State must act to sort out pensions hole

From kathleen barrington: 31 January 2010

By Kathleen Barrington

Last year, the Organisation for Economic and Cultural Development (OECD) published a survey showing the effect of the financial crisis on the performance of pension funds.
Using figures for 2008, it found that private pension funds lost 23 per cent of their value in 2008, or about $5.4 trillion.
Of the 23 countries surveyed, the largest loss was in Ireland, where pensions lost 37.5 per cent of their value.
The scale of the underperformance of Irish pension funds was huge. The second-worst performer was Australia, where pension funds fell by 26.7 per cent, while the average fall was 23 per cent.
The big differences in investment returns were explained by differences in the way that pension funds were invested. Stock markets in OECD countries all fell by around 45 per cent in 2008, while government bonds tended to rise with the international index up by 7 per cent in 2008.
Pension funds with the largest exposure to equities suffered the most. Stocks made up the majority of pension funds’ portfolios in English-speaking countries at the end of 2007, before the crisis hit.
Given that Irish pension funds had invested about two-thirds of their assets in equities, the investment losses were largest in Ireland.
So Irish pension funds performed badly, not just because the stock markets performed badly, but also because Irish fund managers adopted an investment strategy which left investors comprehensively exposed to those falling stock markets.
But the selection of asset classes is not the only reason why members of Irish private pension funds suffered appalling performances.
There is also the vexed question of the charges associated with private pension funds, which have tended to be high.
The launch of Personal Retirement Savings Accounts (PRSAs) in Ireland was supposed to offer a low-cost, private pension alternative aimed at people who did not have an occupational pension.
But a new study*, published earlier this month, found that PRSAs had a very disappointing take-up. This was partly because the PRSAs were launched at about the same time as the government’s Special Savings Incentive Accounts (SSIAs). The SSIAs were more attractive to investors because they were more transparent and tied up investments for a shorter period of time.
Jim Stewart, senior lecturer in finance at Trinity College Dublin, and Gerard Hughes, visiting professor at Trinity College Dublin, argue in the study that PRSAs have also failed because they are ‘‘a relatively high-cost product with a bewildering range of charges for the consumer which has increased the complexity of the pensions market rather than simplifying it’’.
The authors point out, for example, that the charges have a substantial impact on the performance of pension funds. Where charges are high, the reduction in yield to the pension investors can be as high as 4.2 per cent per annum. It points out that even the government itself estimates the reduction in yield on a standard PRSA ranges from 3 per cent per annum for a five-year period to 1.3 per cent per annum for a 25 year period.
The disappointing performance of private pensions, coupled with the fact that many people do not have any private pension provision at all, is worrying at a time when unemployment is rising and earnings are under pressure from pay cuts and shorter working hours.
This reduces the ability of members of pension funds to increase their contributions to their private pension funds – at the very time when the holes in their private pensions most need to be plugged.
This exacerbates the challenge of replenishing depleted pension funds, even when stock markets improve as they did last year.
Similarly, the demand for unemployment and other benefits increases during an economic slump. This makes it hard for governments to find resources with which to plug the holes in private pension funds, with the result that some pension holders can be left short.
For example, the government has so far failed to take any meaningful steps to plug the hole in the pension funds of Waterford Crystal workers, after the parent company went bust leaving inadequate pension assets to meet the pension fund’s liabilities.
The lack of action has left Waterford Crystal workers with only a fraction of the pensions they had expected after making many years of pension contributions.
Speaking at the launch of the study, which compares personal provision of retirement income across a number of EU countries, Stewart argued that Ireland could not rely on personal pensions to improve income adequacy for lower income groups.
He said that PRSAs had not been successful in expanding pension coverage, particularly among low-income groups.
At the same time, Stewart and Hughes found that tax expenditure on private pensions in Ireland, as a proportion of GDP, was the highest in the OECD.
Much of the tax expenditure is in the form of generous tax breaks on pension contributions, particularly for higher earners. This is estimated to cost the exchequer about €3 billion.
Indeed, at one point, the tax breaks on private pension contributions were so great that two individuals were found in 2006 to have accumulated personal pension pots of more than €100 mill ion, while former Irish Nationwide chief executive Michael Fingleton amassed a €27 million pension pot boosted by the perfectly legal use of tax breaks on pension contributions.
The government subsequently introduced restrictions on tax breaks for individual pension funds.
Stewart’s and Hughes’s book was launched at an event hosted by Tasc, a left-leaning think-tank.
Sinead Pentony, head of policy at Tasc, said the most efficient and cost-effective way of increasing retirement income for those without current pension coverage was to increase the state pension. The proposal has not been fully costed, but Tasc argues that it could be partly funded by slashing the tax breaks for pension contributions, by standard-rating all pension-related tax reliefs at 20 per cent.
Such a move is likely to be resisted by the powerful pension funds industry, while the government is unlikely to want to commit to improving the state pension in the current economic climate.
But the government should, at the very least, force the pensions industry to improve transparency and lower charges on private pension products, while insisting that the industry takes measures to improve the investment skills of its fund managers who appear to be the worst in the developed world.