by Mike Orszag, TowersWatson
Economists typically criticize price regulation because, for most products, competition is seen as sufficient to drive pricing to reasonable economic levels. Moreover, consumers are usually better off as a result of the competitive process. Exceptions would include cases where significant economies of scale exist, as in the case of utilities, and also where imperfect information impedes the orderly operation of markets.
Many would argue that pension plans and related long-term savings products fit into the latter category: that is, the complex and abstract nature of long-term saving can make it difficult for market pressures to drive down product fees and charges. International experience suggests that these markets do not function particularly well when there is no regulation at all.
Countries have taken various different approaches to deal with such market failures, including:
- Product regulation making the underlying product simpler and more comparable;
- Cost regulation capping product costs;
- Intermediary regulation regulating the sales process so it works more smoothly.
Interestingly, the UK has experimented with all three approaches over time, and hence its experience offers insights into concerns likely to arise for other countries. After the introduction of personal pensions in 1988, the UK heavily regulated intermediaries via a “polarization” regime for retail financial services. The term “polarization” was used because financial advisers either had to represent a single investment company, or remain independent and represent all companies on the market. During the early years of the UK personal pension model, administrative costs proved to be very high, and surrender values sometimes eroded years of contributions. By the mid-1990s, it had become clear that the regime did not work at all well, perhaps because the regulation was inadequate, or the approach on its own may have been insufficient to prevent product complexity and high costs. In particular, the regime did not eliminate the payment of commissions to intermediaries, possibly misaligning incentives. And in addition while various disclosure regimes were tried, all had serious deficiencies.
Next, the UK adopted stakeholder pensions in 2001, with prescribed charges, minimum contribution levels, and flexibility on timing of contributions. The regulatory regime accompanying this new pension model included a mix of product and cost regulation. Annual administrative charges were capped at 1% of assets. The government’s effort to cap charges did succeed in driving down overall pension management costs, and the regulatory change forced an industry-wide wave of cost reduction and modernization. Nevertheless, the reduction in surrender charges produced unexpected consequences, because surrender charges had subsidized fund distribution; accordingly, lowering these provided less incentive for companies to seek consumers. As a result, the regulatory and capital burden imposed under the new regime reduced the number of firms in the industry and hence narrowed options for consumers.
Even today, 15 years after the launch of stakeholder pensions in 2001, the move to impose charge caps on pensions remains incomplete. For instance, earlier this year, the government proposed a 75-basis point cap on the default investment funds used by participants who were automatically enrolled into pension savings products. This may sound straightforward in theory, but it has not been simple to implement in practice.
One problem is that existing plan participants who were previously defaulted into funds with charges over the new cap must be informed of the cap changes, and such communication can be costly, complex, and often difficult for many members to understand. Further complicating matters are implementing new rules, effective next year, to protect members by disallowing any commission payments that are indirectly paid by members.
Moreover, plan sponsors still have many unanswered questions about the charge caps. Practically speaking, pension charges are allocated variously into asset-based, contribution-based, and annual fees, making cross-plan comparisons difficult. Additionally, new measures will be required to ensure that non-contributing members are not forced to subsidize those who do contribute. Another practical consideration is how to obtain plan compliance certification, and how to clarify what to do when a pension plan inadvertently exceeds a cost cap.
The UK experience with capping pension fund changes suggests that such caps can drive down retirement plan costs. Yet the process is complex, and the regulatory burden may be unexpectedly heavy on providers as well as participants. In other words, charge caps have long-term consequences for the structure and nature of pension saving.
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