Its-YOUR-money looks at Pensions
Having enough money to enjoy a decent quality of life once we stop working has to be the top priority for most of us when thinking about saving and investing. The money we put into company and private pension schemes represents a major investment – probably the biggest investment many people will ever make. What we get out of this investment will decide how comfortable we can be in retirement. We all need to understand the key facts about pensions.
The ‘Pensions crisis’
In the past, it will often have been taken for granted that whatever pension arrangements we had would enable us to retire reasonably comfortably. However recent talk of a ‘pension crisis’ will have raised doubts in many people’s minds.
Living too long
Life expectancy is increasing. At the age of 30, the average male can now expect to live to 77, the average female to 81. Ten years ago, they would be expected to die two years younger. If you survive to 60, the chances are you will live at least another 20 to 25 years. Not so long ago, the average 60 year old would be lucky to live 10 more years.
Retiring too soon
Retirement ages have generally been falling across Europe (although in the UK it tends to be slightly higher than in France and Germany). Recently there have been moves to raise the age of compulsory retirement and it seems sensible to allow people to decide whether they want to carry on working. However, it seems fair to say that many of us would prefer to retire sooner rather than later, if we could afford to. And we’d certainly like to have the choice.
Starting work later
With more people going to university or into other forms of higher education, the average age when we start work is rising. The effect naturally is that we can expect a shorter working life (although hopefully higher wages and salaries as a result of having better skills).
Having fewer children and having them later
The UK birth rate has been falling, and is now at an all-time low. At the same time, women are tending to delay starting a family until late twenties or later.
As the number of retired people rises, the health care burden rises too. Each time medical science succeeds in reducing the incidence of deaths from one or other of the major causes, it becomes a victim of its own success. The ‘wear and tear’ problems like knee and hip joint failure and cataracts have time to develop in more and more people. The cost implications for the state are obvious: longer retirement costs more in pension provision, and more in health care, and both are being carried by a shrinking workforce. It is inconceivable that the state will be able to provide more than a basic level of provision in the years ahead.
The Government is already talking about encouraging us to work until we are 70, and is proposing to cut back on the generous pensions previously available to civil servants. In the US, which is faced with similar challenges, President Bush is proposing to shift the burden of fallback pension provision away from the state and onto the individual. Many companies have closed pension schemes that provide a defined benefit (typically a proportion of your final salary), and instead provide pension schemes that simply invest your contributions plus whatever the company contributes on your behalf. The pension you get from a defined contribution scheme, as it is called, depends on the investment performance of the scheme and the annuity rates available when you retire.
This brings us to the second factor: actuarial assumptions and the recent history of pension funds.
The crucial issues for pension funds are life expectancy after retirement, and fund investment performance. The other demographic factors mentioned above (the age you start work and the number of years during which you contribute to a pension scheme) are normally taken care of by the rules of the scheme. Let’s have a look at the kind of scheme you might have.
Defined benefit scheme
Typically, in a so-called defined benefit scheme, your pension will be something like one sixtieth of your final salary for each year of work after you join the scheme. (Your final salary might be taken as the average of the last five years before you retire). If you work for 40 years you retire on two thirds of this final salary. The rules might specify a maximum pension (for example, the maximum allowed under Inland Revenue rules is 2/3 final salary after 40 years), and will also probably have provision for a tax-free lump sum on retirement and maybe a reduced pension to your spouse on your death. A defined benefit scheme is attractive to the employee because unless there is some disaster (like the firm going bust or you losing your job) you are pretty well guaranteed a reasonable level of pension. The pension scheme and the company are carrying the risks, and the key risks are that you might live longer than they expect and that the investment performance of the scheme (including annuity rates) might not be as good as they predicted. If they get their sums wrong on either or both of these risks, then the scheme and the company are in trouble.
