Are CDC pension schemes “a game changer”?

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Amber Rudd, the Secretary of State for Work and Pensions, has announced a “revolutionary” new workplace pensions scheme – Collective Defined Contribution (CDC) – that she claims will result in improved investment returns for workplace retirement savers.

This is a potentially significant development, which could ultimately involve billions of pounds and affect thousands of workers and employers, notably large unionised workforces. Given the recently low UK savings and business investment rates and the substantial deficits in many defined benefit schemes, it could also have a major impact on labour force relations, intergenerational fairness, capital allocation and the asset management sector.

Cross party and union support

The scheme, originally proposed by the Royal Mail and the Communication Workers Union (CWU) will be introduced, “as soon as parliamentary time allows.” What is interesting is the proposal has support from the Government, the Royal Mail, the unions and, we are told, it has “cross-party support”.
Already operational in Denmark and the Netherlands, CDC schemes offer a middle ground between the declining Defined Benefit (DB) schemes and Defined Contribution (DC) schemes.

For many businesses, the introduction of this new scheme will allow them to provide pensions provisions to their employees without the burden of huge pension liabilities. There is no guaranteed benefit at retirement, rather a target benefit meaning that pensions payments will fluctuate depending on the performance of the investments. Therefore, although risk is pooled, it nonetheless falls to investors, not employers.

Pooled risk

Proponents of the CDC scheme cite a number of advantages including improved investment returns because risk is pooled, regular and relatively reliable income in retirement and reduced risk for scheme members, while cutting costs and red tape for employers. They also suggest there will be benefits for the wider economy such as the prospect of these schemes investing in longer-term assets including infrastructure projects.

The pooling of risk might also provide an excuse for the Government to raise the lifetime and annual contributions caps.
The new scheme could also be transformative for the asset management industry if it entices greater participation in savings, resulting in the potential creation of vast new funds.

Too big to fail

However, whilst the introduction of the new scheme has been hailed as a “revolutionary reform” – a number of questions remain unanswered.

Already concerns have been raised about whether this new scheme would sit easily in the UK’s pensions system or whether it is more at home in a more unionised society. Other questions have been raised about whether this is the most effective way to encourage greater savings into pensions, how will the risk profile of such schemes be managed for the benefit of all members, what demand will there be for such schemes and does it offer investors sufficient choice.

Hargreaves Lansdown has warned that CDC schemes are “similar to the with-profits funds” which let down investors in the past. It has also said that large CDC schemes could become “too big to fail” and that the Government would have to stand behind them. This makes sense. The additional political risk for large quasi-public sector funds must ultimately sit somewhere.

The Dutch and Danish schemes are highly regulated with contributions and returns effectively governed by their central banks.

Notwithstanding the numerous questions, the CDC seems initially to be a constructive development for the provision of pensions in large quasi-public sector businesses such as the Royal Mail and for the Government. Switching to an entirely defined contribution scheme would be powerfully resisted by the trade unions. As the first scheme of its kind in the UK it will be interesting to see how the Royal Mail one fares and whether other businesses or government schemes would follow suit.

Here is a truly revolutionary suggestion. If they are such a good idea, perhaps Members of Parliament could lead by example and switch their notoriously generous pension plan, where employer contributions are approaching one third of salary, into a CDC scheme.

By Charlotte Walsh and George Trefgarne

 

The EEA is a Brexit life boat for the City and the economy

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The revelation [in the Telegraph on Saturday 9th March 2019] from George Eustice, the ex-fisheries minister, that Britain’s ambassador to Norway, was primed to hand in a letter giving notice that Britain was leaving the European Economic Area (EEA) single market treaty last March, but was mysteriously ordered by the Foreign Office not to do so, is the best news about Brexit for months, especially for the City and the wider economy.

The reason is very simple. If Brexit goes belly up, we can leave the EU, but still stay in the single market, for the simple reason we haven’t yet given the required notice to leave.

The EEA delivers Brexit. It is a working free trade agreement with the EU, but outside it. It is outside the Customs Union, the Common Agricultural Policy, the Commons Fisheries Policy and the jurisdiction of the European Court of Justice, and enables us to bring in controls over freedom of movement.

