# Proposed New Approach to DC Drawdown



## Colm Fagan (12 Mar 2018)

Gordon Gekko said:


> Colm, as an aside, from memory I’ve seen some interesting stuff you’ve written around the ARF and drawdown phase; perhaps you’d share that and stimulate a discussion in another thread? Many thanks.



On 7 February last, I made a presentation to the Society of Actuaries in Ireland, which I claimed would set out a “new and radically different approach" to drawdown under group defined contribution pensions arrangements (modesty isn’t my strong suit!).  The full presentation and commentary can be found under the "past events" heading on the website of the Society of Actuaries, www.actuaries.ie.  The following is a summary of the presentation.

The presentation identified three key defects with drawdown at present: (1) high charges; (2) low investment returns; (3) no security of income.

*High Charges*
High charges are a consequence of DC members having to leave their occupational schemes on retirement.  They lose the valuable discounts the trustees have negotiated for active service members.  They also have to cash in their existing holdings and take out new individual arrangements, Approved Retirement Funds (ARF’s).  A 2016 report of the Pensions Council reckoned that charges on individual insurance-based arrangements were equivalent to a yield reduction of between 1.5% and 2% per annum. The presentation proposed to address the problem of high charges by allowing members to stay in the scheme post retirement and to draw down from their accumulated funds within the scheme.  An easy win.

*Low Investment Returns*
This nut is not so easy to crack.  Low investment returns are caused by ARF holders choosing low-risk investments.  In November 2015, a Working Party of the Society of Actuaries in Ireland reported that over 40% of insured ARF’s were 100% in cash.  There is a straight trade-off between risk and reward: the higher the risk, the greater the reward.  It follows that the straightforward solution to the problem of low investment returns is to encourage ARF holders to invest in higher risk instruments, such as equities and property.  But is it right to encourage people who are well into their third age to take the high risks that are inextricably linked to high rewards?  The presentation looked first at how much investment returns could be enhanced by investing in equities and property, and then examined how the associated risks could be mitigated.

*The Equity Risk Premium (ERP)*
The presentation examined various approaches to estimating the Equity Risk Premium, defined as the extra return expected to be earned on average (a very important qualification, of which more anon) by investing in equities, property, and other "real" assets.  The conclusion was that it was reasonable to expect an average ERP of 4% to 6% per annum in future.  The ERP can be enhanced still further by investing in private equity and other illiquid investments.  Some experts believe that returns on private equity are 3% per annum or more higher than on unquoted equities.

*Higher Returns Mean Higher Volatility*
Higher expected returns carry a high price tag.  In the 32 years since January 1986, the stock market rose by an average of over 8.5% per annum, but it fell more frequently than one month in every three.  In other words, the odds of being poorer one month after investing were shorter than 2/1 against.  In 12 months out of 384, market values were down by more than 8% in the space of a month.  That included one month (October 1987) when market prices fell by more than 25%.

Not only can sharp falls be experienced, but they can be quite prolonged.  I reckoned that £1,000 invested in the UK stock market in December 1999, with dividends reinvested, would have delivered a lower return than if it had been left in the post office between then and October 2013.  (A fund management charge of 1% per annum was assumed in the calculation, and an average interest rate of 3% per annum for post office savings.)  Given that result, it is worth asking why should one risk the stock market, and all the volatility that goes with it, if there is a possibility that you could earn more in the post office, even over quite a long period.

Human nature is a contributory factor to high levels of risk aversion.  Behavioural economists have found that people give twice as much weight to losses as to gains.  We can all relate to that:  we hate losing money.  Hindsight bias is another feature of behavioural economics: advisers (think financial advisers) who expect to have their recommendations scrutinised with hindsight are driven to extreme reluctance to take risks.

We are thus faced with a conundrum:  investment in real assets such as equities and property delivers much higher long-term returns than bonds - of the order of 4% to 6% per annum on average - but the associated short-term risks and risk aversion, which is part and parcel of being human, militate strongly against investment in such assets.  The psychological objections to high risk investment are particularly relevant for people into their 60s, 70s and 80s - and maybe even into their 90s.  It is simply wrong to ask them to bear too high a level of risk.

*Smoothing*
Smoothing was the proposed solution to this conundrum.  The presentation recommended that a high proportion of the fund be invested in equities and property, with returns smoothed to ease the pain of downturns.  The presentation set out the principles that should guide whatever smoothing formula was devised. 

The formula should be utterly transparent, with no scope for subjectivity and no actuarial black boxes.  When applied to historic data, the formula should mitigate - ideally eliminate entirely - negative movements in smoothed values, but at the same time it should faithfully reflect long-term trends.

The proposed smoothing formula gave just 1.5% weighting to the current month’s market value and 98.5% weighting to the previous month’s smoothed value increased by one month's interest. Applying the formula, the graph below shows what smoothed prices would have looked like over the last 32 years for the UK stock market.  The graph looked similar for the US stock market.



The smoothing formula worked wonders.  Whereas previously there were 12 occasions over the last 32 years when values fell by more than 8% in a month, including one month when they fell by over 25%, there were only two occasions over the same period when smoothed prices fell over a one-month period and on both those occasions the fall was less than 0.05%.  In other words, smoothed prices never fell, when prices were rounded to one decimal place, not even in the infamous month of October 1987.

There remained one major problem.  Whenever the smoothed value is less than the market value, there is a risk that new investors will pile into the fund to avail of the discounted price.  For example, someone joining in the late 1990s could have bought in at less than 70% of market value.  The converse is also true.  Whenever the smoothed value is less than the market value, there is a risk that investors will leave the fund, pocketing more than the market value of their investments.  Someone selling in the early 2000’s or in 2008/2009 could have netted 150% of market value.  Continuing members lose out in both cases. They foot the bill for pay-outs at greater than market value, and they also subsidise new people coming in at less than market value, so it's vitally important to take effective action to reduce the risk of adverse selection to the absolute minimum.