Defined contribution scheme
The safest bet for a pension scheme is to transfer these risks to you, and the defined contribution scheme does just that. The employer and employee each contribute to a pension pot with the employee’s name on it. The money in the pot is invested by the trustees of the scheme (advised by appropriate professionals), but is very often given to an insurance company to invest. When the employee retires, the money in the pot at that point is used to provide a tax-free lump sum and what is left goes to purchase an annuity (an income for life). How much you get as an income depends on how much is in the pot, how long you are expected to live, and what annuity rates apply at the time. The risks by and large are yours. Personal pensions and small self-administered schemes are effectively defined contribution schemes, and increasingly company schemes are going in that direction. There are still risks for the annuity provider (usually a life insurance company) because once the annuity is fixed the provider is taking a gamble on your life expectancy and on the rates of return used in their calculations. Let’s talk about annuities for a minute.
An annuity is an income for life that you get in exchange for handing over a lump sum of money to an insurance company. A level annuity gives you the same amount each year (retirement annuities are actually paid monthly as a rule, and taxed as income, but the rates you see quoted are normally for the yearly amount). An index-linked annuity increases the amount each year in line with the change in the retail price index (RPI). A guaranteed annuity provides an income for a specified number of years (usually five or ten) even if you die during the guarantee period. A joint life annuity provides an income as long as you or your partner is alive.
The right choice of annuity for you will depend on your circumstances. The amount in each case will depend on your age and to some extent on your health (there are what are known as ‘impaired life’ annuities for smokers and those with certain medical conditions). As always, you will need to shop around for the best deals. However, standard annuity rates are quoted in financial pages and web sites. For example, a male age 60 wanting a level annuity could expect an income of £6,336 a year for life in exchange for a lump sum of £100,000, based on the current best-buy.
Since we know that a male age 60 can expect to live for 20 years, we can calculate the rate of return the annuity provider is expecting. In fact for the above example it is 3.1% after taking into account all their costs. Annuity rates only reflect life expectancy and expected rates of return (annuities are normally based on the returns to government bonds which in turn reflect the market’s view on interest rates over the annuity period). As there are quite a lot of life insurance companies competing for annuity business, we can be reasonably confident that their guesses about mortality and future interest rates are as good as anyone’s.
Companies will probably use their own tables for life expectancy (the ones I've used are from the Government Actuary) and will have their own view on interest rates and their overall investment returns, as well as their administration costs. As a result, you do get variations between the rates offered by different companies and it is very well worthwhile shopping around. If your pension fund has been invested through an insurance company (as many are) then you will be under some pressure to take out an annuity with the same company. However, you are likely to have an ‘open market option’ that allows you to buy an annuity from any provider (although your pension fund provider might apply an administration charge for taking your funds out). You can ask for quotations from your pension fund provider and from other annuity providers, and see which looks the best deal overall. As with everything else in finance, never simply accept what you are offered: it’s your money we’re talking about. Once you have bought your annuity you can’t change providers, so it’s even more important to get the best deal you can at the outset.
How much money do I need when I retire?
The Inland Revenue limits the amount payable under approved schemes to 2/3rd final salary. Since by the time we retire most of us will have paid off our mortgages and seen our children through school and university, a retirement income of that level seems reasonable. If you have been enjoying a salary of £100,000 a year whilst working, it would mean an income of around £65,000 a year when you retire. Using the annuity rate example above, to retire at age 60 with an income of £63,360 we would need a pension pot of £1 million. If you want to have that income increase in line with inflation you will need almost £1.5 million – and be running up against another recently introduced tax barrier that will tax pension pots in excess of £1.5 million.
These are big numbers, and it brings us to another aspect of the ‘pensions crisis’: investment performance.
The ‘pensions crisis’ part two
As well as having to adjust their calculations to take account of increased life expectancy, pension funds are also faced with having to estimate how quickly the money in their schemes will grow. Traditionally, pension funds have had a high proportion of their investments in shares (equities). When we discuss investment in general you will understand why shares have featured high on the list. But whilst shares offer a link to economic growth and shelter from the effects of inflation, the rate of return can be pretty variable.
