DC pain before consumers’ gain
Peter Maynard looks at the DC lessons from the US and Australia
In two markets outside Europe, private individual pensions founded on low-charge investment accounts have already been implemented on a large scale. The 401k plans in the US and Superannuation – ‘Super’ – Guarantee in Australia are both weapons against demographic pressures on social security, although their backgrounds and development are quite different. Both are big business too. Do they hold some lessons for Europe and signpost the future of the pensions market?
Fortune in the US
The 401k plans take their name from a section of the Employee Retirement Income Security Act 1974. Their success occurred rather by accident through new interpretation and exploitation of the detail of the Act; the original legislators never had in mind a radical transformation of retirement savings throughout the US.
Any business can set up a 401k plan. Contributions can be made by employees via salary deduction or by employers or both; employer contributions must be at the same rate for all employees. All contributions are tax-free provided they fall within certain limits. Significantly, high earners’ ($85,000-plus) ability to contribute is linked to the take-up among lower earners. Funds roll up tax-free.
From the mid-1980s 401k plans took off in a big way. In terms of assets they currently represent 15-20% of a total US pensions market worth $7.5trn. Around 28m Americans – including numerous 401k millionaires – participate in these schemes offered by 280,000 sponsoring firms.
So, by accident of birth, 401(k) plans have transformed the US pensions scene. Defined benefit (DB) schemes used to be the norm, but 401ks stimulated a pronounced swing towards defined contributions (DC) for new schemes. These plans are neatly aligned with the spirit of America: empowered citizens free to manage their retirement savings using a range of investments on the open market.
The mutual fund groups are the 401k kings, with the lion’s share of the market, mainly the big schemes with 1,000 or more members. Medium-sized schemes are the province of the regional banks, while life companies operate most effectively in the small-scheme market. Even so, competition is strong. Companies vie with each other to widen the choice of funds, offer deals on related products, provide better and direct access to account information, and drive down their management charges.
While there might have been a 401k revolution, not all employees have been swept up in it. There is low penetration in industries that historically have poor records for pay, benefit provision and employee retention, and it has proved difficult to convince the young and the low-paid. Experience shows that strong employee take-up depends on:
o Education about plan operation and benefits;
o Employers matching employee contributions;
o Easy access to personal plan information;
o A range of investment options; and
o Provision of supplementary personal finance tools.
In the mid 1980s, in response to trade union pressure, the Australian government introduced ‘Award-Super’, a compulsory 3% pension contribution by employers for each full-time employee. In 1992 this was replaced by the ‘Super Guarantee’ requiring employers to make higher pension contributions on behalf of employees or be liable for a non-deductible tax. The original contribution rate was 6% but via a programme of increases this is now 7% and will rise to its ceiling of 9% in 2002.
Employees and employers may make additional voluntary contributions subject to certain limits. A Super Surcharge Tax prevents high earners benefiting unduly. Contributions are exempt from income tax, attracting a concessionary tax rate of 15% instead. Super fund earnings are also taxed at the 15% concessionary rate and payouts on retirement receive favourable tax treatment provided they are within set ‘reasonable limits’. There are special arrangements for the self-employed who can fully deduct A$3,000 during a financial year plus 75% of the balance up to a certain limit.
Penetration of Super is just under 90% of all full-time employees. Contributions totalled just under A$50m (E00m) in 1998/9 and funds currently amount to around A$420bn.
In Australia, as in the US, individual freedom is part of the model, but in partnership with strong state intervention. Not only are employers subject to virtual legal compulsion, the state has systematically re-constructed financial services via successive regulatory changes. Providers with narrow product focus have been replaced by firms offering a wide range of transparent, unbundled products, achieved by intensive M&A activity plus the entry of new players.
Australian firms have the option to run their own superannuation scheme or to contract it out. At the same time employees have the choice of buying in to the firm’s group plan or going the DIY route, either individually or as a group. Total membership of in-house schemes has been static over the last five years, while that of retail ‘master funds’ has grown by more than a half. Trade union-run schemes have grown by a fifth; originally covering specific industries but now open to all-comers, these offer favourable deals on a range of other products such as mortgages and life cover thanks to strong buying power.
The Australian financial services market is fiercely competitive, and thus the balance of power in Super is constantly shifting. The creation of innovative deals that break up the supply/value chain is putting pressure on charges, particularly those of the master funds whose might is being challenged.
In both countries pensions have become democratised: an entitlement to all rather than a perk for the few. This transition has been achieved most effectively in Australia as a result of virtual compulsion; in the US there are significant gaps in penetration – the low-paid and the young. But Australia is not without its problems. Super has been labelled an employment tax and its introduction has been a big corporate disruption. Further, Australians tend to think that pensions are the state’s responsibility, and are markedly reluctant to add voluntarily to the statutory minimum contribution levels.
In both the US and Australia financial services are founded on free competition, consumer choice and empowerment. It remains to be seen, though, whether these classic ideals ultimately deliver. A great deal rests on the ability of individuals to manage their own finances. Yet research suggests that they are not always up to making the right financial decisions, especially when faced with a wide range of choice; the wrong decision could just make the difference between a comfortable and a miserable retirement. Consumer education and informed decision-making are vital. But it remains to be seen how investors cope with a serious, prolonged investment downturn. Some US commentators do not rule out a future backlash against funding and strong consumer empowerment. The wide choice of providers and product options illustrates that, although a pensions product concept might be generic, there is still plenty of scope for variation and differentiation in how it is delivered. So much for fears that commoditisation means blandness. Both the US and Australian markets are notable for innovation, particularly new models for delivering service to customers – both corporate and individual – and efficiencies to keep charges down. In Australia financial advice has enjoyed a revival; consumers need help to make sense of the array of choice – in both planning savings and in managing retirement finances.
Time will tell whether the UK’s stakeholder and other European DC plans will achieve the goal of significantly increasing retirement savings. Consumer education will be key, to achieve both strong uptake and informed choice of providers and funds. And here is a fresh opportunity for advisers, who can rightly claim a continuing role even in an increasingly e-dominated world.
In the UK, for the time being, additional charges are to be factored in to allow for the cost of advice, but financial advisers will need to re-work the way they do business to continue to make it pay. This is just one illustration of how business models will have to change to meet the challenge of the 1% maximum charge. Group markets look most attractive given the economies of scale and the government’s insistence that all but the smallest employers must offer their workforce a stakeholder scheme. Here technology will have to be used to the full to achieve efficiencies as well as strong service, as it will elsewhere, such as in administration. But effective worksite marketing will require new skills and lessons learned from the US.
While the transition to DC promises to involve some pain, US and Australian experience suggests that a generic product concept can still produce a vibrant, dynamic, competitive market place with plenty of opportunities for agile, innovative companies. UK and elsewhere in Europe consumers look like being the beneficiaries.