Special feature: Slim pickings – will the arrival of the new public pension scheme be enough?

The 2012 launch of personal accounts (PA) pension provision for around seven million UK citizens not in occupational pension schemes is getting closer. But plenty of questions remain unanswered and the answers matter, not least because according to official estimates, the PA fund will have £200bn of assets by 2040.

The Personal Accounts Delivery Authority (PADA), set up in 2008 to design and deliver the plans, has the noble aim of bringing more people into the pensions net. How well they fare once theyíre in will depend to a large extent on how that £200bn is invested.

In May, PADA published a consultation paper on investment strategy. (A detailed consultation paper on employers' duties is promised by the autumn.) As Steve Charlton, a principal at Mercer notes, it all comes down to the as-yet unresolved question of whether PADA is going to focus on scheme costs or investment returns as its primary driver for PAs. He argues that there is really not much room for manoeuvre for PADA here. The scheme's default fund, which can be expected to contain the vast bulk of its assets, has to provide a lower risk profile than a normal employer's scheme.

'It has to appeal to a much wider audience who are less financially aware, on lower earnings and with a lower appreciation of the role of risk in generating returns and a much lower appetite for risk,' he says.

Passive aggressive
Put all that together with PADAís stated desire to drive administration costs down to 30 basis points and you end up with an extremely large passive tracker fund. So what is wrong with that? As US pensions expert Denise Valentine, senior analyst with Aite Group observes, 'Passive trackers often outperform actively managed funds ¿ and do so without the fee overheads of active management.'

True, and this is what makes them a 'no-brainer' for the PADA default fund. However, passive funds are essentially 'lazy money'. By the time PA is in full swing, perhaps one pension scheme pound in every five could be from a PA fund. But the investment 'decision' will rest on whether any particular company is a constituent of the benchmark market index and not because of that plc's strategy and prospects. The PA fund would only exit its shareholding if the plc in question messed up badly enough to be slung out of, say, the FTSE-100. Until then, the money will sit there – fat, dumb and happy with a full market weighting in the stock.

The problem is this money acts as a counterweight to shareholder pressure for performance. It encourages management slothfulness because the investment plan effectively takes away the ultimate sanction of selling shares in unattractive companies, while the schemeís cost structure doesnít afford the luxury of investment managers who take a keen and proactive role in governance.

Hamish Wilson, senior partner at pensions advisory Hamish Wilson, argues that one of the more spectacular – and comical – unintended consequences of the government's PA scheme is that it will make it much easier for sharp hedge fund managers to outperform the market and, in turn, justify exorbitant performance fees of 20% to 30%. The logic is, if the rest of the market is acting dumb, you don't have to be all that bright, or work very hard to outperform. 'One of the real problems with the PA is that while it has the potential to be the largest pension scheme in the country, by far, it will not be designed to be hunting the best returns. So it will be dragging down market [performance] and hedge fund managers will simply love it,' Wilson says.

Wrong time
He also points to the fact that the PA is likely to launch as a compulsory 'tax' at a very inauspicious and uncomfortable time for employees and employers alike. 'By 2012, we are likely to be seeing the initial impact of rising inflation as a consequence of the government's policy of quantitative easing, allied to the US printing money at high speed. At the same time, a cash-strapped government (of whatever stripe) is likely to be raising taxation across the board. The timing for the introduction of PA could hardly be worse.'

Long term, the big risk the PA runs is that low-paid workers who remain in the scheme turn out, on retirement, to be no better off than their colleagues who opted out and who then receive means-tested benefits. 'If people actually sat down and did the calculations to find out how much they would have to save to be significantly better off being in the scheme than out, they would be quite surprised at how much they would have to pay in to the scheme,' Wilson says.

The other big risk, as Mercer's Charlton notes, is that UK employers 'dumb down' good occupational schemes to match the new, lower standard of contributions inaugurated by the mandatory PA contribution level. That way, no one wins.