Does compulsion work?
Gail Moss looks at whether compulsory contributions make for better workplace pensions
Are compulsory, supplementary funded pensions the answer to unwieldy pay-as-you-go state pension systems? Does the success of compulusion depend on cultural attitudes in different countries? Or is the answer soft compulsion - auto-enrollment?
In Europe as a whole, DC scheme coverage is less than 50%, according to Mercer’s 2009 Global Defined Contribution Survey. The survey shows that in continental Europe, the take-up of company DC schemes is currently 45%, compared with a target take-up of 52%.
In the UK, there is even more of a disparity, with companies setting a target take-up rate of 66%, and only a 40% take-up rate. This is the lowest percentage of all the regions surveyed - Latin America, for instance, has a 43% take-up rate. In the US, the rate is 47%, while for both Asia Pacific and Canada it is 73%.
Few European countries have a compulsory second pillar scheme but one of the exceptions is Switzerland, where there is a mandatory DC system for employees earning over CHF20,520 (€14,572). Age-related contributions range from 7% of insured salary at age 25 to 18% at 55-plus. At retirement, the lump sum is converted into an annual pension at a rate defined by the government, which will decrease progressively to 6.8% by 2014.
“The compulsory system is culturally ideally suited to the Swiss, because they are ready to invest and forsake income for their future retirement,” says Peter Zanella, director, retirement solutions Switzerland, Towers Watson.
Zanella attributes this willingness to a range of factors. “Pension funds still enjoy a great amount of trust, and the system is based on stable and reasonable actuarial and economic parameters,” he says. “The system is still relatively simple and cost-effective. Trustees and companies have a high level of autonomy in deciding on the optimal funding system and pension benefits.”
Finally, he says, there have been no really big scandals or defaults since compulsion was introduced in 1985.
According to Zanella, the fact that the system is privately structured with various funding options and a high degree of autonomy means that the Swiss look on it as ‘forced deferred salary’ rather than ‘tax’.
He says: “The best way to introduce a mandatory system elsewhere is to base it on a private and liberal structure, presenting it as an investment for people’s own future. For that, state agents need a high level of moral credibility so that people do not feel they could potentially be exploited, for example by opaque and costly pension schemes, or mercenary providers.”
And he says that if the general public can rely on a sound political environment with independent legal institutions, politicians should have the courage to introduce a compulsory system.
Outside Europe, another country with a mandatory second pillar is Australia, which introduced compulsion in 1992. Employees contribute 9% of salary, investing in a mature market offering a range of investment options.
Today, over 80% of the A$1.1trn (€776bn) Australian private pension system is in DC schemes.
“The Australian system has been pretty successful,” says Jerry Moriarty, director of policy, Irish Association of Pension Funds. “There is a high level of ownership and engagement. People understand how their account works and how it’s building up for retirement.” But he adds: “If people are on low earnings and have no money for the next 12 months, there is no way they are going to save for 30 or 40 years’ time.”
Where governments shy away from full compulsion, other tools such as auto-enrolment or auto-escalation of contributions can provide soft compulsion instead.
As with the UK, Ireland is setting up a soft compulsion scheme to start in 2014. Aimed at people over 22 without pension provision, it is similar to the planned British scheme, and includes auto-enrolment except that there is the possibility to opt out after three months. However, anyone who opts out will also be auto-enrolled every two years.
“It is hard to predict how soft compulsion will work in Ireland,” says Moriarty. “This scheme will increase coverage rates, but contribution rates are relatively low, probably in order to get political acceptance.”
The Irish scheme will require a 4% contribution from employees, 2% from employers and a 2% government contribution in lieu of tax relief.
But Moriarty thinks the proposed UK system has one potential flaw. “In Ireland, there is a €230-per-week state pension which is not means-tested,” he says. “But the UK minimum income guarantee is means tested, so that your savings might mean you don’t get all your benefits.”
The UK’s new system - the National Employment Savings Trust (NEST) - will also fall short of full compulsion, depending on auto-enrolment by employers, with the right to opt out.
Professor David Blake, director of the Pensions Institute at Cass Business School, says that one powerful human trait that will be exploited in the NEST system - inertia - has employees staying in the scheme because they can’t be bothered to opt out.