During the ‘bull’ market for shares over the twenty years or so up to the turn of the century, rates of return were abnormally high. Pension funds (and life insurance companies) were tempted to build these rates into their projections, and to effectively bank the ‘paper’ gains that their share portfolios were showing. Many company pension schemes looked to have plenty of money to meet their obligations to their members and several employers reduced the amount they were contributing. Pension schemes were an attractive target to a new government elected on the back of a promise not to increase income tax.
Taxing the income that pension funds obtain from dividends on shares has two seriously damaging effects. Not only does it reduce the rate of return, it also increases risk. The returns on shares are part dividend and part capital gain. Dividends are quite low risk and once you've got the cash it is yours to keep. Share prices are very volatile, and although you can argue that because a share price has risen you have made money, in reality you haven’t. It is only a paper profit until you actually sell them, and meanwhile if prices fall, all those gains you thought you had can vanish.
Pension funds were faced with having to reduce their investments in shares to re balance their risks and boost income, which caused or at least exacerbated the stock market crash from 2000 onwards. As a result, very many pension schemes found that their investment pots were drastically reduced as share prices fell. And to make matters worse, they could no longer expect the rates of return they had become used to during the 80s and 90s. They have a smaller pot of money that will grow at a lower rate.
How much do I need to pay into a scheme to get a decent pension?
Let’s ignore inflation and assume that you need a pension pot of £1 million when you are 60, and you are 30 now. We also need to make a couple of other assumptions: the rate of return you can expect to receive on the investments in your pension scheme, and how fast your salary is likely to grow. (We will assume that you put the same proportion of your income into the scheme each year).
Let’s say your income increases by 3% a year in real terms (that’s about 5% including inflation). We will also assume that the pension scheme can make 5% a year average real return on its investments after allowing for tax and management fees. Since we've assumed that your final salary will be £100,000 a year, it means that you must be earning £41,200 a year now, and to have a pension pot of £1 million in 30 years time you need to contribute £9,300 this year. That’s 22.5% of your income and you will have to contribute that proportion every year. Those are not unrealistic assumptions. In fact to make an average real net return for all investments of 5% would be pretty good for a large fund (the Institute of Actuaries uses a maximum nominal (money) rate of of return of 7% in current pension projections).
You can see why pension schemes are back-peddling on defined benefits. Even with 40 years of service, you need a pension contribution of at least 15% of income to be reasonably confident of affording to pay 2/3rd final salary even with today’s life expectancies. If you are in a defined contribution scheme (or no pension scheme at all) it is up to you to make sure you have enough invested to provide a reasonable retirement income.
Won’t my home count as part of my ‘pension’?
Hopefully it will. Normally, by the time we get to retirement age we have paid off any mortgage we may have had and our children have left home and are pretty well self-sufficient. We may well feel able to ‘downsize’ to a smaller property and release some of the equity tied up in our previous home. But the type and location of the property we are living in just before we retire will set the standard for whatever comes after. We don’t want to have worked all our lives only to have to live in what we might regard as second best. Although property could and should form part of our investment strategy, it would be foolish to think we can ignore some other form of pension provision simply because we've been buying an expensive house.
The other concern about relying too much on our home to help pay for retirement is that although property in general has been a pretty investment for many years, that doesn't mean that any one particular property will be as good. When you invest in individual properties (as opposed to a property fund) it is almost impossible to spread the risks adequately. This exposes you to the chance that something will happen to affect the value of an important part of your wealth. That can work both ways of course: the value of your home could rise (or fall) much faster than prices across the whole property sector. Because housing is such a major investment for so many of us, we can’t dismiss it as part of plans for retirement but we can’t afford to be complacent.
Before we go on to talk about investment in general, let’s have a look at another topic that has been in the news: endowments.
|9 October, 2008 © 2008 K.R.Wade and Co Ltd|