Towards a useful pension system

Nick Silver writes: In my previous NSFM blog, I highlighted that government subsidizes the pensions industry through tax relief in return for the industry addressing certain social goals: first, encouraging savings so people will not be a burden on the state when they grow old and second, encouraging investment which will lead to future economic growth. I argued that the current system is really not achieving either of those aims and hence should not continue in its current form.

I now propose how the system could be reformed to encourage useful investment of retirement savings.  How personal savings could be encouraged will be the subject of a subsequent blog.

The Problems: Our current system results in the bulk of pension savings being effectively indexed by investors.  Assets are invested predominantly across listed company equities, with share allocation done in relation to a company's relative market capitalization. This allows investee companies, at the margins, to obtain cheaper capital, as they can raise funds from their shareholders or issue debt against the company's higher market capitalization (which is also purchased by pension funds).  Allocation of capital rests primarily in the hands of management at these companies.

There are a number of problems with this system. A recent paper by the Bank of England has identified that management decisions are increasingly driven by short-term considerations, which results in misallocation of capital, as profitable long-term projects are undervalued and overlooked.[1] In addition, capital allocation is biased toward incumbent companies, who are likely to invest in 'what-they-know' from historic practices.  This enhances capital lock-in.

Both of these effects lead to under-allocation of capital toward areas without established players and which have longer term payback periods. The under-resourced areas are often in sectors of the economy that are strategic public policy priorities, but which are being largely ignored and therefore present serious threats to future quality of retirement livelihoods.  For example, clean energy / eco-efficiency, sustainable food production, affordable antibiotics, quality education and care for the elderly are among common under-served priorities. They are the very areas which need capital for economies to thrive in the coming century.

The Proposed Solution: People should be able to invest and save in any way or form they like. However, to receive a tax incentive, they should be required to invest in ways that have been determined to be socially beneficial. This could take one or both of two forms:

1.       The government could reward investments in specified sectors, for example healthcare, education or clean tech;

2.       The government could reward investments in infrastructure projects with a long payback period.

Some readers might mistakenly view this as being like Soviet style economic planning.  That is not the case. My proposal lets people invest in whatever they want.  However, if they want a tax break, they need to invest in something that has been determined to be socially useful.  This recognizes the primary function of government – to determine public policy priorities.  It does not put government in the role of specifying investments, just determining priority sectors.  Although governments might not always choose appropriate sectors, identification of priorities is the proper focus of democratic debate.

Addressing Fee Subsidies: The second problem identified in my previous blog was that much of current retirement savings tax incentives effectively go toward fees. To mitigate this, most tax subsidy legislation around pension savings could be removed. That would amplify the effect of sector tax incentives. If you invested in one of the options above, then you would receive the tax relief.


This would simplify the system considerably and reduce the level of costs associated with expensive administration. Asset allocation decisions could still be delegated to the financial service sector.  But with the new system, the financial sector would be incented to allocate capital into prioritized activities.


Alternatively, we could follow a solution put forward by US economist Laurence Kotlikoff, in which the regulator’s job is to (a) make sure that funds are invested in what they say they are and (b) obtain a credit rating (funded by the regulator[2]) for all investments.[3] In that way, investors could invest in standardised infrastructure bonds in a theme of their choosing, with a transparent and independent risk-return rating.  This would minimize retirement savings leakage by reducing the need for fees flowing to the financial service sector beyond an administration support function.


Nick Silver is an actuary with 20 years experience in the pensions industry. He is a director of Callund Consulting, which advises governments and companies in developing countries on pensions and social insurance reform, and he is a co-founder of the Climate Bonds Initiative. He is a senior visiting fellow at Cass Business School and visiting fellow at the Grantham Institute at the LSE.


This article is part of the NSFM opinion series, in which participants propose specific steps towards real and sustainable market reform. Contributors write in a personal capacity. NSFM participants are invited to comment on blogs articles and contribute to the series. Please contact Ebba Schmidt or Frank Jan de Graaf for further information.

[2] This could be a private company; it is just important that it is not funded by the issuer to avoid conflict of interest.

[3] See for example Kotlikoff (2010) Jimmy Stewart is Dead, John Wiley & Sons