The presentation proposed a number of safeguards to minimise the risk of adverse selection.  New money would only be accepted from new retirees:  people could not defer the decision on whether to join the smoothed fund until some time after retirement.  Even with this restriction, it was also proposed that money would be allocated to the fund (at the smoothed price) evenly over two years.  Withdrawals would have to follow a smooth progression (“it's a pension, not a piggybank").  On death, payment of the balance on a member's account would also be phased, not because of the risk that someone might commit suicide when market values were less than smoothed values, but because of the option available to dependants to take continuing income or a lump sum on death.

Despite these safeguards, there could still be a risk of adverse selection.  The presentation looked at what would happen if new money fell by 50%, or dried up completely, whenever market values were less than 90% of smoothed values.  Back tests over the last 32 years for both the UK and US stock markets indicated that, even on these extreme assumptions, adverse selection would not be a problem.

The same would not have been true for the Japanese stock market. A similar back testing exercise for Japan indicated that continuing investors would have been cleaned out completely if withdrawals were allowed at smoothed values rather than market values.  The adverse result for the Japanese market was due partly to the massive bubble in the late 1980s followed by the crash in the early 1990s, but the failure of smoothing for Japan could be mainly attributed to the fact that markets stayed low for decades following the boom and bust.

It was concluded that the Japanese experience was an aberration, not a precedent, and that there was a negligible risk of a smoothed fund, which would be invested in a range of asset classes and across many geographies, suffering a fate similar to that experienced in Japan.  This conclusion was supported by data from a December 2017 paper “The Rate of Return on Everything, 1870-2015", which analysed returns on real assets across 16 developed markets over the entire 145 year period since 1870.

*Investment Strategy*
It’s worth stating the context that determines the appropriate investment strategy for a fund managed on the proposed lines:
(1) future cash outflows are highly predictable.
(2) there is no risk of sudden unanticipated cash outflows, unlike banks, insurance companies, and even mutual funds;
(3) since only 1.5% weighting is given to the current month's market value, accurate estimates of current market values are not vitally important;
(4) payments to beneficiaries are paid gradually over a 20/30 year period, so a long-term focus is essential;
(5) smoothing of investment returns allows the investment managers to escape from the tyranny of short-term performance measurement, and allows them to focus on long-term performance.

Consideration of the above context leads inexorably to the conclusion that the investment strategy should be radically different from that normally recommended for pensions in drawdown.

First and most important, every single investment of the fund, without exception, should be selected with the aim of generating the desired target return of the risk-free rate plus 4% per annum, or more.  This means that there is no room whatsoever for bonds in the portfolio.  This completely contradicts the conventional wisdom that retirees should invest their age in percentage terms in bonds: 70% at age 70, 80% at age 80, et cetera.  I concluded that the percentage in bonds should be zero at all ages.

Another consequence for the investment strategy of the criteria set out above is that up to 20%, possibly even more, of the fund can be invested in illiquid securities and property.

Needless to say, risks must be managed so as to avoid excessive exposure to specific industries, geographies, technologies, investment themes or economic outcomes.  As readers of my "Diary of a Private Investor” column will know, a personal belief is that a surprisingly small number of investments - possibly even as low as a dozen - would be sufficient to ensure the required level of diversification, but I recognise that this view will not be shared by many investment professionals.

*Ensuring Security of Income*
The proposals so far have dealt with two of the three deficiencies noted at the start for DC pensions in drawdown: high charges and low investment returns.  There remains the third deficiency: lack of security of income in retirement.

One of the biggest worries facing a DC pensioner is *"How much can I withdraw each year so that I don't run out money before I die?"*  It's no use telling them that they should plan for an average life expectancy of 26.4 years, or whatever the mortality tables say.  For someone in drawdown, all that matters is their personal life expectancy, not some average dreamt up by the actuaries.  Their personal life expectancy could be anywhere between zero and 40 years.  There is a risk that they could draw down too much or too little.

The traditional solution to this dilemma of an unknown future lifespan is to buy an annuity, but this option carries a heavy cost:
(a) the money is invested in the low-yielding bonds and
(b) most of it is lost on early death.
The solution to the dilemma, as proposed in the presentation, was what I called the "Lifetime Income Fund" (LIF).  The LIF works as follows: on retirement (say at age 65) the retiring member divides their retirement pot into 25 identical sub-pots.  They cash one of the sub-pots every year for 25 years.  Thus, at the end of 25 years, they will have cashed all their sub-pots and will have nothing left.  In the meantime though, they have been contributing (say) 1% of their fund each year to a separate, pooled, LIF account, which is managed by the trustees.  (The 1% contribution will vary slightly from scheme to scheme, depending on the gender and occupation mix of scheme members.)  The yearly 1% contribution to the LIF can be considered as being similar to an additional management charge.

On surviving to the end of 25 years, i.e. to age 90, and having taken the last of their pension sub-pots, the Lifetime Income Fund rides to the rescue.  It gives the member another sub- pot each year for the rest of their life.  For example, suppose Joe retires at age 65 with a pension pot of €250,000.  His pot is divided into 25 identical sub- pots, each of €10,000.  The first year, he cashes his first €10,000.  The second year, he cashes his second €10,000 plus whatever smoothed interest has accrued in the year, say €10,400 in total.  The third year, he cashes his third sub-pot plus another year's smoothed return, making a total encashment of (say) €10,700; and so on in each subsequent year.  If Joe dies at the end of year two, after cashing his first two sub-pots, the other 23 sub-pots, i.e. €230,000 plus two years’ interest, i.e. 107% of €230,000 in the above example, are paid to his estate.

Suppose on the other hand that Joe is still alive at age 90.  He has cashed a sub-pot each year since retiring at age 65, taking his final (i.e. his 25th) sub-pot in his 90th year.  By that time, the starting €10,000 in a sub-pot has increased with interest to (say) €30,000 (implying an average interest rate of 4.5% per annum, net of the 1% per annum contribution to the LIF, over the 25 years.)  The following year, when Joe is in his 91st year, the LIF pays him €30,000 plus another year's interest, and so on each year for the rest of his life.  This assures him a sub-pot every year for as long as he lives.

People who die before reaching age 90 pay for this largesse.  The biggest “losers” are those who died shortly before reaching age 90; they paid 1% each year to the LIF but get nothing in return, other than the consolation (not to be sneezed at) of knowing that if they had survived for another few years, they too would benefit from the LIF.

