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?