The Institute and Faculty of Actuaries (IFoA) is the professional body for actuaries in the UK. It’s the body that regulates and accredits British actuaries.
This year, the IFoA staged an inaugural competition to reward innovative ideas in the field. The question posed this year was: What would be a sustainable and effective pension system? The judging panel was chaired by the esteemed economist Sir John Kay.
On Thursday night, at an awards ceremony in London, the retired Irish actuary Colm Fagan shared first prize for his submission, A New Approach to Auto-Enrolled Pensions.
Fagan’s paper isn’t a technical matter, of interest only to professional actuaries. It’s fair to say it has the potential to be revolutionary.
What it’s offering is a way to improve the performance of the pension system by up to 70 per cent. That is, for a given level of savings, Fagan says his system could increase the size of people’s pension pots by 70 per cent or more. Or, a given pension pot could be achieved with two thirds the amount of contribution. This is strong stuff!
In our current system, to end up with a pension covering 50 per cent of pre-retirement income, a 30-year-old needs to be putting away 17.2 per cent of their gross salary, according to the Pensions Authority calculator.
Under Fagan’s system, the 30-year-old saver could hit their targets by only saving 11 per cent of their salary. It’s the equivalent of a good-sized pay rise for every saver in the country.
The basic problem with pensions is that people don’t save enough. 47 per cent of people worry they won’t be able to retire. Even among the most engaged savers, with their spreadsheets, not many are on track to retire early.
From the state’s perspective, the cliche is that pensions are a time bomb: in a couple of decades, there will be many more retired people than today, and a big chunk of the retired won’t have enough savings or assets to live comfortably.
Solving this is a hard problem. The problem has two legs. The first leg is that people don’t like thinking about or organising their pensions. So they don’t do anything. And when it comes to long-term savings, inaction is a killer.
The second leg is, even if one is paying attention, it’s simply hard to put away enough money. As we’ve seen, a 30-year-old saver needs to put away about 17 per cent of their income per year. For most, that’s just not possible. Life is too expensive. Housing is too expensive.
The government has made a stab at solving it this year, with the belated launch of its auto-enrolment pension plan. The plan has strengths and weaknesses.
The strengths are the auto-enrolment aspect and its relative simplicity, the generosity of the subsidies, and the low fees during the saving period of the plan.
Its big weakness of it is the drawdown phase. Under the government’s plan, once you hit retirement, you need to buy a post-retirement product. That’s when the industry makes its fees on you. Fagan calculates that pension providers’ gross margin is 10x greater for a customer who is at retirement than one in their early years of saving.
The other weakness is that the expected returns are about 50 per cent smaller than Fagan thinks are achievable under his scheme.
Fagan’s idea will be counterintuitive to most investors, who by their nature are individualistic. Investors are all about taking responsibility for their own affairs. Their goal is to make themselves independent of other people (financially at least). They achieve their goal by shrewdly choosing the best possible strategy of the hundreds available to them.
Fagan’s scheme, by contrast, takes the individual out of the investing process. Savers in his scheme would get no choice of strategy. They would get no opportunity to leave the scheme, apart from upon retirement or death. They would have to withdraw their money according to a strict and inflexible timetable. Their pension contributions would be lumped into a giant pot, with everyone else’s. But by way of compensation, the saver would end up with a lot more money.
How does it work? It’s all about harnessing something called the equity risk premium. The equity risk premium is the extra money investors get to compensate them for the riskiness of investing in stocks.
Stocks return 7-10 per cent per year in the long run. The catch is that they’re volatile. For that reason, they’re not suitable for anyone who will plans on cashing in their investments soon — ie savers in their 50s and 60s. Older savers are better off with bonds, which are more stable but lower-returning.
In our current system, everyone has an individual pension account. The account gets allocated to stocks when the saver is in their 20s, 30s and 40s, and gradually shifted into bonds as they hit their 50s and 60s. The idea is that the account grows fastest in its early days and is at its most stable close to drawdown.
Fagan’s idea is that, by pooling people’s pension pots, there will be no need to reduce the allocation to stocks over time. That’s where all the extra money comes from. By staying 100 per cent in stocks at all times, everyone gets 100 per cent of the benefit of the equity risk premium from day one to the day they draw down.
A separate problem that comes with investing 100 per cent in stocks is the sinking feeling you get when the market falls. This is a problem whether or not you need to cash in any time soon. Just knowing your retirement pot has lost value is unpleasant in itself. Another benefit of Fagan’s scheme is that it smoothes out the ups and downs of the stock market. A saver on Fagan’s scheme wouldn’t be confronted with the stock market’s ups and downs. Their savings would grow at a smooth, steady rate.
Too good to be true?
The big objection to this scheme is that it’s never been tried before, anywhere in the world. The idea is so simple and the payoff is so great that it’s amazing no country has ever tried it.
So, it might be that there’s something wrong with it. 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. But the details of Fagan’s proposal are quite intricate. They might have missed something, and the IFoA’s judging panel might have missed it too.
Or, maybe this is a chance to implement what could be a unique and spectacularly successful policy initiative.
Either way, there’s no excuse to ignore it at this point. The IFoA endorsement gives it enough credibility that, at the very least, the government needs to kick the tires. There’s too much money at stake not to.