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Investment Life & Pensions Moneyfacts: OECD – Auto-enrolment a second-best

Investment Life & Pensions Moneyfacts: OECD – Auto-enrolment a second-best

This article was originally commissioned and published in May 2013 for Investment Life & Pensions Moneyfacts publication. Tom Murray, Head of Product Strategy at Exaxe, explores why the OECD is steering the Irish pensions system away from auto-enrolment and what UK pension reformers could learn from this.

Ireland is steered away from UK model

Last April’s review of the Irish pension system by the Organisation for Economic Co-operation and Development (OECD) is well worth a read by anyone who is interested in UK pensions. That might sound anomalous but it’s true. The current Irish pensions system bears striking similarity to the one in place in Britain before the current reforms and now change is needed, you would expect the Irish to introduce reforms similar if not identical to the ones introduced by the UK government. Yet that’s not what the OECD is recommending to them.

The Irish public pension system, like that of all OECD members, is under strain, although at this point it is mainly under pressure from the current financial crisis in Ireland and not from the on-going effects of longevity. Ireland has had a higher birth-rate than most other developed countries for historical reasons and this means that their pensions crisis, whilst definitely coming, is a little further down the road than everyone else’s.

The Irish are under pressure to prove that their budgetary stance is viable as they are under a lot of scrutiny from the markets and to do this they need to get their future liabilities under control. Luckily they still have time. While there was a lot in the report about the changes needed to get the public sector pension schemes under control, what was interesting from the UK viewpoint was the sections on increasing private sector pension saving in Ireland.

Keeping up with the Jones’s

Ireland’s pension strategy has always lagged the UK’s. Given the fact that the Republic has only one sixteenth of the population of the UK, the Irish have tended to let the UK experiment in many areas, including pensions, and then bring in legislation that is based on the results their bigger neighbour has had rather than lead from the front. Thus personal pensions, drawdown products and PRSAs (a version of stakeholder) were all introduced a number of years after the UK first introduced them, with fine-tuning applied to overcome any issues that had arisen during the UK implementation.

Thus now it would naturally follow that the Irish, facing the same shortage as the UK of private sector pension savings among low to middle income earners, would be looking to introduce a version of the auto-enrolment that the UK are in the process of implementing.

This time, however, in need of international approbation to assist their re-entry into the markets from their Troika bailout plan, they commissioned a special report from the OECD into the Irish pension system, seeking external approval for the move to an auto-enrolled system. To their surprise, however, this isn’t what they ended up with.

Mandatory is best

The OECD’s report didn’t quite come out the way that they expected. Instead of pushing Ireland to follow the UK ‘s path of auto-enrolment, the report’s main recommendation pushes the Irish government towards a mandatory or quasi-mandatory system in order to reduce the pressures on the public purse and to maximise the number of people providing for themselves in the future. Even though it acknowledges that Ireland is not facing anything like the severity of the impending pension crisis in the UK, the OECD still felt that auto-enrolment was too weak and inefficient an approach to tackle the problem. In fact, the OECD’s opinion was that auto-enrolment was very much a “second-best” approach.
OECD report
How did the OECD come to this conclusion? It’s not as if it was a snap decision by the UK to go this direction. The UK’s auto-enrolment approach was the result of years of study and investigation by government and industry sponsored groups and should have been the obvious choice for a country coming from a similar background to follow.

Instead the OECD have been rather lukewarm about the benefits of auto-enrolment as approached by the UK and are pushing the Irish into a mandatory system that would reflect more of the features of other OECD pension systems rather than that of the British. It is worth considering what are the objections of the OECD to the British approach; do they have substance and is the UK likely to have to make significant further changes to its system in the short to medium term?

Auto-enrolment is not very effective

This is the core of the OECD’s objection. Auto-enrolment on its own tends to lead to high dropout rates in the lower deciles of income earners. The opportunity for employees to effectively give themselves a small pay rise by opting out far outweighs the long-term benefits of pension saving, which are difficult to explain anyway.

As those who are on the lowest incomes need to spend all of their money, the effect of the opt-out sacrifice on their lifestyles is highly noticeable, unlike those of the higher quartiles whose day-to-day life is unaffected by the removal of some of their salary into a savings pot. Therefore, pure auto-enrolment capitalising on inertia to get people saving doesn’t do much to keep those on lower wages on board with the programme.