*Approximate calculations indicates that someone who lives to age 100 could expect under these proposals to receive a total income in retirement of more than 2 1/2 times what they would have got from an annuity.*

The combination of
(1) allowing members to remain in the fund post retirement so that they continue to benefit from discounted charges,
(2) investing their money in assets expected to generate an average return of at least 4% per annum greater than the risk free rate;
(3) smoothing investment returns in order to alleviate, or possibly even remove completely, the pain of the higher volatility associated with those high returns; and
(4) establishing the "Lifetime Income Fund", which gives members the peace of mind of knowing they can run down their savings to zero and still enjoy a regular income for the rest of their days;
will transform the retirement landscape for DC pensions.

The presentation also looked at whether the proposed approach could be extended beyond people retiring from large group schemes, to include those retiring from small group schemes and individual arrangements, and also whether it could be extended to the accumulation phase pre-retirement.  There are major challenges under all these headings.  The same is not true for the government's proposed auto-enrolment scheme.  The presentation concluded that the proposed approach was ideally suited to auto-enrolment, both pre-and post-retirement, provided that the rules are set appropriately at the start.

I now have the zeal of a missionary in promoting the proposed approach.  I do not want it to be an academic exercise.  I would appreciate whatever support AAM contributors can offer in promoting it to employers and trustees of DC pension schemes.  I would also welcome questions and comments on the proposed approach.

I emphasise once again that this is a summary of my presentation of 7 February.  Please refer to that presentation and accompanying commentary for further enlightenment, but come back to me if you still have questions.

I’m going to be out of contact for much of the next couple of days.  Instead, I’ll be enjoying myself in Cheltenham!  All tips gratefully accepted as I know nothing about horses!


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## Gordon Gekko (20 Mar 2018)

Hi Colm,

A fascinating post; you have clearly put a lot of thought and work into this.

Would employers want retirees “hanging around” the company pension scheme though? My employers covers the costs associated with the scheme (excluding the fund charges). Should that benefit accrue to ex-employees? The counter-argument is of course that the greater the total assets under management, the greater the discount we can all get on the fund management charges.

The investment piece is frightening, especially the stat around 40% of insured ARFs being in cash. Far too many people will run out of money in retirement.

Gordon


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## rob oyle (20 Mar 2018)

Interesting article, much to get through.


Gordon Gekko said:


> Would employers want retirees “hanging around” the company pension scheme though? My employers covers the costs associated with the scheme (excluding the fund charges). Should that benefit accrue to ex-employees? The counter-argument is of course that the greater the total assets under management, the greater the discount we can all get on the fund management charges.



That was my first takeaway from this article... I believe I am currently benefitting from a former employer covering the costs associated with my deferred pensions fund still with them.
Would an increase in assets under management by keeping ex-employee funds outweigh the potential savings that could be negotiated from the fund managers? I suspect not. Small balances from short-time employees are, I'm sure, a nightmare to maintain and manage. Also, the former employer owes their ex-employee nothing in terms of maintaining their pension savings, right? This move may be more altruistic than practicable/sensible from an ex-employer's perspective.


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## Steven Barrett (20 Mar 2018)

interesting article. Are you proposing something like a With Profits fund? 

I had the same thoughts as Gordon regarding remaining part of the employers scheme. Do you think employers would be willing to continue to pay for ex employees all the way to their death? 

There is an increasing body of research on sequencing risk that shows staying invested in equities and all the ups and down that goes with it, is more financially beneficial than being invested in cash/ bonds. It's another thing however, getting a retiree who has built up a pot of money over their lifetime, to invest in something that could fall by -50%!!


Steven
www.bluewaterfp.ie


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## elacsaplau (20 Mar 2018)

SBarrett said:


> There is an increasing body of research on sequencing risk that shows staying invested in equities and all the ups and down that goes with it, is more financially beneficial than being invested in cash/ bonds.



Hi Steven,

Can you share any such evidence please?

Thanks


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## Steven Barrett (20 Mar 2018)

elacsaplau said:


> Hi Steven,
> 
> Can you share any such evidence please?
> 
> Thanks



Here's a link to a very good blog on it. There's a couple of links within it to that are relevant and another one by Paul Resnik who owns the risk profiling tool, Finametrica.


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## Colm Fagan (20 Mar 2018)

Gordon Gekko said:


> Would employers want retirees “hanging around” the company pension scheme though? My employers covers the costs associated with the scheme (excluding the fund charges). Should that benefit accrue to ex-employees?





SBarrett said:


> I had the same thoughts as Gordon regarding remaining part of the employers scheme. Do you think employers would be willing to continue to pay for ex employees all the way to their death?



Fair questions both.  In order to answer them, it is important first of all to set the context for the proposals.  I'm thinking (initially at least) of the large employers who traditionally offered generous DB pensions to their employees. Think companies like Glanbia, Diageo, CRH, the banks, the major insurance companies, etc..  Pension payments to DB pensioners in those companies traditionally came (and still come) from the same funds as were used for active service members. The requirement for members to take their money and leave the fund on retirement is a product of the DC era, and did not exist previously.  All I'm suggesting therefore is that we go back, but only part of the way, to the regime that has traditionally existed for DB.

I can readily understand why the sponsoring employers and trustees of DC schemes would not want to be saddled (a pejorative term but sadly an accurate reflection of prevailing sentiment) with a responsibility for former employees once they have retired.  There could be a natural fear that, if a retired member were to draw down all their DC funds within the first (say) 10 years following retirement, they might come back to the employer or the trustees asking for a handout.

The proposed "Lifetime Income Fund” (LIF) addresses this risk.  The LIF eliminates the risk of members drawing down all their funds prematurely.  Employers are not being asked to "continue to pay for ex employees all the way to their death", as Steve suggests.  All pension payments to former employees will come from the funds that they have accumulated during their working lifetimes or from the LIF, which is built up from contributions from themselves and other retired employees.  Not a cent will come from the employer, over and above what it has contributed pre-retirement.