The EEA is a separate treaty to the EU Treaties. We are signatories in our own right, and we can make it operative by applying to join Norway, Lichtenstein and Iceland in the related European Free Trade Association. This Brexit option is continuously dodged by the Government, because it is excessively worried that the national controls over freedom of movement in the EEA are not sufficient.

The City’s misconceptions

One thing you will hear about the EEA is that the City doesn’t want it because we would be a “rule-taker” from Brussels, as the Bank of England Governor Mark Carney said before the Treasury Select Committee in December 2018. Until about a year ago, the City wanted to stay in the single market, because it would keep its market-passporting rights, but now the consensus has now shifted.

However, it is notable that when you ask City figures why? a whole load of misconceptions pop out.

It is not true we would be a “mere rule taker” in the EEA.  Nor is it true that the Bank of England would have to take orders from the European Supervisory Agencies during a crisis, jeopardising financial stability.

How laws are made in the EEA

Less than a third of EU directives are single market ones, appropriate for the EEA.

There are three stages to law-making in the EEA. First, the European Commission comes up with some legislation which, much of the time, originates in global standards bodies on which EFTA nations sit independently. The EFTA nations then have a right to be consulted by the EU at a technical level. This is the “decision shaping process”. EFTA states do not have a vote at this stage.

Second, once a directive has become EU law it is passed on to the EEA Joint Committee, on which representatives of the EU and the EFTA states sit, for incorporation into the agreement. Its decisions must be unanimous and at this stage, the EFTA nations can delay, adapt or veto legislation either by claiming it is not “relevant” to EEA nations, or that it triggers constitutional requirements. Failure to implement the directive outright (reservation, in the jargon) results in the relevant area of the EEA agreement being suspended.

Finally, if agreed, the directive must be implemented by Parliament. If it is rejected or mangled out of shape, then the EFTA Surveillance Authority (the body which effectively polices the rules in EFTA) can bring an infringement action before the EFTA Court. Both institutions would have substantial British representation, as it would be the biggest member. Minor differences are usually overlooked by both sides.

Rows of this kind are very rare. This is because law-making in the EEA is much more collaborative than in the EU. It is effectively a form of “equivalence” in rule-making which the City has said it ultimately wants from Brexit. The EFTA Court is a more pragmatic institution than the ECJ. There is no ideological principle “of ever closer union” to follow.

Those pieces of onerous EU legislation about which one hears the most City complaints, like MIFD2 (covering find managers), or Solvency II (covering insurers), could have been revised or in extremis rejected. The latter course would, admittedly, have resulted in a massive row. But it does mean there are more sovereign protections in the EEA than we have currently as an EU member, adopting unedited rules in their entirety, as we would do also during the “implementation period” in Theresa May’s deal.

The Bank of England in charge

What about the idea that the EEA would jeopardise the ability of the Bank of England to police financial stability? This is also a misconception. The Bank would have dozens of representatives on the EFTA Surveillance Authority. EU supervisory agencies do have powers to send draft directions to the EFTA Surveillance Authority. But just as now, the Bank of England could veto a direction which “impinges on fiscal responsibilities” (ie nearly everything).

For those who care about economic growth, the EEA is the best way out of the Brexit impasse. Not only would it deliver certainty and sovereign legislative flexibility, it would allow business investment and market activity to recover. Sterling would regain its strength. Given the chronic low valuations of UK assets, there might even be a Trump-style boom.

The opportunity

Joining Norway in EFTA would also bring the world’s largest international financial centre alongside the world’s largest $1 trillion sovereign wealth fund, which Norway has thriftily accumulated from its North Sea oil revenues (incidentally, this has a disappointing average annual return of 5%, I am sure the City’s expertise could help increase that). This is a strategic opportunity for both sides. The EEA has cross party support, including from Tory MP Bim Afolami and Labour MP Seema Malhotra, both of whom used to work in financial services and co-signed a letter to the Financial Times.

