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RELEASE: Tuesday, March 16, 1999 |
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Robert Greenstein, |
Administrative and Other Costs
Consume More Than 40 Percent of
Included Accounts in the United Kingdom New Study Finds
I. Executive Summary |
A new study of privately managed individual retirement accounts in the United Kingdom shows that more than 40 percent of their value is consumed by administrative fees and other costs, a figure that is "significantly higher than acknowledged thus far in the debate in the United States, although not as high as some other studies from the United Kingdom have suggested."
The report, "Administrative Costs in Individual Accounts in the United Kingdom," released today by the Center on Budget and Policy Priorities, is based on a World Bank research project undertaken by three economists. As part of that project, the economists constructed a comprehensive database on administrative and other costs of individual accounts in the U.K. system, compiled on a company-by-company basis.
As a result, unlike the findings of other reports, "This estimate reflects a comprehensive treatment of costs associated with individual accounts and is based on actual data from financial providers," said the study's author, Dr. Peter R. Orszag, one of the three economists who conducted the underlying research. Orszag teaches economics at the University of California at Berkeley and was formerly a Senior Economist on the Council of Economic Advisers.
The study comes as Congress is debating options for Social Security reform in the United States, including proposals to allow individuals to opt out of the Social Security system and into individual accounts.
Some proposals before Congress would set up a centralized plan for individual accounts with investment options that are limited to a few broadly diversified index funds and managed by a single provider, along the lines of the Thrift Savings Plan for federal employees. Other proposals would use a decentralized approach, under which individuals choose their own private financial providers and invest in a wide range of assets, like the current Individual Retirement Accounts available to U.S. workers not otherwise covered by pension plans.
The U.K. experience "vividly illustrates...that if individual accounts are created in the United States, a decentralized approach could carry a variety of potential dangers. In particular, the U.K. data suggest that administrative costs could prove surprisingly high under a decentralized approach," Orszag said.
Orszag emphasized that administrative costs "depend on the structure of individual accounts." He said that costs would be lower under a system of individual accounts that took advantage of potential economies of scale through centralized management, as seen in the Thrift Savings Plan for federal employees.
The Social Security system in the United Kingdom consists of two tiers, a flat-rate basic state pension and an earnings-related pension. The first tier is provided through the government to all workers who have contributed to the system for a sufficient number of years.
At the individual's option, the second, earnings-related tier can be an employer-based pension, a retirement benefit provided through the government, or a privately managed individual account.
In the World Bank research, Orszag — along with Dr. Mamta Murthi of Cambridge University and Dr. Michael Orszag of the University of London — uses data from financial providers to examine the lifetime costs on a private individual account over a 40-year span for a typical U.K. worker. The new report examines the full range of costs imposed on account holders and expresses them in a "simple, comprehensive way by measuring how much of an individual account's value is dissipated by costs over a working life."
The report released today, "Administrative Costs in Individual Accounts in the United Kingdom," breaks the costs associated with individual retirements accounts into three categories:
- Accumulation costs, which reflect the costs for administration and fund management — including advertising and marketing — that are incurred on the accounts kept by workers whose accounts remain with the same company for 40 years and who contribute consistently to that account throughout their careers. These costs reduce the value of an individual account in the United Kingdom by approximately 25 percent.
- Costs incurred when an account holder switches from one financial provider to another or leaves the workforce and ceases to make contributions. These costs, termed "alteration costs" in the report, reduce an account's value in the U.K. by an average of at least 15 percent over a career. Although these costs are significant, most previous studies have overlooked them.
- Annuity costs, incurred by the typical individual in converting an account to a lifetime annuity upon retirement. These costs reduce an average account's value by about 10 percent.
Taking into account interaction effects, on average "43 percent of the value of individual accounts in the United Kingdom is consumed by various fees and costs over a typical career..." Orszag found. That finding is consistent with other studies from the United Kingdom, including one published in the respected U.K. financial publication Money Management, which found that accumulation and alteration costs alone would amount to about 42 percent of an account's value over a typical 40-year term. Orszag added that some other previous estimates of administrative costs in the U.K. system failed to consider alteration costs and therefore underestimated the total costs.
The report released today suggests that the high costs associated with individual accounts in the United Kingdom are intrinsic to a privately managed, decentralized system and are not the result of excessive profits taken by financial providers. This conclusion is based on the competitiveness of the individual account markets in the United Kingdom and the departure of some providers from that market.
Orszag said the lesson of the study is that, "In addition to considering the broader question of whether to create individual accounts, policymakers in the United States must consider what type of individual accounts to create if they decide to adopt such accounts. The decision on what type of accounts to create will have a large bearing on how much of the accounts is consumed by administrative fees and other costs."
Orszag noted that this question applies both to individual accounts that could replace part of Social Security and to individual accounts created outside the Social Security structure, such as the USA accounts the Clinton Administration has proposed.
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"The Charge Ratio on Individual Accounts: Lessons from the U.K. Experience," the report upon which this analysis is based, along with supporting information, is posted to http://www.econ.bbk.ac.uk/ukcosts
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