However, he warns that inertia is no protection against some other problems. “The fear is that unscrupulous employers employing workers on the minimum wage with little job security are going to pressurise these employees to opt out,” he says. “The other fear is levelling down, ie some employers will use the opportunity to reduce contribution rates down to NEST levels.”
He also believes that politicians in most countries are too cowardly to go for all-out compulsion. “This seems to be the situation in the UK, at least, whatever party is in power seems unwilling to talk about having compulsory contributions for fear of opposition parties calling it a tax. For example, the Labour government has tried everything, introducing low-cost stakeholder pensions and auto-enrolment into NEST, except compulsion. But it does not seem to have worked, because per capita pension contributions are the lowest they have ever been.”
Blake says that apart from auto-enrolment, any soft compulsion system should also include auto-escalation, putting the next few years’ pay increases into the pension fund. This means, for example, that if the annual pay rise is 3%, then after four years, the individual will be saving a decent amount - 12% of pay - in their pension fund without any drop in take-home pay.
“Of course, this exploits another behavioural trait - money illusion - the inability of many people to differentiate between nominal and real (inflation-adjusted) values,” says Blake, “The real level of pay has fallen, but most people won’t see this as clearly as a fall in take-home pay. Another powerful incentive is ‘employer matching’, where the employer matches employee contributions up to some cap.”
Damian Stancombe, head of corporate DC at Punter Southall, says: “The vast majority of individuals are apathetic about pension schemes, so we have got to have an intelligent conversation about compulsion. Cross-party consensus is essential to achieve stability for non-state pension provision and bring an end to the constant damaging intervention arising from conflicting policies. The hung parliament has contributed to a climate of cross-party consideration.”
He says: “But we may have to think the unthinkable, and ask whether decent pensions are now a luxury. What has changed in the UK is the culture of savings. There has now got to be a broad-brush approach, accepting that pensions are just a component of retirement provision, and looking to vehicles such as ISAs as well.”
In the Netherlands, over 90% of the workforce is covered by compulsory second pillar plans, usually run on a DB basis. Workers must contribute to an industry-wide scheme or if there is none, join a company scheme. A total of 76% of the workforce in a pension fund are in industry-wide funds with 12% each in company plans and insurance plans.
Premiums for compulsory schemes are a fixed percentage of salary, negotiated every two or three years by employers and trade unions. The average contribution for an industry-wide scheme is 15-20% of salary, although this includes taxes to pay for the first pillar system. Union representatives make up half of each pension fund board, the other half consisting of employers’ representatives.
“People have accepted the compulsory aspect,” says Arie Perfors, director of pension affairs, Aegon corporate & institutional clients. “But scheme governance is very important. The union position is very strong, and this makes it easier to sell.” He says that one reason compulsion works is that pension contributions are like tax: “What you don’t see, you don’t miss.”
However, in industry-wide schemes, some members subsidise others. “In the long-established industries, the average age of scheme members is increasing, and it is the younger people who subsidise the older members,” says Perfors. “They are now saying they are not prepared to pay more money into their pension schemes.”
And he thinks this issue might to some extent jeopardise the success of soft compulsion in the UK. “Cross-subsidies don’t work if there is soft compulsion, because younger employees - who contribute most - are not obliged to join a pension scheme,” he says. “So there is going to be a potential problem.”
Other experts are divided as to whether soft compulsion will work. Zvi Bodie, professor of finance and economics at Boston University School of Management, says: “My conjecture is that it will work. If so, then there will be no need for compulsion. We will all learn from this massive social experiment.”
But Anne Maher, non-executive director and consultant, says: “I think that auto enrolment is just a ‘scenic route’ to compulsion. There is no evidence that it works, as far as I know, and I believe that compulsion is the only way of ensuring basic pension provision for all.”
Ultimately, Blake believes that if soft compulsion does not work, then hard compulsion is the only alternative. He says: “As a society, we simply cannot have millions of people going into retirement having made no financial provision apart from their contributions into the state pension system.
The risk of intergenerational conflict, whereby the next generation of taxpayers refuses to pay extra taxes to bail out the previous generation, is too great.”