Falling back on the EEA is the best Brexit life-boat to hand. It isn’t perfect, but it works. It would remove most of the political and legal uncertainty hanging over the UK.  Why not give it a go? If it does turn out that it is insufficiently flexible and the EU does use the EEA treaty to make us a mere “rule taker”, as its detractors fear, then we can move into a new arrangement and our ambassador in Oslo can hand in that departure letter, which we know has already been drafted.

This article was first published on the Reaction website

Time for a National Government? Lessons from 1931

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It is an interesting question as to whether the formation of a National Government would help solve the current Brexit impasse. It has certainly worked in the past.

In 1931 a National Government was formed to get us out of the Depression and overall it did a pretty good job. Britain recovered faster than any other major economy, helped by coming off the Gold Standard, restructuring War Loan, tax cuts and embarking on a housebuilding boom.

When the crisis began that year there was a minority Labour Government, the pound was under pressure and the Cabinet was divided. An Austrian bank called Credit Anstalt had gone bust and contagion had spread to London’s financial markets. The budget deficit was spiralling out of control due to faltering tax revenues and the cost of rising unemployment benefits.

During the summer, the Prime Minister Ramsay MacDonald was trying to get agreement among his Labour colleagues to cut government expenditure and raise taxes. Balancing the budget was a prerequisite to the approval of an emergency loan being arranged by JP Morgan in New York. The Conservative and Liberal parties refused to countenance the £100m in tax rises which the Cabinet agreed to and instead demanded further economies.

Throughout August the political arguments raged and there was an impasse. The critical intervention finally came from King George V, one of the most underrated monarchs in our history. The best narrative of events is in Kenneth Rose’s excellent biography of the King.

On Saturday August 22nd, having only just arrived in Balmoral, the King turned straight round to see MacDonald at Buckingham Palace the following morning.

The Prime Minister tried to resign, but the King talked him out of it at two meetings on the Sunday. The second one took place after the King had a private dinner with Edward Peacock, a director of the Bank of England and partner in Baring’s Bank, who helped manage the King’s affairs. Left-wingers claimed that Peacock was at the centre of a “bankers’ ramp” and had a role in advising the King what to do. He had been summoned at short notice, but he himself said that all they talked about at dinner was the recent fluctuation in wheat and barley prices.

The King told MacDonald he was the only one who could lead the country at that time and he believed he could depend on Conservative and Liberal support. The King then summoned all three parties to a meeting at Buckingham Palace the following day. The Conservatives were led by Stanley Baldwin and the Liberals represented by Sir Herbert Samuel, as their leader Lloyd George was convalescing from an operation.

The King told MacDonald that it was “out of the question” he should resign and told the three men to go into a room, to come to an agreement and they were not to emerge until they had drafted a communiqué which would restore confidence at home and abroad. This took about an hour and the three agreed to form a National Government under MacDonald. This was not a formal coalition, but a “co-operation of individuals” to tackle the economic emergency.

Lord Wigram, the King’s private secretary, noted in his diary:

“His Majesty congratulated them on the solution of this difficult problem, and pointed out that while France and the other countries existed for weeks without a Government, in this country our constitution is so generous that leaders of Parties, after fighting one another for months in the House of Commons, were ready to meet together under the roof of the Sovereign and sink their own differences for a common good…”

Amen to that.

The Labour party subsequently split, but the National Government won a landslide victory in an autumn election demanded by the Conservatives. Churchill transformed it into a “Grand Coalition” in 1940 and it remained in office, broadly successfully, until 1944.

Would such an approach work now? It is hard to see either the Queen intervening or the current party leaders taking a similar approach. But anecdotally, the public appetite for “banging MPs heads together so they sort things out” is very high and they are not immune to this sentiment. It is also noteworthy that first steps in cross party co-operation, both by backbenchers and in formal talks between Theresa May and Jeremy Corbyn, have already been taken. Let’s see what happens in coming weeks.

Introducing Section 20 of the EU Withdrawal Act

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Extending Article 50 is easier and more likely than some people let on.

The Conservative party conference is going about as expected, with the Prime Minister reportedly booed at the Association chairman’s dinner; Boris Johnson giving a witty, tub-thumping speech which ended, incongruously, with a call for everyone to back Theresa May; and every Cabinet minister jostling for leadership attention.

