NSFM Participant Opinion: Pensions or deckchairs?

Nick Silver writes: I started out to write about how actuaries and other pension fund advisors might change their behavior. But I am going to change my brief; when you are employed to move round deck chairs, it’s more important to point out the ship is sinking than to perfect chair placement.

The critical feature of many private sector pension systems, including the USA and UK systems, is that government gives the sector generous tax subsidies (predominantly tax exemptions for pension contributions and interest) in return for strict regulations. Why does the government do this?

Private pensions are perceived as a social good for two main reasons:

1.  People are encouraged to save so that they are not a burden to the state when old; and

2.  They increase the savings rate, and hence investment, which is required for economic growth.

Most people who have pensions are those with other assets– i.e. the relatively affluent. Also, the very rich have the biggest pensions and disproportionately benefit from the tax subsidy. These are the people who will look after themselves when they are old anyway; whereas, the poor are typically pension-less – they are the people who will have to be looked after by the state – the private system makes virtually no difference.  Savings by the rich are subsidized, through tax rebates, by the average tax-payer.

If there were no tax subsidies, ceteris paribus, the government would be raising more taxes, which is also counted as savings by the economics profession. So, economically speaking, pensions would only be useful if extra savings are generated. And clearly they are not, as the US and UK have some of the world’s lowest savings rates.

But things are worse when you look at where the savings actually go. The majority of pension fund assets are invested in equities, with a large minority in bonds. If we look at the equity part, where does this money go? Large pension funds are effectively index trackers, so investments go into the shares of the largest companies. This indirectly increases the ability of companies to raise capital, as the stock market is a secondary index.

It also has adverse side effects, like encouraging short term behavior at investee companies.  Furthermore, the economy does not need increased capital and liquidity for BP.  It needs capital to invest in things like energy efficiency, smart infrastructure and education, but a negligible fraction of pension savings goes into this.

Society has outsourced its capital allocation decisions to a small group of professional fund managers who invest in a way which is of little social benefit. These managers have little or no understanding of the larger impact their decisions have on the broader economy, and even if they did, there would be external constraints on their investment decisions.

A recent study found that up to 40% of the value of a pension is taken in fees – approximately equivalent to the value of the tax subsidy. Hence, if you look at flows in the UK, the government is effectively subsiding the pensions industry. This has in part led to a sophisticated financial service sector and capital markets. Is this a good thing?

Martin Wolf has argued that the UK is like a single resource economy, where that resource is the financial services sector. If you want a good job in the UK, you go into banking or accountancy. In a small scale, this industry might be useful, but our economy has been totally skewed to this sector, making the UK’s economy extremely fragile and vulnerable to economic shocks.

So, our current pension system transfers huge amounts of money to the relatively rich (people with assets) or the very rich (the financial services sector).  It subsidizes an industry which is already far too big and delivers low savings rates, but it does not allocate capital to the sectors of the economy that need capital

Abandoning the pension tax subsidy would take away justification for the system’s regulation.  That might end the current system as we know it, but that would be a good thing. The current system is regressive and produces little social benefit.  In my next post, I shall elucidate what could replace it.

Nick Silver is an actuary with 20 years experience in the pensions industry. He is a director of Callund Consulting, which advises governments and companies in developing countries on pensions and social insurance reform, and he is a co-founder of the Climate Bonds Initiative. He is a senior visiting fellow at Cass Business School and visiting fellow at the Grantham Institute at the LSE.

This article is part of the NSFM opinion series, in which participants propose specific steps towards real and sustainable market reform. Contributors write in a personal capacity. NSFM participants are invited to comment on blogs articles and contribute to the series. Please contact Ebba Schmidt or Frank Jan de Graaf for further information.