Saving for old age with personal pension schemes –
more regulatory oversight is badly needed
Here I am discussing my latest research into pension regulation, explaining why people with individual personal pensions could retire with as little as half the value of a comparable pension fund managed by an employer.
The importance of saving for old age has been growing over the years. Individuals must now ‘think long term’ from early on in their careers - the shift away from a multigenerational family model; the effective privatisation of the old age provision; and the fact that employers adopt a hands-off approach by closing down defined benefit schemes to new members (if not completely) means that people are under increasing pressure to secure their own retirement income.
DC Pension Schemes
The pension market is rapidly being taken over by defined contribution (DC) schemes – this is a type of scheme in which the size of a retirement pot depends heavily on returns generated from investments. Saving with DC schemes demands that contributors become smart investors. That is, even if contributors don’t have appropriate financial knowledge to decide what assets to invest in, they must be able to choose with whom they should invest and select a pension fund (or funds) from the hundreds operating on the market that best suit their personal circumstances and risk profile. Individuals are also expected to become conscious investors, that is investors who can control the progress of their portfolios, and take appropriate steps if they are dissatisfied with how their money is being invested.
Obviously, regardless of such expectations, many individuals cannot do that. This may be down to their limited financial skills and knowledge, a lack of time to collect and analyse information about market trends, economic conditions and the performance of their current investments; or simply, they may not have access to relevant information. “Free riding” is also a factor here – many individuals do not monitor the performance of their investments because they hope that investors with greater skills, more time or more information will keep an eye on things. They expect someone else who is involved in the process to monitor whether fund managers do their job properly and whether the fees they charge reflect the quality of services provided.
The need for regulation
Whatever the reason is, there is plenty of scope for things to go wrong and many individuals reach their retirement point with little money, even if they diligently saved for years. This is why it’s important to set appropriate regulatory structures and rules. These regulatory structures and rules are to fill gaps and smooth the imperfections generated by the asymmetry of information between investors (that is individuals saving with pension funds) and asset managers (that is those who invest money on behalf of the individual investors). But do they fill these gaps? Do some regulatory structures and rules offer better protection to investors than other?
Answering these questions is important given that the DC pension industry has been growing rapidly. According to Wills Towers Watson’s “Global Pension assets study 2020”, in 2019, DC pension assets amounted to $46.7 trillion in 22 major pension markets. The World Economic Forum estimates that by 2050, the assets of DC pensions will grow to $224 trillion. In the UK, the DC pension industry has also been growing rapidly. According to the Office for National Statistics, in 2019, 22.4 million Brits contributed to DC schemes, compared with 18.3 million contributing to schemes that had some defined benefit (DB) component (that is schemes that were ‘pure’ DB schemes or were hybrid pension schemes that combine DB and DC elements). Thus, the numbers of Brits whose pension pots will depend on the performance of DC pension schemes is likely to already be around 30 million. The UK’s DC schemes amounted to £146 billion worth of assets at the end of 2019.
Comparing the performance of DC Schemes between countries
While the DC pension industry is on its way to becoming the main form of retirement provision around the world, very little is known about whether and how institutional differences in setting up, monitoring and governing DC pension funds impacts their performance. Different countries have adopted different pension industry structures and models which additionally complicates the picture. It may be difficult to compare pension industries between countries because, even if differences in the performance of DC pension industries are observed, it is hard to unambiguously link these differences to particular institutional or regulatory characteristics. The observed differences may also result from differences in cultural, legal, social and other factors.
So, if one wishes to understand whether and how, for example, the governance of pension funds affects fund performance, it is necessary to single out two sizable groups of pension funds (where ‘sizable’ means numerous enough to allow for a meaningful statistical comparison) that are comparable but differ in some aspect of governance practice and/or organisation.
The UK personal pension industry offers such a sample. More precisely, a comparison of the performance of group personal pension (GPP) schemes and of individual personal pension (IPP) schemes sheds the light on how important the monitoring and oversight of funds is for maximising the returns investors earn on their savings.
Group funds versus individual funds
The GPP and the IPP agreements are both between individual contributors and providers, and offer seemingly similar services. They differ, however in that GPP schemes are only available to employees of the company who set the agreement with a particular provider, while IPPs are available to the general public. This means that in the case of IPP schemes individuals are free to choose from any provider offering IPP schemes.
Even though GPP investors are limited to investments in funds agreed between their employer and pension provider, they benefit from their employer’s engagement in multiple ways. For instance, a company is able to negotiate lower fees and more flexible terms than IPP schemes offer. Also, when the scheme is created, it is common for an employer to establish a governance group whose responsibility is to conduct periodic reviews of the performance of the scheme, consider amendments (e.g. changes to the pool of funds on offer) or even seek a new pension provider if they are dissatisfied with the current one.
IPP schemes, do not have such oversight. Individual investors can (and are even encouraged) to monitor the performance of the funds they invest in, but even if they did so, the bargaining power of individual investors is incomparably weaker than the bargaining power of corporations. Not to mention that costs of switching providers for individual investors are much higher than when corporations exercise their power to exit particular agreements. So, even though there is no reason to believe that the individuals saving under GPP schemes are any more financially savvy than the IPP schemes’ investors, the involvement of employers (as a third, well-informed and powerful party) in contract setting and subsequent monitoring may be beneficial to the GPP investors, as we see that GPPs outperform IPPs.
Saving with Group or Individual Personal Pension Schemes: How Much Difference Does It Make?
In my Management Science paper, using UK data for over 10,000 DC pension funds (between 1990-2019), I study how returns earned by GPP funds (which benefit from external monitoring) and by IPP funds (which practically do not have any governing and monitoring bodies) differ, after controlling for many fund and provider characteristics. I find that GPP funds delivered 0.96%–1.67% higher gross returns and charged 0.7% lower fees per annum than IPP funds. This means that after 30 years of saving for retirement with the average IPP scheme, investors may have in their pension pot half of the money the average GPP scheme investors have, even though the amount both types of investors put aside is the same. Moreover, while differences in fees between the GPP and the IPP funds have been an open secret, my research is the first to show that these two types of funds differ in performance and importantly that the difference in performance is bigger than the difference in fees.
To better understand the importance of governance and monitoring for fund performance, I also test the impact of the introduction of the Independent Governance Committees (IGCs) on the performance gap between IPPs and GPPs. The IGCs were introduced in 2015 by the Financial Conduct Authority to improve GPP schemes’ transparency and market competition. Their role is to scrutinize the value for money of the provider’s GPP schemes. I find that the performance gap between GPP schemes and IPP schemes has increased since the introduction of the IGCs. Moreover, the gap increased more for smaller providers and smaller GPP schemes which is consistent with the notion that smaller employers were less engaged in monitoring and oversight prior to the reform.
My research implies that empowering individual investors may not be enough to solve the problem of certain pension funds’ weak performance. IPP schemes need more institutional oversight in the way GPP schemes have. Moreover, the governance and monitoring of GPP schemes needs to be further improved. The creation of the IGCs is just one step on the way of improving the quality of the personal pension industry. But this is not the end of the journey. We still have a long way to go to ensure that the system is effective and efficient in supporting individuals in their efforts to save for retirement.