Nothing has changed. I doubt anyone is watching much at home. Certainly, I noticed that the YouTube figures for Boris’s speech topped out at 1,896.

None of our political leaders wants to focus their minds on the matter at hand. What happens on 30th March 2019, the day after we are scheduled to leave the EU?

Theresa May wants us to believe we will be out of the EU, but in some sort of limbo. Having handed over a cheque for £39bn, we will have won in return a political declaration for her Chequers proposals which are a complicated and unsatisfactory. Failing that, we will supposedly walk away without a deal.

Boris Johnson wants us to be in exactly the same limbo position. Only “negotiating properly” for a “Canada style free trade deal”. He apparently has no answer to the questions about the Irish border or why the EU would agree to anything he proposes. Perhaps this is why some call it “Blind Brexit”. 

Markets are sanguine

Here is another scenario, which explains why, relatively speaking, markets remain so sanguine. It is easy, from a legal point of view to extend Article 50. Even if Chequers and Canada Plus etc all fall by the wayside, there is still a strong likelihood that Britain will be limping along, obeying all the rules and doing as it is told without any say in the matter.

No wonder the IPO market remains open. Sterling is hovering around $1.30. 10-year gilts are yielding 1.6%. The economy is still plodding along.

Section 20 of the EU Withdrawal Act

The provisions the EU Withdrawal Act, paragraph after paragraph of them, all pivot on “Exit Day” which we are told in Section 20 “means 29 March 2019 at 11.00 p.m.” But later, it goes on to say that:

“A Minister of the Crown may by regulations amend the definition of “exit day” in subsection (1) to ensure that the day and time specified in the definition are the day and time that the Treaties are to cease to apply to the United Kingdom.”

Flip the pages on to Schedule 7, Part 2 (14) and the Act says:

Power to amend the definition of “exit day”.
14. A statutory instrument containing regulations under section 20 (4) may not be made unless a draft of the instrument has been laid before, and approved by a resolution of, each House of Parliament.

So, put simply the Government of the day can change the day we leave the EU, as long as it gets approval from Parliament. More likely, Parliament would compel it to do so if dropping out without a deal looked probable.

What about the EU? How would it respond to a humiliating appeal from the British Government, perhaps initiated by Parliament, to extend Article 50?

Well, the relevant powers are in Article 50 itself. The third paragraph says:

The Treaties shall cease to apply to the State in question from the date of entry into force of the withdrawal agreement or, failing that, two years after the notification referred to in paragraph 2, unless the European Council, in agreement with the Member State concerned, unanimously decides to extend this period.

Is No Deal really likely?

Clearly businesses have both a fiduciary and regulatory duty to prepare for No Deal. One cannot help feeling that, in reality, Limbo Land is much more likely. Extending Article 50 does not require primary legislation by either side.

If everything else falls over, our plan to use the UK’s existing membership of the European Economic Area by applying to join the related European Free Trade Association (by far the best option for 30th March 2019) remains on the table. If only politicians would admit it.

We have published Norway then Canada, a new strategy to avoid a Brexit smash, with a foreword by David Owen, on Amazon LINK.

It is official – Brexit squabbling is damaging the economy

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The British economy is slowing. There. I have said it. After repeatedly writing upbeat pieces for CapX to counter the doom and gloom mongers in the last two years, the facts are changing and so is my mind.

I would go further and say that the weakness of the economy, much of it Brexit-related, is going to put the skids under the tedious stasis which passes for political activity in Westminster these days. Voters are going to be cross.

Extreme Remainers and Brexiteers in Parliament better watch out in case they get the blame. And horror of horrors, Jeremy Corbyn’s claim that there is something fundamentally wrong with the way the economy is managed might yet land on fertile ground.

The full article was published on CapX and is available to read at this link.

Tweaking MiFID II post-Brexit

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Today signals the deadline for MiFID II compliance, new regulation that has been causing a sense of disquiet in some areas of the City, especially amongst advisers to and investors in smaller companies below the FTSE 250. A question worth asking is will Brexit allow some of the anticipated consequences of MiFID II to be addressed?

MiFID II covers numerous uncontroversial areas. But one stands out. Company research. From today unbundling means research will be priced separately from execution, putting pressure on fund managers to justify their research spend.

