonds is not unlike leaving it in the credit union. The returns are about the same. 

Colm Fagan’s idea is a new way to organise savings for retirement. It offers the best of both worlds: stock-like returns with bond-like security. It’s so simple I’m annoyed it never occurred to me (and I’m wondering if there’s a catch I haven’t yet spotted — email me at [email protected] with your ideas).

Colm Fagan

More, together

What Fagan proposes is – as he offhandedly called it – a meitheal fund. What this means is that instead of everyone keeping individual, segmented pension funds, Irish savers would pool their money. 

In this system, the fund would be made up of the savings of a diverse group of people of all ages. Some would be putting money in, some would be taking money out. Thanks to this – and some rules, which we’ll come to later – there would be no need for the fund to have safe, low-yielding assets like bonds. It could be invested 100 per cent in stocks, which are high-yielding.

Bonds, remember, are like money in the credit union. They don’t return much. And they’re certainly not going to return much in the coming decades, based on their current prices. 

The extra return an investor gets for investing in stocks is what academics call the equity risk premium. Over time, it’s been about three to five per cent, depending on which country you’re looking at. By keeping the meitheal fund 100 per cent in stocks, everyone gets all the benefit of the equity risk premium, all the time. None of this 100 minus your age craic.

A couple of extra per cent on your annual return probably won’t set your pulse racing. But, as ever with investing, it’s all about the long run. Fagan calculates that his scheme will more than double the size of a participant’s pension pot; or alternatively will halve the amount of contribution needed to reach the same pension pot. 

Another benefit of the scheme is that its value would be derived from a formula that smoothes out the ups and downs of the stock market. Checking their pension account, savers wouldn’t be confronted with the stock market’s massive spikes and crashes. Their slice of the scheme would appear to them as a particularly high-yielding savings account.

Fagan is keen to point out: this isn’t a free lunch. The big catch here is that savers would have to commit to the fund. If they leave the fund, they wouldn’t be able to take their assets with them. They can only withdraw funds upon retirement, or death. And when it comes to taking money out – after getting a lump sum – people must spread their withdrawals out over many years. 

Another issue is costs. As I’ve written before, costs are a scourge in the Irish pensions industry. Academics from Maynooth and TCD have estimated total costs to come in at 2.2 per cent per year for Irish pension funds. And costs in retirement — when the drawdown process begins — are higher than in the earning period. 

In a normal defined contribution pension scheme, the scheme matures when a person retires. Then it’s time for the person to go back to the industry for a new product, like an ARF or an annuity. The fees on these products are even higher than for the funds.

The meitheal fund is intended to run continuously, from the moment a person starts saving to their death. And because the scheme is conceptually much simpler — one giant equity fund, instead of the panoply of funds on offer today — costs should be much lower. Fagan estimates it could be invested passively in a global equity index fund, with total costs of no more than 0.5 per cent. This compared to the 2.2 per cent estimated to be charged by our existing defined contribution schemes. 

The scheme would produce a giant pot of money. Who would manage it? Who would control it? This is an important consideration. A meitheal fund under political control could easily get into trouble. Would a future government be tempted to raid the fund, or ask it to invest in worthy Irish projects, or worthy Irish companies? The promise of the fund is that it can return more by being invested in global equities. To be effective, says Fagan, it would need to be fully autonomous and independent. “This is where the trustees earn their money”, he says. 

Rachel McGovern of Brokers Ireland is not a fan of the government’s proposed auto-enrolment scheme, a cousin of Colm Fagan’s scheme. It would, she says, “Make small schemes unviable.” As for the savings on fees these schemes say they’ll deliver, McGovern says she has “Yet to see any evidence of it.” People want choice in their pension plan, she says: “One size does not fit all.”

My own doubt about the Fagan scheme is that it seems too good be true. Why haven’t collective pension funds like these been invented yet?

Fagan and his research partner Brian Woods have run over 2,000 simulations on the model, and found it robust to all kinds of market conditions. For his part, Fagan says he wants the government to throw a small amount of money at the proposal and have the Central Bank or ESRI kick the tires. What’s Fagan’s interest in this? Retired himself, he says “I do it because I care about the pensions jungle facing my children and grandchildren.”