There is a wider philosophical point here. There is a widespread view among pension and HR professionals that the pendulum has swung too far in the move from DB to DC.  Yes, it was far too generous of employers in the past to promise a pension for life of 50% (or whatever) of the member’s retiring salary, and to promise inflation proofing in some instances, but it is going too far in the other direction to kick them out the door and leave them completely to their own devices once they retire.  What I'm proposing goes a small way to redress that imbalance.


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## elacsaplau (20 Mar 2018)

Hi Colm,

Firstly - interesting proposals and I totally agree that the application of one's DC fund in retirement is a huge challenge facing society.

Up until recently, I was involved in a global pension de-risking project for a large US multi-national. We linked in with other US MNCs via a working group. De-risking is shorthand for getting the hell away from as much pension liability as possible - not legally possible in all jurisdictions. At corporate, i.e. decision making level, I would have the exact opposite view to the quote below based on personal experience and from my discussion with peers on the working group.



Colm Fagan said:


> There is a widespread view among pension and HR professionals that the pendulum has swung too far in the move from DB to DC.



Just a point of detail - seemingly plausible smoothed DC funds have been tried and have failed before in Ireland - e.g. one was designed for one of the BOI staff plans in the 1990s and say, the more generally available Secured Performance Fund by Irish Life. Both were designed by members of your noble profession and both succumbed for different reasons and at different times. [You were in Cheltenham last week - When Ruby sluiced in on Benie des Dieux, it was hard to envisage him not winning top jockey, yet again - but weird stuff / scheisse happens!]

The problem you are attempting to address is real. That said, I would be absolutely amazed if employers sign up to your proposed solution. Amongst other things, the simple fact is that actuaries did not generally provide sufficient warnings in the 1980s and 1990s of the prospective liabilities and risks inherent in DB plans and the then level of risk control at corporate level was generally poor. This risks are gradually getting under control - in my opinion, there is just the very remotest of chance that employers would go down that road again. It would be a bit like a new CEO pf an Irish bank suggesting to the Board that the way to get market share would be to offer 100%+ mortgages!!


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## Gordon Gekko (20 Mar 2018)

Surely the State has a role to play on the basis that it has a vested interest in the performance of an individual’s ARF? I posted some figures recently which I don’t have to hand, but in broad terms the State forgoes circa €360k in the form of tax relief for a high earner but then collects circa €2.5m in taxes (i.e. income tax, USC, and quasi-CAT) down the line. The more the individual embraces risk, the more comfortable his or her retirement should be, and the more the State will collect. So perhaps the State should incentivise more appropriate asset allocation?


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## Colm Fagan (21 Mar 2018)

elacsaplau said:


> Just a point of detail - seemingly plausible smoothed DC funds have been tried and have failed before in Ireland - e.g. one was designed for one of the BOI staff plans in the 1990s and say, the more generally available Secured Performance Fund by Irish Life. Both were designed by members of your noble profession and both succumbed for different reasons and at different times.



You're absolutely right on both counts.  I have to admit that the BOI staff plan was my baby.  There are still people in the Bank cursing me for it.  The main reason why both the BOI plan and the Irish Life Secured Performance Fund failed was because they were open to active service members.

I learned my lesson.  I made it very clear in the presentation that the proposed approach would only work for retired members of medium to large DC schemes (and for auto-enrolment, provided certain rules are set at the outset).  It would not work for active service members (other than auto-enrolment with the rules drafted appropriately) nor for small schemes or individual arrangements.

The purpose of the February presentation to the Society of Actuaries, of similar presentations that I plan to make to other expert groups, and in exposing the proposals for scrutiny on this and other fora, is to stimulate constructive discussion and to find the fatal flaw in the proposals, if there is one.  I believe there isn't a fatal flaw and that the proposed approach will deliver approximately double the income (on average ) to retirees that they could obtain under current arrangements (under either an annuity or drawdown).  That is a result well worth fighting for.


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## Colm Fagan (21 Mar 2018)

SBarrett said:


> It's another thing however, getting a retiree who has built up a pot of money over their lifetime, to invest in something that could fall by -50%!!



I agree that it would be totally unreasonable to ask someone, particularly a retired scheme member, to take the risk that the value of their investment could fall by up to 50%.  I'm not making that request. 

The smoothing formula was back-tested over the last 32 years.  This period included one month when market values fell by more than 25% (October 1987), and another seven months when market values fell by more than 8% in the month.  Despite these sharp gyrations in market values, the worst monthly outcome for the smoothed price over the entire period was a fall of less than 0.1%.  

Under the proposed approach, retired members will invest, and take their money out, at the smoothed price, so they will be truly protected from the risk of big falls in market values.


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## elacsaplau (21 Mar 2018)

Gordon Gekko said:


> Surely the State has a role to play....



That's an excellent point for many reasons



Colm Fagan said:


> That is a result well worth fighting for.



Agreed.

I must admit to only scanning briefly your proposals abot two weeks ago so I will look at in detail over the next few days. In the meantime,

- Has something like this been tried anywhere else?
- What would be the accounting treatment and cost for MNCs - FAS, FRS, IAS?


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## elacsaplau (21 Mar 2018)

Hi Colm,

I had some unexpected time due to a flight delay so I had a look at your paper. Lots of really good stuff. That said - I'm not sure if it will catch on.

A few observations / thoughts / questions....

1. The model _may_ work if your assumptions are borne out in practice. I say _may_ because I don't understand enough / haven't sufficient visibility as to how sequence of return risks impact here. In any event, being critical, I think you are basing your model on an ERP which may or may not materialise - and I just can't see any possibility of corporate America (with which I am very familiar) wishing to get involved here. Like Carlsberg, it will work.........._probably_................just don't think that _probably_ will be good enough no more!