While this is unlikely to affect large companies, for the myriad of smaller companies the risk is that fund managers don’t really want to pay for research in hundreds of securities that they may never buy. Some fear this will make it even harder for smaller companies to get attention from investors.

One of the best-known figures in the small companies’ market is Katie Potts, who founded and runs the Herald Investment Trust. In its latest annual report, its Chairman said: “…the regulatory shock of the impending introduction of MiFID 2 has led to dire illiquidity, and commensurately wide discounts for smaller company trusts in general.”

This is more than an idiosyncratic issue for a minority of investors. If the smaller companies market dries up, it is hard to see how we can enhance UK productivity and invest in the innovation, entrepreneurship and new ideas of the future.

The domino effect of reduced research for small caps is potentially serious. With less research there is less liquidity. With less liquidity the attractiveness of a growth business looking to launch an initial public offering (IPO) disappears. In effect, a go-to source of funding for growing British businesses is removed. The result? Companies could turn to the debt markets or even a listing in the US to raise money. Some just may not bother to grow at all.

In the short term, while the UK is still a member of the EU or “in transition” until 2021, Brexit would not make any difference to the implementation of MiFID II. Large international firms are not going to countenance any move that will hinder their trading with the EU and nor should they.

However, after that, things may change. One of the most creative legal thinkers about Brexit is Barnabas Reynolds, a partner at Shearman & Sterling and was a contributor to Prosperity UK, a politically independent platform bringing together business leaders, academics and policy-makers to look constructively at a future outside the EU. He has written several papers on the subject and says that the UK should opt for an “equivalence regime” with the EU. This is the same status as countries like the US, Switzerland and Japan, and allows access to markets if regulations are broadly aligned.

The key thing about equivalence is it does not mean “identical”. It therefore allows some flexibility to change regulations which relate to domestic activity. Depending on how the trade negotiations go, and whether an equivalence regime is agreed or something more prescriptive, MiFID II could indeed be tweaked.

We will have to see how the deal comes out in the end.

Imagine how other people feel

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One of the great achievements of the Enlightenment was a sense of other. Instead of thinking only of ourselves, or our tribe or locality, European societies began to think philosophically about other people and their rights and duties. Although religion was a motivator, this respect for others became a doctrine in its own right.

Here is hoping that, after the disputatiousness of 2017 and a further decline into a bizarre negativity in public and social discourse, we can renew our respect for other people, their feelings and their proper selves.

I was very struck earlier in the year by an impromptu speech US Defence Secretary Jim Mattis gave in Jordon. He told US soldiers, to “just hold the line”, because Americans “need to get back to respecting one another, and showing it.”

Adam Smith, book of the year
It is for this reason my book of the year is Adam Smith’s other great work, The Theory of Moral Sentiments. This was published in 1759, 17 years before his more famous Wealth of Nations. It is deceptively simple, arguing that sympathy for other people is the basis of all morality.

The historian Simon Schama has gone so far as to argue that it provided the intellectual underpinnings which made the Acts of Union between England, Scotland and Ireland work.

The reason The Theory of Moral Sentiment is my book of the year is twofold. First, by coincidence, the thoughtful Conservative MP and transport minister, Jesse Norman, is publishing a biography of Smith in 2018, which he says will put particular emphasis on Smith as a moral philosopher and not just as an economist. It is intended to sit alongside his recent biography of Edmund Burke (a friend of Smith).

Secondly, it is my firm belief that the great task of our time is to bring the country back together: to respect one another, to compromise and to calm the hysterical and obstructive public rhetoric we find on Brexit, but also numerous other issues. All this has been amplified by social media which, in my opinion, needs regulating. Nor do the continuing rumpuses in Parliament help.

Prosperity UK
In April this year, it was my privilege to help organise the Prosperity UK conference in Westminster, which brought 600 business people, bankers, politicians, academics and journalists from all sides of the debate to look beyond the Referendum to how we might make a success of Brexit.