Supporting incentives

Of course the UK recognised this and put in other incentives as well to keep everyone on board. So employers’ contributions and government’s contributions are added in to make it seem like there is a free bonus for each contributing employee. Yet because these are matching, rather than flat rate, the redistributive effect is very low compared to other countries like Germany or New Zealand and this means that the benefits are far less obvious to lower earners than they could be.

For instance, in Germany with the Riester pensions, the flat rate contribution level has led to significant increase in those saving in the lowest income decile because its effect is far more pronounced at that earnings level.

Can’t we take no for an answer?

The other unusual feature of the UK’s pension reform is the attempt to bludgeon non-believers into submission by re-enrolling the employees who opt out every three years. While we have yet to see what the reaction is from those employees – they may find it offensive to be re-enrolled when they’ve already made their position clear – it certainly lends a level of complexity to the system that is not present in any other developed economies. This feature appears to be unique among the main developed OECD member countries.

This aspect of the pension reforms will particularly affect the micro-employers, who employ large swathes of the lower earners and part-time earners and will have their work cut out to constantly monitor their workforce to ensure compliance with the regulations. This imposes a level of cost on the economy that would not be there with a compulsory system.

How much is enough?

There is also the critical issue of contribution levels. Here again, the OECD is wary of the approach taken by the UK (and others) of low contributions from the employee that are increased over time. While it may help to reduce initial opt-outs, there is a danger of lingering resentment growing worse each year. Also, inertia generally means that people will stay in at the rate they started contributing at but increasing it means that you bring them to a decision point each time it happens and that may trigger an opt-out.

The most successful auto-enrolment process has been run by New Zealand with their Kiwi-Saver system, which gives incentives to the employee by providing a lump-sum starting grant and matching contributions. They also have got over people’s fears of being pension-rich and cash-poor by allowing withdrawals at significant moments of peoples’ lives such as when they buy a house or send their kids to college and also permitting contribution holidays. The very fact that people know they can do this makes them far more relaxed about saving for the long-term and doesn’t necessarily mean that they actually will take these breaks. Even if they do, it is far better situation than if they had never saved for their pension at all.

It’s all down to design

The design of the scheme is considered vital and Ireland is being warned away from the UK approach which is seen as more expensive and less effective than mandatory redistributive schemes. The question we must ask ourselves in the UK is whether the OECD are correct in their assessment? If they are, are we avoiding tackling these issues because we don’t believe the solutions would work in the UK setting or because we don’t believe that it is possible to sell them politically. If the latter, then what we are experiencing is a failure of leadership. This will come back to haunt future generations, if the savings level of the general population prove incapable of supporting them in their old-age and we are forced to resort to taxpayer bailouts via the welfare system.

The only aspect of the current UK reforms that Ireland is being urged to follow is the simplification of the state pension system by raising it and including in it all peripheral benefits. This approach is believed by the OECD to be the optimal way to provide a base level of income replacement that will not disincentivise people from saving for themselves.

Too important for complacency

The report which is available free online from the OECD is well worth a look, as it gives a non UK-centric view of the changes proposed by the current government. The fact that most features of the UK reform package are dismissed in favour of other alternatives for a country with a broadly similar structure and culture to our own should give UK pension professionals pause for thought. In particular, the auto-enrolment approach instead of having a mandatory system is seen a big flaw that will result in a far poorer result than is required if the strategy of making people save for their own pensions is to work.

It would be foolish to ignore the possibility that we need to make changes already to ensure that we can make these reforms a success. Indeed, the work and pensions minister, Steve Webb, has already done some work on simplifying the regulations but they are still highly complex. However, we should examine all external reviews and opinions that we can get and assess them, instead of waiting until there are problems before we move to amend and improve features of our reform programme.

Pension reform is a big issue and any failure risk turning large amounts of people off the system, causing them to opt out and never return. For that reason alone, any changes we can make to improve outcomes should be taken as soon as possible. We should not hold back for fear of causing confusion. After all, pensions are currently seen as confusing and the main changes we need to make should simplify the system and deliver more to the employee; these are the types of changes that people will have no difficulty understanding and coping with. The sooner we act, the better for everyone.

Tom Murray

Twitter: @TomMurrayDublin or @Exaxe

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