Irish taxpayers, still smarting from the shock of massive cost-overruns on the proposed new national children’s hospital, now face the prospect of another budgetary black hole, this time in financial services. At least that’s the view of some respondents to the government’s proposals for a national auto-enrolment retirement savings scheme, due to be rolled out by 2022.
All employees, even those in tiny two or three-person enterprises, are due to be enrolled automatically in the new savings scheme. There will be an opt-out clause, intended primarily for employees already in good quality pension schemes.
The scheme’s potential black hole is the proposed Central Processing Authority (CPA), which will be charged with overseeing the scheme. The CPA is the cornerstone of the “Strawman” proposals for auto-enrolment, which Regina Doherty, Minister for Employment Affairs and Social Protection, unveiled last year.
It is envisaged that the CPA will license a small number of product providers and will set an upper limit on what they can charge for administering contributors’ accounts and managing their investments. The CPA will also specify the range of investment options that providers must make available to contributors and will set minimum acceptable service levels.
Contributors will be asked to choose a product provider from the CPA’s approved list. Anyone who doesn’t choose a provider will be allocated one by the CPA on a “carousel” basis, i.e. contributors who haven’t made a choice will be allocated in turn between providers.
Contributors will also be asked to decide how they want their money to be managed. Do they want to be boy (or girl) racers and choose an aggressive investment strategy, or would they prefer the financial equivalent of a Zimmer frame, opting for low-risk, low-return investments? Some won’t be able to – or won’t want to – decide where they stand on the risk/return spectrum. The CPA will oblige product providers to make default funds available for such ditherers. Generally, default funds put people into the boy/girl racer box when they’re young, then move them towards the Zimmer frame as they get older. As a wannabe boy racer whom the experts want to put in a Zimmer frame, I disagree with the conventional wisdom: it means taking the foot off the gas when my fund is at its maximum earning power, but that’s a discussion for another day – or another day in court for the litigiously-minded – so I’ll ignore it for now.
Another of the CPA’s key responsibilities will be to collect contributions from employees and employers and remit them, together with a state top-up, currently proposed at one-third of employees’ contributions, to the chosen product providers. The CPA will have a web-based portal to allow contributors keep to tabs on their contributions and on the progress of their investments. Product providers will be required to populate the data on the portal.
The CPA will have an onerous workload. How much will it cost to set up and run, and how will the costs be shared between the state and product providers? That’s the 64-thousand-dollar – or is it a 64-million or even a 364-million-dollar question?
The Strawman gives no indication of the likely cost of the Central Processing Authority but has asked for views on how the cost should be shared between government and providers. Providers haven’t been shy in coming up with their cost estimates, nor with suggestions for how they should be shared. Irish Life, the country’s largest pension provider, reckons that the cost of developing the full range of infrastructure from scratch will be “huge”, citing the example of New Zealand, whose hub cost more than €300 million. Irish Life also looked at the UK, where auto-enrolment was introduced in 2012. They estimated that, if the costs of the CPA are just one-third of the publicly available costs for the UK’s NEST scheme, it will take more than 80 years to recoup the initial costs. And that’s optimistic: it assumes that providers will be allowed to charge 50% more than the government’s proposed maximum.
To put these figures in context, my own back-of-an-envelope estimate is that, if the hub costs the same as its New Zealand equivalent, the cost of setting it up will equate to three times total charges to contributors in the first eight years.
Small wonder then that providers and industry and professional bodies, such as the Irish Association of Pension Funds and the Society of Actuaries in Ireland, are united in arguing that the CPA set-up costs should be met entirely by taxpayers rather than by product providers. Irish Life has also asked that the state bear ongoing running costs in their entirety and that providers should not be on the hook for any cost overruns.
The CPA also has legal risks. It must decide at the start, and at the end of each contract period, probably every 7 or 10 years, which providers to grant a license to and which to refuse. What if a provider’s application is rejected? Will they have recourse to the courts?
The CPA also faces legal risks with contributors. What if the default fund to which a contributor has been allocated on the “carousel” basis underperforms? Will the contributor blame the provider or the CPA for putting them into that fund without consultation?
At this stage, the taxpayer can reasonably ask whether the state should forget entirely about auto-enrolment.
Happily, there is a solution, one that results in low set-up and running costs, that will cause minimal financial risk to the state, that addresses the legal risks, and that will not necessitate charges to contributors being raised above the proposed ceiling of 0.5% of funds per annum.
The solution flows from identifying the key risks and costs in the model as currently proposed and working to eliminate them.
The complicated provider and product proposals are at the heart of the problem with the CPA. A single provider, established on a trust basis with independent trustees and mandated to operate on a non-profit basis, will be able to achieve economies of scale that couldn’t be matched by commercial providers. The product can be simplified by offering just one fund, which can be administered like a post office savings account, with the same interest rate being credited to all contributors. Such an account will be simple and cheap to administer. It will also be easy for contributors to understand.
The real secret to the success of the proposed approach is how funds will be invested and how returns on the investments will be credited to contributors. Because the fund will have positive cash flows for the first twenty years at least, investments can be chosen that will deliver good returns over an investment horizon of ten, twenty years, or even longer, without the trustees having to concern themselves with short-term fluctuations in market values. They will also be able to quote returns that smooth out the humps and hollows of short-term fluctuations in market values. Comprehensive modelling of possible future returns on the type of real assets in which funds will be invested – equities, real estate, forestry, etc. –indicate that an initial (net) return of 4% to 5% a year can be credited to contributors. This compares with less than 1% a year from bank, post office and credit union accounts. Returns in subsequent years could be higher or lower but are most unlikely to fall below zero for the first 20 years.
The cost to the exchequer of creating the required infrastructure to collect and invest contributions is likely to be a fraction of the €300 million cost of the New Zealand hub, while the ongoing costs of the CPA can be covered by margins in the management fee of 0.5% per annum.
All in all, an excellent outcome for contributors, the state, and taxpayers.
Author: Retired actuary, investor, independent non-executive director