I was easily the least distinguished person on the advisory board, which was co-chaired by Sir Paul Marshall and Lord Hill of Oareford, and included the Marquis of Salisbury, Lord Wolfson (CEO of Next), Sir John Peace (chairman of Burberry and Midlands Engine), Baroness Stroud (CEO of the Legatum Institute), Anthony Clake (a partner at Marshall Wace), Professor Sir Steve Smith, Vice-Chancellor of the University of Exeter and Professor Colin Riordan, Vice-Chancellor of Cardiff University.

I am glad to say it was a great success and, partly because the amazing goodwill and positivity in the room was sadly dissipated by the election, another conference on global trade is being planned in March, together with some more bespoke regional events. Alex Hickman, an entrepreneur, has been appointed Director and has been leading the effort. The website is HERE

A quote from The Theory of Moral Sentiments
I am sure I am not the only person to think we are never going to get anywhere as a country if we go on arguing with one another.

Adam Smith would agree. Here is a quote from The Theory of Moral Sentiments:

As we have no immediate experience of what other men feel, we can form no idea of the manner in which they are affected, but by conceiving what we ourselves should feel in the like situation. Though our brother is upon the rack, as long as we ourselves are at our ease, our senses will never inform us of what he suffers. They never did, and never can, carry us beyond our own person, and it is by the imagination only that we can form any conception of what are his sensations. Neither can that faculty help us to this any other way, than by representing to us what would be our own, if we were in his case. It is the impressions of our own senses only, not those of his, which our imaginations copy. By the imagination we place ourselves in his situation, we conceive ourselves enduring all the same torments, we enter as it were into his body, and become in some measure the same person with him, and thence form some idea of his sensations, and even feel something which, though weaker in degree, is not altogether unlike them. His agonies, when they are thus brought home to ourselves, when we have thus adopted and made them our own, begin at last to affect us, and we then tremble and shudder at the thought of what he feels.

In other words, lets cheer up, and show some fellow-feeling, to each other and to our friends and neighbours in Europe and across the world.

Happy Christmas.

800 years of interest rates. Did high interest rates set off the Wars of the Roses or even Game of Thrones?

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Here is a light historical distraction, for those who take a long-term view.

We are currently in the midst of the third longest secular bull market in bonds ever (at 36 years), beaten only by one from 1441 to 1481 (40 years) and the record of 1605-1672 (67 years).

I know this because the Bank of England has just published a fascinating blog , and Staff Working Paper Eight Centuries of the Risk Free Rate.

The highest ever developed market real risk free rate, of 23%, apparently occurred in 1453 with the siege of Constantinople, when it finally fell to the Ottomans. The 26-year old Sultan Mehmed II had already conquered the important silver mines of the Balkans and there were fears he would disrupt Venetian trade. Only the subsequent arrival of gold and silver from the New World really ended the specie drought.

These ultra-high interest rates put our own history into some perspective, especially the Wars of the Roses.

1453 was also the year when Henry VI’s weak reign descended into the chaos with the loss of his French possessions after the Battle of Castillon. Like the siege at Constantinople, the losers at Castillon were for the first time bombarded into submission by artillery.

With the loss of its French possessions, the English crown also lost a substantial portion of its revenues, especially the tonnage and poundage on wine shipments from the Dordogne and Gironde rivers.
The financial situation was made worse by Henry’s lavish of devout tastes: spending much of his dwindling revenues on his foundations of King’s College, Cambridge, and Eton College. One might facetiously argue that those establishments continue to cause political trouble 700 years later.

No wonder a terrible civil war ensued. Everyone, including the King, was skint.

The data set has been culled and amalgamated from various sources, commencing with Prestiti perpetuals issued by the Republic of Venice. The first open market quotations are from 1285, when Prestiti apparently yielded 6.625%.

This year’s record low yields are not unprecedented. In the first quarter of 1946, US Treasuries yielded a similar 1.4%. Real yields were also a negative 5.3% due to a repurchase programme.

The Wars of the Roses are famously the inspiration for George R.R. Martin’s Game of Thrones. Although he does not mention yields, the fact the crown is heavily in debt to the Iron Bank is a backdrop to the plot and Queen Cersei is contemptuous of money lenders. I wonder if there was a bear market in bonds in Westeros too?

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