In your presentation, you mention your interest in behavioural economics - I believe there is a little _confirmation bias_ going on here!! Let me try back this up by challenging the statistics used! Let's just take the first bullet in the first of your slides which deal with ERPs, as set out below:

*Federal Reserve Bank of New York, 2015: ERP between 5% and 6% per annum*
_–Derived from a combination of models, retrospective and prospective
–Between 1960 and 2013, mean ERP of 9.3% per annum_

This is exactly the type of thing that I was referring to last night - the under-playing of the risk! It presents a nice rosy picture but fails to sufficiently explain the potential pitfalls! Specifically,

(a) The Fed's paper, which analysed c. 20 ERP models, showed a mean / average ERP expectation of 5.7%. However, the range of outcomes in this report was massive (not the gently reassuring range of 5% to 6% as bolded in the presentation - but from negative to the mid-teens - i.e. a huge range of possible outcomes!) What happens if returns are towards the lower end of the spectrum on a sustained basis?

(b) The mean ERP of 9.3% p.a. suggests an historic ERP over this period of 9.3% p.a. - that's certainly how I read it, initially. Then I remembered that stocks did not fare particularly well in the US in the 1960s and 1970s - so I decided to dig a little. In reality, the historic ERP over this entire period is circa 3.2% p.a. That's a pretty big difference?!

In fairness, the Fed report does indeed show a 9.3% return, using a "time series" basis, one of the 5 models it examined. Selecting the model with the highest ERP (i.e. c. 6% p.a. greater than the actual ERP) - to help frame (.....see what I've done here?!) how reasonable and appropriate your assumptions are - and not explaining why a particular model is used - is, well, pretty selective indeed!!


2. The other figure that doesn't quite smell right is a dividend yield of 3.25%. Perhaps, just a little on the high side on a global basis - I mention this because if that stat was presented to a US audience, it would really stick out as very optimistic!


3. What happens when the sponsoring employer ceases / goes belly up / wishes to sell-off part of its business?


4. How are deferred members treated?


5. How are spouses / partners treated?


6. What would the accounting treatment be?


7. Is there a precedent for this model anywhere?


8. What would happen if we ever had a bit of a nutter, simultaneously, in the White House and in the Kremlin?  [The emoji belies the genuine seriousness of the question - what I really mean is if some really bad stuff occurs.]


The thing is that over the next 50 years, the ERP may well be of the order of 5% on average. But - it's a long way from being sure - and the progression is unlikely to be smooth. It's invariably the peaks and troughs (and mostly the troughs) that I'd be worried about. Eventually, stuff happens - sometimes good, sometimes not.

At a general level, after spending the last decade or so torturously buying as much pension certainty as possible throughout the globe, why would any MNC want to get involved here again? Apart from anything else, pension related issues took up inordinate amounts of time in recent years.

Just re-reading now - apologies if the tone comes across as overly critical / negative.


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## Duke of Marmalade (21 Mar 2018)

Gordon Gekko said:


> Would employers want retirees “hanging around” the company pension scheme though?


Several contributors are raising this objection.  One then asks why did employers give DB pensions in the first place, why do they give DC pensions now?  The answer is not all down to paternalism.  These were seen as genuine incentives to attract employees.  If Colm's proposal can be made to work and if people really understood how naked they are on their own in an ARF then I could see it being a very attractive employee benefit.

The idea of pooling longevity risk and pooling the timing risk of equity investment is quite compelling.  Certainly on longevity risk the risk to a large pool is much less than the risk to an individual and this should be a free lunch.  Unfortunately the artificially low interest rate environment together with the (legitimate) requirements for solvency capital make longevity risk insurance per annuities a very unattractive proposition.

The pooling of the timing risk in equity investment is less obviously a free lunch and relies in a confidence that over time the Equity Risk Premium will be earned on average but it may need pooling between generations.

So the three prizes are there:  pooled economies of scale in investment management, pooled longevity risk and pooled timing risk of equity investment.

Colm has gone to some lengths to address the main practical objection - anti selection.  Other contributors have raised legitimate other practical issues.  I think _elac _is also challenging that the ERP is a free lunch.  My challenge is that Colm recognises that the wheels can come off as in Japan illustration.  This needs transparent rules around timely intervention - which must necessarily mean adjusting implied expectations downwards.

But here is a perverse thought experiment.  Let's say Colm's proposals are adopted _en masse _and a substantial portion of our ever increasing pensioner population end up being 2.5 times better off than would otherwise have been the case.  I don't think Colm is suggesting that his proposal adds economic value in the aggregate.  Therefore there will have been an implied generational transfer of wealth, a phenomenon which already has the younger generation crying foul.  Maybe ARFs being invested 40% in cash is an acceptable reversal of this transfer of wealth.  Just a thought


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## elacsaplau (21 Mar 2018)

Duke,

The points about the merits of pooling are undisputable - unless Brendan is the fund manager and takes to spread betting even more seriously!

I just can't see employers adopting the proposed model. Personally, I believe it's a job for insurers and the state. [I'm not close enough to the detail but I'd like to understand the experience of "participating" annuities - other obviously than Equitable Life - as in, how they have fared and why?] It's their core business - not regular employers. I met my old (U.S.) CFO recently who had sponsored the project that I'd been working on. "How's it going" I enquired - "great, now that we're out of the pension business" he retorted......I kid you not.



Duke of Marmalade said:


> My challenge is that Colm recognises that the wheels can come off as in Japan illustration.  This needs transparent rules around timely intervention - which must necessarily mean adjusting implied expectations downwards.



Exactly - member, nay pensioner, communications bringing bad news to pensioners. Ouch.


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## Colm Fagan (21 Mar 2018)

Lots of good points have been made – as I would have expected from contributors to this forum.

I’ll try to deal with as many of them as possible.

One recurring theme is that employers would not want to touch this with a 40-foot barge-pole, that they got their fingers burnt badly with DB pensions and they would not wish to go down that road again. It is claimed that this would be particularly true of MNC’s.



elacsaplau said:


> At a general level, after spending the last decade or so torturously buying as much pension certainty as possible throughout the globe, why would any MNC want to get involved here again? Apart from anything else, pension related issues took up inordinate amounts of time in recent years.



