How do you protect people from outright scammers or bad advisers without depriving of them of the right to make their own financial choices?
If regulation appears unable to eliminate mistakes or fraud, should the ‘nanny state’ step in and restrict choice? Is it better to protect people from possible harm even if it means they miss out on the chance of better outcomes? Or does it all depend on the terms: how big is the risk of harm and how much better could the outcomes be when running that risk?
British Steel Pension Scheme
As soon as the Pension Freedoms were first announced in 2014, they pitched paternalists against libertarians, both amongst the financial community and in the media. It is an ancient and pervasive divide reflecting personal philosophical bias resistant to argument and evidence. The strength of the bias showed itself again at the tail end of 2017 when members of British Steel Pension Scheme found themselves forced to decide between a new Defined Benefit (DB) scheme or remaining with the old DB scheme as it passed (now without the sponsorship of Tata Steel) into the Pension Protection Fund. This drew past and present steelworkers’ attention to their right to transfer out of the scheme altogether, into a Defined Contribution (DC) pension plan of their choice.
Members who have not left the firm and not yet retired are already receiving DC contributions instead of accruing rights to a final-salary pension (because Tata Steel closed the DB scheme to new accruals to cut its costs). So they are to some extent being exposed already to financial-market risks and choices. But even so, transferring previously-accrued rights, potentially amounting to a much larger capital sum than they have ever handled before, is probably a step they would not otherwise have considered.
That is not to say that they do not stand to be materially better off transferring out and exploiting the Pension Freedoms than remaining in either DB scheme. In fact our modelling (see below) suggests the chance of losing out from a well-managed and sensibly-priced drawdown plan is very small in their case: they can be very confident spending will be higher exploiting the Pension Freedoms. Even mediocre real returns will deliver spending improvements that are likely to be transformative for individuals and families in their position. There is a cost to these outcomes in terms of living with the emotional roller-coaster of exposure to financial markets. But is is patronising to suggest that steelworkers should not be shown the opportunity of better outcomes just because they may be unused to stock market volatility; that they should not be exposed to risk because they will not be able to learn to live with risk. This is a sentiment that clearly puts us on the side of libertarians rather than paternalists.
A voice of reason struggles to be heard over the outrage triggered by the feeding frenzy as advisers of all hues descended on Port Talbot to tout their pension transfer services. Paternalists are blaming the Government’s Pension Freedoms and blaming the FCA for failing to prevent scammers and charlatans hiding amongst those advisers doing a perfectly respectable job of helping members make their choices. In fact the FCA did step in promptly. It sampled recommendations made by the most active advisers and decided several firms needed to stop advising on transfers altogether. There look to have been some sales of inappropriate unregulated funds by one firm before the FCA stepped in but as far as we know the type of fraudulent schemes that we associate with pension scams have not been sold to steelworkers. Perhaps the glare of publicity was not what they thrive on.
Meanwhile, the outrage doubtless put off many good advisers from getting involve. The frenzy itself attracted a number of individual do-gooders from IFA and actuarial firms to Port Talbot but these are not the ones holding the necessary qualifications for advising on transfers so all they could do was warn (paternalistically) against talking to transfer specialists because they may be sharks.
The Work and Pensions Committee’s posturing
Enter the Work and Pensions Committee. After hearing evidence in late December, including from Megan Butler, Executive Director of Supervision at the FCA, Frank Field (as Chairman of the Committee) wasted no time in firing off a letter to Ms Butler criticising the FCA for its failure to deal promptly with either the Port Talbot feeding frenzy or the need to ensure higher standards of advice about transfers generally. For example:
“More broadly, it is apparent that insufficient protections are in place to prevent consumers with defined benefit (DB) pension pots being seduced into a transfer against their interests. While the protection of requiring those with rights worth over £30,000 to take financial advice before transferring is helpful in theory, it is useless in practice if that advice is shoddy or just plain crooked. The FCA has repeatedly stated that transferring out of a DB pension, an option now available under pension freedoms, is rarely in the interests of individuals. You said a transfer is the wrong option for most people, most of the time. In our recent report we noted that someone who has passively accumulated generous pension entitlements may be particularly vulnerable to making inappropriate investments or being scammed out of a large pot.”
Seduce, shoddy, crooked, scammed: it looks very much as though the Committee, or perhaps just a dominant Chairman, are to be counted amongst the paternalists. It is also looks like the witnesses were paternalists by instinct: only critics of transfers need attend.
This is a pity as there is a desperate need for the principles of pension drawdown, and their application to the DB to DC transfer option, to be more rigorously aired and challenged amongst experts and for this technical debate to inform regulatory policy. At the moment there are far too many people spouting sweeping generalisations without apparently understanding the decisions involved.
It is particularly rich coming from a Parliamentary committee since it is largely government monetary policy (Quantitative Easing) that has created the conditions in which low-risk and inexperienced investors stand to be much better off by taking the exceptionally generous transfer terms available from so many DB pension schemes. Though I have some sympathy with Megan Butler when faced with prejudiced questioning, she did her organisation no favours by not correcting Mr Field’s erroneous rendering of the FCA’s position as being that transfers are ‘rarely’ in a member’s best interests. That simply shows she, if not the FCA generally, does not understand what has changed to make transfers sensible.
