Governments need to better educate individuals about the importance of saving for retirement, and should ensure suitable incentives to do so and promote low-cost savings vehicles in which to invest. Those are the conclusions of a report by the OECD published today, in which policy-makers are recommended to address 10 action points.
The authors of the OECD Executive Summary: DC Design and Delivery report noted the dramatic global shift away from public- and private employer-sponsored schemes (i.e. defined benefit (DB), in which the final benefit to the individual was predetermined) towards private retirement savings plans (defined contribution (DC), in which eventual benefits to the individual depend on the value of accumulated assets); highlighting that this shift represents a transfer of inflation, interest rate, investment and longevity risks from the state and employers to individuals. Add to this trend that fact that countries are witnessing lower overall rates of contribution into retirement savings plans, and you have a problem on your hands.
“Together these developments raise very significant concerns about the adequacy and security of future retirement income at a time when longevity is increasing and when the global experience of low returns and high volatility, following the 2008 financial crisis, have reduced public confidence in retirement savings,” stated the report.
The main obstacles to an adequate level of retirement saving by individuals, according to the report, are low levels of public confidence and understanding; inability or unwillingness to choose appropriate investment funds; an inadequate level of protection supplied by investment strategies; overly volatile funds in the lead up to retirement; and a lack of clarity around options available to individuals as they approach the withdrawal phase of their life.
So what are the OECD’s recommendations? Among the 10-item list, four action points stand out:
- Encourage high participation rates among the general population and adequate contributions paid over the long term;
- Incentivise individuals to save for retirement;
- Promote low-cost retirement savings instruments; and
- Address financial illiteracy and lack of awareness.
How to Encourage Participation?
Individuals and policy-makers must be made aware that saving for retirement requires a long-term commitment and also that it is important to diversify the sources of retirement income, the report states. While auto-enrolment policies, such as that recently initiated in the UK, are a “step in the right direction,” the authors feel that the design of retirement savings schemes requires further improvement.
The report states: “Returns on investment are also crucial, but the OECD argues that while policy makers and individuals should strive to achieve long-term attractive returns, their primary focus should be the variables they can control – i.e. the contribution rates and contribution period.”
Unfortunately, the words “retirement” and “pension” tend to make many switch off. The international evidence from OECD research indicates that the simplest and most effective way to encourage people to invest for retirement is through compulsion. Indeed, in OECD countries, the difference in coverage rates between countries with mandatory (e.g. Australia) or quasi-mandatory solutions (e.g. the Netherlands) and voluntary private pension systems, is as much as 30%. The alternative approach to full compulsion is that recently adopted by the UK: auto-enrolment, in which individuals can opt out.
How to Incentivise Individuals to Save?
The report also maps out options for giving individuals a “nudge”: tax incentives and/or matching contributions (by employers and/or the State). The UK auto-enrolment system incorporates a government top-up of 1% to the individual’s contribution from 2018. In the meantime, tax advantages are the main incentive in the UK. However, tax advantages typically take the form of a deduction on the income tax base, which means that incentives are greater for higher-income earners and may be of little or no value for workers with low-to-median incomes, the report states. “In addition, given that generally enrolment and retirement savings increase with income, an incentive structure skewed toward higher income is not the best way to increase participation and/or contributions,” notes the report.
An alternative is tax credits, which provide tax incentives that change inversely with income. Replacing tax deductions with tax credits, therefore, may help increase coverage among low-to-median earners, the report states. However, the very low paid, who pay little or no income taxes, hardly benefit from tax credits any more than they do from tax advantages, so they need a different form of incentive in the form of a government subsidy or matching contribution into the individual’s retirement savings account.
How to Promote Low-cost Investments?
The authors feel strongly that policyholders need to ensure that there are incentives in place in the pensions market to improve efficiency and reduce costs, as fees and charges can have a substantial impact on retirement income. “Indeed, reducing charges from 1% to 0.5% of assets under management lowers the potential reduction in pension benefits from around 20% to around 10% (assuming contributions of 10% for 40 years and average returns of 5%).”
The OECD has considered several approaches to improving efficiency and reducing costs and recommends that disclosure-based initiatives should be promoted, though these may not be sufficient on their own. More effective solutions include pricing regulations (a cap on fees/charges, for example), the report states, though these are not necessarily conducive to cost-reductions and efficient improvements in the industry.
Costs are another factor that individual savers can control. Morningstar has long been a proponent of cost transparency from investment providers and with good reason: our studies and those of numerous academics have shown that fund costs are one of the better predictors of future outperformance available. (At the most basic level, costs eat into returns and therefore higher costs mean lower returns.) We think the industry would do well to educate investors and improve transparency around these costs so all participants can make informed decisions.
How to Address Financial Illiteracy and Lack of Awareness?
Here’s where Morningstar can really help. While the above points of discussion lie outside out control (though we can certainly do our best to encourage participation), providing essential education to existing and would-be investors is our life blood. There is undoubtedly a distinct lack of understanding among the public as to how to set financial goals, assess risk appetite, decide on an investment strategy and embark on managing a private portfolio.
Auto-enrolment is making investors of many of us, potentially without a full understanding of the implications, but whether individuals decide to DIY invest for retirement or seek the help of a financial adviser, Morningstar.co.uk aims to provide the education and tools needed to make better investment decisions.
“Plan members should also have free and ready access to comparative information about costs and performance of different providers,” the report says. Morningstar.co.uk fund reports and tools do exactly that.
The full list of recommendations made to policy-makers by the OECD report include:
1. Ensure DC pension plans incorporate a coherent transition between the accumulation phase (i.e. saving) and the payout phase (i.e. withdrawing income);
2. Encourage high participation rates among the general population and adequate contributions (relative to the required outcome) paid over the long-term;
3. Promote well-designed incentives to save for retirement, particularly where participation and contributions to DC pension plans are voluntary;
4. Promote low-cost retirement savings instruments;
5. Establish appropriate default investment strategies, but also provide individuals with a choice of funds with different risk profiles and investment horizons;
6. Use life-cycle strategies (target date funds would be an example of these) as default option to protect people close to retirement against negative outcomes;
7. Encourage annuitisation as a protection against longevity risk;
8. Promote the supply of annuities and cost-efficient competition in the annuity market;
9. Develop appropriate information and risk-hedging instruments to facilitate dealing with longevity risk (i.e. the risk of outliving one’s income);
10. Ensure effective communication and address financial illiteracy and lack of awareness.
The full report can be downloaded from the OECD website.
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