My main counter is that, other than the costs of administering regular payments to members in drawdown (which service can be charged for, if the employer is so minded, but which I haven’t factored into the figures) there is no risk to the employer.  When members retire, their accumulated funds (less what they take by way of tax-free cash at retirement) remain in the pension fund, where they are administered by the trustees and are held completely separate from the employer.  Subsequently, the swings and roundabouts in terms of “winners” and “losers” that are an inevitable consequence of pooling investment returns, smoothing investment returns through good times and bad, and pooling longevity risks, are all shared with other members of the pool. It all takes place within the ring-fenced fund.  The employer has no involvement whatsoever and will not carry any risk.

Related to this is the question of accounting treatment and cost.  As I intimated, there is no cost to the employer, so it will have no impact on the balance sheet of the sponsoring company.  The only cost that will go through the sponsoring company’s P&L account is the contribution to the DC scheme, as would be the case if there were no smoothing and no longevity pooling.

There are interesting questions on how the scheme might appear on the balance sheet of the pension fund itself.  For example, if the smoothed value is 100 but the market value is 120, what are the liabilities and assets shown at on the fund’s balance sheet?  My contention is that they will always be shown at market value, irrespective of whether the smoothed value is greater than or less than market value at an accounting period end.  The smoothed value is just one element of a formula for determining the smoothed return to be credited to retired members in future.  The key thing to remember, what makes the smoothing formula work, is that members cannot take their money out on a whim at the smoothed price, just a portion, which they have already notified to the trustees.  “It’s a pension, not a piggy-bank” is the mantra.

Another recurring theme is whether my estimate for the Equity Risk Premium is over-optimistic.  First, I presume we all agree that there must be a positive expected ERP.  Otherwise, why would anyone put their money at risk of loss?  Opinions differ on its size.  My estimate of 4% to 6% was arrived at from a variety of sources, not just from the work by the New York Fed.  I doubt very much if it will ever fall below the lower end of that range over a ten-year period, but I could be wrong.  Even if it’s (say) 3% or 2.5%, the argument is still valid.  There is a free lunch to be had from investing in equities and property, PROVIDED you have a sufficiently long time horizon and can live with the short-term gyrations. The proposed smoothing approach addresses both of these challenges.  The smoothing formula works over a very long period – my recollection is that it only gives 50% weighting to market values in the last five years, so short-term market gyrations have only a very small impact on the smoothed price.


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## Colm Fagan (21 Mar 2018)

Duke of Marmalade said:


> Several contributors are raising this objection. One then asks why did employers give DB pensions in the first place, why do they give DC pensions now? The answer is not all down to paternalism. These were seen as genuine incentives to attract employees. If Colm's proposal can be made to work and if people really understood how naked they are on their own in an ARF then I could see it being a very attractive employee benefit.


Duke is right.  If an employer decides to run with these proposals and makes them work, it will be an attractive employee benefit.


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## elacsaplau (21 Mar 2018)

Thanks Colm,

Just a few additional comments /questions:



Colm Fagan said:


> The employer has no involvement whatsoever and will not carry any risk.



So what would happen if the employer ceased operations? Are you saying that the Trustees could continue on and pay the administration charges and benefits from the fund? What would happen if the trustees did not want to continue upon employer cessation? Why, specifically, can insurers not partner with large employers and offer this service now? Why would there be anything other than negligible  "capital" requirements for insurers if all the insurer is doing is effectively smoothing the investment return in a stand-alone, ring-fenced, unit-linked fund?


Regarding ERP expectation, like the young lad going on a hot date, there is a difference between expectation and reality. I presume we all agree on that?!


Regarding actual returns - the S&P trailed 10 year US Treasuries for the whole of the 1970s - i.e. negative ERP - 10 year bonds did better than the S&P.

I have already mentioned that the actual US ERP for the entire period 1960 to 2013 was c. 3.3% p.a. in the U.S. This is a gross return before taxes and charges. [I'm sorry I can't recall what allowances you made for tax and charges in your modelling]. The markets did what they do but there was no real disaster during this period - who is to say that the next 50 / 60 years will or will not be better? Do you actually accept the figure of 3.3% p.a.?


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## Duke of Marmalade (21 Mar 2018)

elacsaplau said:


> Regarding ERP expectation, like the young lad going on a hot date, there is a difference between expectation and reality. I presume we all agree on that?!


I luv it.  ERP has two definitions in the FRBNY report.  One is what people expect which is undoubtedly positive. The other is what was actually achieved which for Japanese punters was definitely negative. Though ironically reality seems to have exceeded expectation in most situations.


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## Colm Fagan (21 Mar 2018)

elacsaplau said:


> So what would happen if the employer ceased operations? Are you saying that the Trustees could continue on and pay the administration charges and benefits from the fund? What would happen if the trustees did not want to continue upon employer cessation?




Yes, that's the principle underlying all pension funds governed by Trust Deed and Rules, that the fund can trundle on if the employer goes bust.

In practice, if the employer were to disappear, it is likely that the trustees would turn to an insurance company to administer the scheme subsequently. As to why insurance companies are not offering this "service" now, the answer is that they are in the same boat as yourself: they too are sceptical about the proposed approach.  I hope to convince them too - eventually.

I agree that there should be negligible capital charges for insurance companies - or any other type of institution - running drawdown arrangements for retired employees on the proposed lines. Having had long experience of dealing with insurance regulators, domestic and European, however, I reckon they will take some convincing that this is the case.  This is one of the reasons why I would prefer to steer clear of the insurance route at the start.

It's a long time since I was a young lad going on a hot date, so I can't comment on the difference between expectations and reality in those circumstances!

There is a more serious issue in relation to historic returns on equities versus bonds, which often causes confusion.  For a number of decades now, bonds have delivered high returns, but a large proportion of those returns have come from eating the seed corn.  Seed corn can only be eaten once.  Let me give a simple example to illustrate what I mean.  At end 1980, US bond yields, on the information available to me, were 11.6%.  At end 2016, they had fallen to 2.8%.  Let us suppose for simplicity that someone had bought an irredeemable bond carrying a coupon of 8% at end 1980.  They would have paid $69 for the bond (8/69 = 11.6%) at the time and would have received a coupon of $8 in each subsequent year.  At end 2016, the price of that same bond would have increased to $285 (8/285 = 2.8%).  I estimate that, over the entire 36 year period, their average return would have been 12.2% per annum.  Of that 12.2%, 11.6% came from the $8 coupon received each year on the bond purchased for $69, while the other 0.6% per annum came from converting the profit of 285-69 = $216 on selling the bond at the end of 2016 into an annual return on the original $69 purchase price.  The problem is that the high historic return was earned on the back of a low prospective return for people buying now.  Current purchasers can only earn a higher yield than 2.8% if interest rates fall even further in future.  I reckon that this phenomenon explains a high proportion of the apparently superior returns that you say (and I believe you) were achieved for bonds in the 1970's.  Any such "windfall" profits should be excluded from the calculation.

