Government top-ups are the way
Stephen Lalor and Kirstie Flynn advocate replacing pensions tax relief with a system of state sponsored top-ups
In the good old days, when defined benefit (DB) ruled the earth, the investment of pension assets was almost exclusively the concern of plan sponsors and trustees. Plan members could afford to be largely indifferent to investment performance; if returns were lower than expected the sponsoring employer had to fund any shortfalls.
Then came the shift to defined contribution (DC) plans. In the past 15 years almost no new DB plans have been established except where there was an inherited obligation to maintain pre-existing expectations, as in takeover situations. The 2006 Annual Report from the Pensions Board, the regulator, shows 255,008 members in DC plans and 542,362 in DB plans; a ratio of 2 to 1, as compared to 4.5 to 1 in 1996. An estimated 40% of DB plans are now closed to new members.
At the same time, there has been a significant growth in interest in additional voluntary contributions, the personal contributions a person may make to increase his or her retirement benefits. Where a member is a member of a DB plan, additional voluntary contributions are usually applied on a DC basis.
Mostly, the selection of the appropriate investment vehicle and the investment manager remains the responsibility of the plan trustees. Although recognising members' differing preferences and ability to tolerate risk or volatility over time, trustees began to offer them a choice of investment funds. But trustees retained responsibility for the proper investment of funds under the legal trust deed establishing the plan and by general trust law. In theory, therefore, they could still be liable for poor investment if an individual were to make a bad choice.
This anomaly was addressed in a 2002 amendment to the Pensions Act which relieved trustees from responsibility for members' investment choices under certain specified conditions.
To be able to exercise choice, people need to understand the implications of their decisions and regulations issued in 2006 require trustees to give members certain minimum details. Such minimum standards were required for compliance and to avoid responsibility for adverse consequences of a member's choice.
However, the protection given may have been tempered by investment regulations introduced in 2006 as a part of the EU's IORP directive which requires scheme assets to be invested "in a manner designed to ensure the security, quality, liquidity and profitability of the portfolio as a whole having regard to the nature and duration of expected liabilities".
It could be argued this means that even where a trustee complies with the standards above, they do not obtain full protection if the choices offered could be considered unwise given the nature of the members' liabilities. For example, does it mean a trustee cannot offer an equity fund to a member approaching retirement or a cash fund to a younger member? The new regulations have not yet been tested in the courts so the extent to which the trustees' protection still applies is unclear.
Nevertheless, around 90% of members do not choose to exercise choice but go with a default option. Therefore, it remains important for trustees to get the selection of designated investment right. A number of ‘lifestyle' strategies have developed that vary the asset mix in the member's fund over time, reducing risk and volatility as retirement approaches. Given the requirements that investments have "regard to the nature and duration of expected liabilities", a lifestyle strategy may be the only default option that trustees can safely offer.
Most managed funds and ‘balanced' portfolios have 70-80% equity exposure, with the remainder spread between bonds, property and cash. Typically, these funds were 15-20% in Irish equities at the end of third quarter 2007 and historically had been an even higher.
The overweight position in the Irish market, which represents less than 1% of the world equity index, was beneficial as the Irish stockmarket performed exceptionally well compared with other regions. But in 2007 the leading ISEQ index of Irish shares fell 26% compared with a rise of 1.7%% in the FTSE World Index.
The Irish market is dominated by a small number of stocks, with the top seven companies accounting for almost 70% of the index. Of these, three are financial and one supplies the construction industry, the sectors that were hardest hit by the borrowing crisis. Consequently mainstream Irish pension funds fell by around 3% in 2007 and at the time of writing continue to fall.
Some managers argue that the Irish market now represents good value, and a buying opportunity, with leading stocks on lower valuations than their peers across Europe.
The effect of continued falls will be to undermine the solvency of a lot of DB schemes, plunging them back into deficits and necessitating difficult funding plans to be put in place. Members of DC plans will have to look again at their expected outcomes, unless a recovery emerges soon.
This bad news comes as serious efforts are being made to encourage more people to make realistic provision for their own retirement. The government's Green Paper on Pensions, published last October, discusses adequacy of retirement income, sustainability of the state scheme and the role of the state and the individual. It also focuses on pension coverage and notes that according to a 2005 survey, 55% of the workforce has made second pillar pension provision.
Unsurprisingly, coverage is higher among the 30-65 age group than the under 30s, among men than women and among employees than the self-employed (most public sector employees are in a compulsory pension scheme, which ups the employed percentage somewhat). Intended to stimulate debate, the Green Paper raises a lot of questions, but is very light on solutions. So let us offer one here:
The success of the Special Savings Incentive Accounts - a savings scheme that ran from 2001 to 2007 under which the state added an additional €1 to every €4 saved on a monthly basis over a five-year period subject to a €254 per month maximum - was largely due to the simplicity and visibility of what was often considered to be ‘free money' and was simple to understand.
Instead of tax relief on contributions, the government could add 25% to a person's contributions while benefits could be drawn down tax free at or during retirement. Financially, this would be the same as tax relief at 20% (the current standard rate of income tax), but is much more tangible.
Controls could be put in place as to upper limits, early draw down (perhaps forfeiture of the supplementary contribution) and whether or not the benefit must be taken wholly or partially in annuity form, but these are details.
This suggestion is far from a solution to all the issues that face pension plans and their members, but it may be a way of offering people a more meaningful incentive and thereby increasing individual participation, which is a central goal of government policy.
Stephen Lalor is associate director, pensions consultant, and Kirstie Flynn Coyle is associate director, pensions lawyer, at Dublin-based consultancy Coyle Hamilton Willis