March 16, 1999
Administrative Costs in Individual Accounts in the United Kingdom
by Peter Orszag(1)
Since 1988, workers in the United Kingdom have been allowed to opt out of that nation's Social Security system and into individual accounts. A research project that the author is conducting with two other economists for the World Bank has resulted in the compilation of a comprehensive database on administrative and other costs, on a company-by-company basis, of the individual accounts in the U.K. system. Our analysis of that data finds the administrative costs to be substantial 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.(2) (It should be noted that the focus of our project and of this paper is to document the lifetime costs on an individual account in the United Kingdom for a typical worker, not to conduct a full cost-benefit analysis of individual accounts.)
The administrative costs associated with any system of individual accounts can be broken down into three components:
- Accumulation costs reflect the costs for administration and fund management that are incurred on the account of a worker who maintains his or her account with the same financial provider and contributes consistently to that account throughout his or her career. As this study finds and as previous studies have documented, these costs reduce the value of an individual account in the U.K. by an average of approximately 25 percent of the funds in the account over an individual's working years. In other words, the amount of money in the account when the worker retires is 25 percent lower than it would be without these charges.
- Alteration costs are the additional costs incurred when an account holder fails to contribute consistently to a single financial provider over an entire working career. Such costs could arise because the worker switches from one financial provider to another or because the worker leaves the labor force and ceases to make contributions. Most previous analyses have ignored these costs. The evidence suggests that such costs are significant. The data indicate that in the U.K. system, these costs reduce an account's value by an average of 15 percent over a career.
- Annuity costs are the costs incurred by the typical individual in converting an account to a lifetime annuity upon retirement. Although such costs may be of a somewhat different nature than accumulation and alteration costs, they represent a financial loss to individuals, just as accumulation and alteration costs do. In the United Kingdom, these costs reduce the value of an account at retirement by approximately 10 percent, on average.
Taking into account interaction effects, these estimates indicate that, 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. In other words, more than 40 percent of an account's value is dissipated by fees and costs. This estimate is based on actual data from financial providers. It reflects a comprehensive treatment of costs associated with individual accounts.
Some 43 percent of the value of individual accounts in the United Kingdom is consumed by various fees and costs over a typical worker's career.
Costs depend on the structure of individual accounts. For example, some proposals for individual accounts in the United States seek to take advantage aggressively of potential economies of scale through centralized management by offering individual accounts only through one provider and limiting the investment options. The Thrift Savings Plan (TSP) for federal employees is an example of such a centralized plan; the accounts under the TSP are all held with a single provider, and the investment options are limited to a few broadly diversified index funds. Other approaches to individual accounts would allow individuals more choice through a decentralized system, under which individuals would be allowed to choose their own financial provider and to invest in a wider array of assets. Under the decentralized approach, the accounts would be similar to Individual Retirement Accounts, which can be held with a variety of financial providers and which impose few restrictions on permitted investments.
The U.K. experience illustrates that if individual accounts are created in the United States, a decentralized system of privately managed accounts (as distinguished from centrally man-aged accounts) would be likely to have high administrative costs.
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. A full analysis of the pros and cons of individual accounts is beyond the scope of this paper. The U.K. experience vividly illustrates, however, 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 are likely to be high under a system of decentralized accounts.
1. Dr. Peter R. Orszag is President of Sebago Associates, Inc., an economics consulting firm, and lecturer in economics at the University of California, Berkeley. He previously served as Special Assistant to the President for Economic Policy and as Senior Economist on the Council of Economic Advisers from 1995 to 1998. He is conducting work for the Center on Budget and Policy Priorities on Social Security issues.
2. See Mamta Murthi, J. Michael Orszag, and Peter R. Orszag, "The Charge Ratio on Individual Accounts: Lessons from the U.K. Experience," Birkbeck College Working Paper 99-2, March 1999 (University of London), available at http://www.econ.bbk.ac.uk/ukcosts