I made no allowance for tax, as pension funds in this country can accumulate returns free of tax.  As I recall, I allowed for asset management and other costs of the order of 0.75% per annum.


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## elacsaplau (22 Mar 2018)

Colm Fagan said:


> Yes, that's the principle underlying all pension funds governed by Trust Deed and Rules, that the fund can trundle on if the employer goes bust.



The schemes with which I am familiar obliged the trustees to determine the scheme upon notice of cessation of employer contributions. Theoretically, if the TD&R didn't expressly prescribe this, the trustees could possibly trundle on but the likelihood of this happening is, I would suspect, remote. That's in Ireland - in the UK, also a trust based model, given the proper protections that exist to members upon plan cessation (unlike here), I'd suspect the trustees trundling on would be even a remoter possibility.

I agree with your seed corn analysis if we were talking about seed corn. I wasn't talking about irredeemable bonds - my figures were based on 10 year treasuries and I don't see much confusion - certainly none that materially detracts from the substantial point.

Irish pension funds do not accumulate tax free! Very common misconception. No tax is levied in Ireland but other jurisdictions levy tax which may or may not be recoverable. Dividend With-holding Tax (DWT) in the US is the primary, but not exclusive example, of this.



Duke of Marmalade said:


> Though ironically reality seems to have exceeded expectation in most situations.



Duke - so I suppose we can surmise that the hot date does often go well - giving rise to not alone a free lunch but breakfast also!

Oh, I was thinking about your crazy thought experiment - I think I can assuage your concerns of social upheaval on the island. The money will be invested overseas meaning that the Paddies get a higher slice of the worldwide cake. It then becomes, not an act of further inter-generational wealth transfer within Ireland, but rather a patriotic Paddies first measure. Mostly kidding around here....

Better go and do some real work now....


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## Duke of Marmalade (22 Mar 2018)

elacsaplau said:


> Duke - so I suppose we can surmise that the hot date does often go well - giving rise to not alone a free lunch but breakfast also!


My expectations were always low on that front


elacsaplau said:


> Oh, I was thinking about your crazy thought experiment - I think I can assuage your concerns of social upheaval on the island. The money will be invested overseas meaning that the Paddies get a higher slice of the worldwide cake. It then becomes, not an act of further inter-generational wealth transfer within Ireland, but rather a patriotic Paddies first measure. Mostly kidding around here....
> 
> Better go and do some real work now....


I think Colm is more ambitious for his proposal than being merely a Paddie solution to a Paddie problem.


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## Colm Fagan (22 Mar 2018)

I posted twice by accident!  This is to delete one (I can't see how to just delete a post:  I have to replace it with some text)


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## Colm Fagan (22 Mar 2018)

elacsaplau said:


> The schemes with which I am familiar obliged the trustees to determine the scheme upon notice of cessation of employer contributions.


I'm no pensions expert, but I understand that the requirement you mention applies to schemes where there are active service employees and where employer pension contributions are required to ensure that promised benefits can be provided.  For retired members, the employer is not making any further contributions, so the requirement doesn't apply.   I nonetheless recognise the validity of the concerns that you and others have raised about the continued involvement of the employer post retirement.  I spoke to a joint meeting of the IAPF/IIPM in Cork this morning, and an alternative approach, which does not involve the employer's continued involvement, was prompted by a comment from one of the attendees.  (Thank you, John)  I hope to produce Mark  II of my proposals soon, to address this concern.



elacsaplau said:


> I wasn't talking about irredeemable bonds - my figures were based on 10 year treasuries and I don't see much confusion - certainly none that materially detracts from the substantial point.


I accept that irredeemable bonds were an extreme example.  Nevertheless, 10-year treasuries would also enjoy a substantial price pick-up from falling interest rates.  Furthermore, we must recognise that the bull market in bonds of the last 30 years or so, when interest rates fell from double digits to low single digits, will not be repeated in future.  The seed-corn of falling interest rates has been well and truly devoured.



elacsaplau said:


> Irish pension funds do not accumulate tax free! Very common misconception. No tax is levied in Ireland but other jurisdictions levy tax which may or may not be recoverable. Dividend With-holding Tax (DWT) in the US is the primary, but not exclusive example, of this.


I recognise the problem of DWT very well from my own investing activity.  The Apple dividends that accrue to my ARF every quarter have 15% taken off the top, and I can't get the money back.  It's nice not to have to pay CGT though.  Also, the Irish and UK dividends paid to the ARF have no further tax deductions (except for UK REIT's - another hornet's nest!).



Duke of Marmalade said:


> I think Colm is more ambitious for his proposal than being merely a Paddie solution to a Paddie problem


Duke, you're absolutely right.  I see this as a world-wide problem and I would like to see my proposed approach being applied world-wide eventually.  I don't know if you're being serious with your thought experiment.  If you are, there's no need to worry.  The proportion of total investments represented by DC pensions is trivial in the wider investment world, so will have no material impact.  Also, think of all the extra work there will be for young, able-bodied people if wrinklies have lots more cash to splash around!


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## elacsaplau (22 Mar 2018)

Colm Fagan said:


> I spoke to a joint meeting of the IAPF/IIPM in Cork this morning, and an alternative approach, which does not involve the employer's continued involvement, was prompted by a comment from one of the attendees.  (Thank you, John)  I hope to produce Mark  II of my proposals soon, to address this concern.



That's great - I actually do wish you well - the central themes are great - just trying to advise you of the probable very marked reticence of employers - look forward to seeing Mark II.