Why transfers are likely to improve welfare for most
This is not a ‘market’ phenomenon but an example of a utility gain created by external intervention. It was once generally true that there was no market-derived potential for gain, when the assets underpinning both personal and DB pensions were broadly similar (‘balanced’ asset allocations targeting standardised volatility not time-specific real outcomes) and so had similar expected risk-adjusted returns. This ceased to be the case with the onset of Liability Driven Investment in occupational schemes, and with regulations introducing real consequences for mark-to-market funding shortfalls. But the nail in the coffin was Quantitative Easing. Once derisking had widely occurred, it was negative ILG yields that meant the default assumption switched to being that drawdown was likely, rather than unlikely, to increase utility, by providing a distribution of possible sustainable real income, drawn from the CETV, most (or even in some cases, all) of which lies above the projected DB income. This is true even when the investment approach is low risk.
The option of an index-linked annuity, equivalent to the DB pension, has always been available to DC members but is routinely rejected because it is so expensive in terms of the resources required to provide a given real income. It is only pension regulation and international accounting that have ‘forced’ DB schemes to pay a price individuals reject. And it is pension regulation that obliges broadly the same price to be offered as a Cash Equivalent Transfer Value (CETV). In other words, you get the payoffs of a risky strategy from the resources required of a riskless strategy, with those extra required resources coming not from your pocket but the employer’s. That is pretty close to a free lunch which (we know) markets alone do not provide.
In fact the FCA (even if not Ms Butler) has recognised it cannot rely (even if it once could) on a general rule derived from standard investment theory that there is not normally scope for a DC pension to provide more personal utility than a DB pension. It now maintains every case must be judged on its own merits. But it has not yet gone so far as to acknowledge that transfers are now more likely than not to increase welfare. We do not know if that is because it still hasn’t fully followed the logic or just that its paternalistic instincts are too strong. It would be good to know.
Informed self selection
In a libertarian vision of advice, it is perfectly possible for non-financial people to make choices for themselves. The best form of selection is one informed by the impacts of a complete set of options to which the selector (not an agent) applies consideration of personal consequences (which only they can envisage). In such a process, what defines personal utility, what their preferences are between different sources of risk and the most appropriate approaches to managing or laying off those risks all emerge jointly from the selection process itself – because these are all attributes that differentiate the options. I don’t need to know what technically differentiates option A from option B as long as I can relate to and think about the differences in implications for me.
Intriguingly, there is no ‘recommendation’ as such when the advice process is designed to support informed self selection. Recommendations are inherently paternalistic, treating the adviser as a proxy design maker, as if a fiduciary, and the client as dependent or even incompetent. Though fiduciary advice is necessary in the case of genuine incapacity, it is not generally necessarily and gets in the way of increasing both responsibility and capacity. Regulation and, for that matter, the courts are not obviously ready to confront this insight and it is probably only technology innovation that will change the nature of the advice relationship and in turn force changes in regulatory attitude.
The question we should be focusing on is what informs that self selection in the case of a choice between a DB pension and a DC pension given a known CETV. This is exactly the same question that the FCA needed to ask itself when revisiting the current highly-prescriptive advice process (a consultation whose outcome we are still waiting for). It recognised (arguably somewhat belatedly) that the current process does not permit a like-for-like quantification of sustainable real income or spending power, because it relies on time-independent growth rates and their deviations rather than time-specific income levels. It focuses on the drivers of outcomes but not the outcomes themselves. This is what leaves people (not just steelworkers) vulnerable to cognitive dissonance when comparing, for example, a capital sum with an income stream.
A steelworker example
As the FCA has stated in its consultative proposals, the key is income comparisons and it has recognised that these are likely to be most robust if they are the generated by a stochastic (probabilistic) drawdown model, using the language of chances.
Applying the Fowler Drew stochastic model to the situation of a 50-year old BSPS member, we can quantify the income comparison. For a CETV representing 25 times current uplifted benefit, 96% of the distribution of potential income (planned to last till age 95) lies above the DB income, even with a low level of risk tolerance. (The underlying investments, consistent with the Liability Driven Investment approach adopted by most DB pension funds, are adynamically-managed combination of cash/ILGs as liability hedges and return-seeking equities; the total cost assumption is 1% pa.)
Try the calculator:
A stylised version of the model is available as a rough and ready calculator (using realistic estimates where you do not have for instance a pension projection or a CETV quotation) on our pension transfer microsite here. This is a good way to check the prima facie case for transferring, since a full advice process is expensive.
The numbers above capture the difference dependent only on net real investment returns. But in this case it is likely that the DB target is itself subject to inflation risk and that the spouse pension difference should be quantified by allowing for an insurance premium. Allowing for both improves the true potential spending gain.
The basis of comparison turned out not to be complicated, as might be expected in the case of a BSPS member, by the need for a prior choice between the old scheme (entering the Pension Protection Fund) and the new scheme. And the choice expressed in the event of not transferring also looked relatively simple as long as tax free cash was relevant.
Though the numbers imply a genuinely transformative difference in spending power, a transfer does of course also transform the experience of risk. The volatility of the market value of the DC assets providing the planned spending, though allowed for in the model, also needs to be lived with and so this too needs to be quantified and explained before a choice can be completely informed and fully costed.
How an individual trades off the path risk and the outcomes (what you have to live with to enjoy what you get to live off) is itself a form of directly exhibiting their utility and risk preferences without requiring a recommendation or interpretation by an agent and without agency biases. Libertarians do not want to see MPs and regulators, however well-intentioned, inserting biases either.