Colm Fagan said:


> I recognise the problem of DWT very well from my own investing activity.



- Whats the story with tax?
- There's no tax
- Not true
- I know well it's not true


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## Duke of Marmalade (22 Mar 2018)

Colm Fagan said:


> I don't know if you're being serious with your thought experiment.


Not terribly serious but I do think the macro socio-economic aspects of pension provision are intriguing.  Imagine a situation where the only factor of production was Labour.  Then all pension provision would need to be by social transfers.  Luckily capital is also a major factor of production.  So a situation is plausible whereby the pensioner claim on society is based on its ownership of capital (supporting your proposal) and not on social handouts.

But, especially given the demographics, there are social limits to much of the cake pensioners can claim versus the active population.


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## SPC100 (19 Dec 2018)

I know this is an old thread - but I saw some references to it and your pension proposal on some other threads, so went searching for this.

Previous posters have brought up any of the concerns I saw, in particular, that the ER premium turns out to be much lower than anticipated, there needs to be clear guidance in advance on what would happen, and who/if anyone would underwrite.

I have three questions
1. I understand it was the concerns about drawdown that inspired the solution. But why limit this just to folks entering drawdown stages? You mentioned elsewhere about an AE meeting recently, so maybe you already extended this proposal?
2. Any updates on if the state or any large employer are considering something like this?
3. is there a thread or place to follow along to see what progress you manage to make with this?


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## Colm Fagan (19 Dec 2018)

SPC100 said:


> I understand it was the concerns about drawdown that inspired the solution. But why limit this just to folks entering drawdown stages? You mentioned elsewhere about an AE meeting recently, so maybe you already extended this proposal?


You're right!  I expanded on the ideas in my February paper and submitted them to the DEASP as a possible solution to the Auto-Enrolment challenge.  I attached them to Post #428 in the "New Sunday Time Feature - Diary of a Private Investor" thread.  They were discussed later in that thread.  I don't know if Brendan or someone else can transfer the discussion to this thread (which seems more logical) and also to change the title to include reference to AE.  For ease of reference, I attach them again to this post.   
In answer to question 2, no-one has yet indicated to me that they are considering implementing the proposed approach.  I will be delighted to speak with anyone who is considering them - and I've retired from consulting so there's no fee!!
3:  As mentioned above, see the discussion under the "Diary of a Private Investor" thread.


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## SPC100 (19 Dec 2018)

Thanks. I'm reading it now.

For others here is a link to Post #428 in the "New Sunday Time Feature - Diary of a Private Investor"  where there is some discussion on this (although intermingled with other topics).


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## Colm Fagan (22 Dec 2018)

I promised (in the thread referred to by @SPC100 above) to give an update on Monday’s seminar.  

The main purpose of the seminar was to assess the technical feasibility of the proposed smoothing approach to auto-enrolment.

As I said in an earlier post, there was considerable support for the proposed approach, but also lots of questions.

My first slide to the seminar (attached) shows the advantages of the proposed approach compared with existing approaches to pension provision, almost all of which involve taking the foot off the gas just when the fund is at its highest earning power.

Arguably, the attached slide understates the potential upside of the proposed approach.  It assumes that the “conventional” approach and the smoothed approach deliver the same returns up to 10 years before retirement.  In practice, very few contributors take an unmitigated high-risk, high return approach to investment at present.  That knocks a percentage or two off _expected_ (with emphasis on the word “expected”) returns.   Even a tiny difference in annual return can have a major impact over a long number of years.

The slide also assumes that costs are the same under both approaches.  That is definitely not true, especially post retirement.  Under the current regime, ARF holders need to get regular investment advice throughout their retirement.  That advice is expensive.  The cost hasn’t been factored into the Fund A calculations.  There is no need for advice under the smoothed approach, since there is no investment choice.  The only decision is how much to withdraw each year.   A financial adviser doesn’t have any special skills in this area.

A considerable portion of Monday’s discussion centred on the two sentences in paragraph 16 of my submission:

*“The integrity of the smoothing formula and its independence from outside influence are essential.   Maintaining the integrity of the smoothing formula also ensures that auto-enrolment will operate on a mutual basis, with no need for financial underwriting or support from the state or an external financial institution.”*

There was general agreement that the government will run a mile from the proposed approach if there is any risk of it (the government) being on the hook if things go wrong.  It was also pointed out that, even if I’m right in asserting that the smoothing approach would have worked for the entire period from 1870 to now, that doesn’t prove it will work in future.  We need to test its robustness by simulating a wide range of possible futures, by running (say) 10,000 simulations of possible developments in financial markets over the next (say) 50 years. 

If the smoothing approach runs smoothly for the entire 50 years for all 10,000 simulations, then we can reasonably assume that the government will back it.  But what if it doesn’t?  What if everything is okay for (say) 9,950 of the simulations, each covering the next 50 years, but the fund goes insolvent without state intervention in the other 50 out of 10,000 simulations?  Would the government be prepared to back the proposed approach in those circumstances?  As an aside, the required solvency standard for (re)insurance companies is that everything should be okay for 9,950 of the 10,000 simulations.  Would the government accept the same risk of being on the hook?

We must also define what we mean by “insolvency”.   It doesn’t mean that there wouldn’t be enough money in the fund to pay beneficiaries the promised amounts as they became due.  That point would never be reached, even in a worst-case scenario.  The writing would be on the wall long before then.  The real risk is of smoothed values exceeding market values by a considerable margin for several years, to such an extent that people under retirement age would decide to stop contributing and retired contributors would withdraw the maximum allowable each year.  Thus, there would be no new money coming in, and continuing members would have to subsidise people making withdrawals at values greater than market values.  In those circumstances, the trustees would have to wind up the fund and distribute its assets in proportion to members’ nominal account balances.  It wouldn’t be the end of the world, but it would be embarrassing at the very least for the government of the day.

There is also the question of who’ll do the 10,000 simulations.  We can’t expect people with demanding day-jobs to do the work for nothing.  (And I no longer have the computer nor mathematical skills to do the job).  Should the government commission a firm of consultants to do the work?


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