The financial world, and particularly that relating to pensions, is one which appears to be steeped in mystery.
In career v1.0 I worked within the pensions industry, starting out training as an actuary and fiddling with lots of numbers (yay!) but fraught with exams I couldn’t pass (boo!) and in the end I switched to pure consultancy via the Pensions Management Institute, which was, ironically, the direction I’d intended to go in the first place.
I still maintain my pensions qualification and accreditation despite being on to career v3.0 now and keep in touch with many of my old colleagues.
What has become ever so apparent from moving from being an ‘insider’ to an ‘outsider – sort of’ is my own appreciation of other people’s knowledge and understanding of pensions. Certainly speaking to those practising as consultants, it’s pretty clear they don’t appreciate quite how little the rest of the country understands about pensions.
So I thought I would attempt a post to make some sense out of some of the myths to help bridge that gap.
Why would I do this?
If you’ve read any of my posts, I have a few areas which I care very passionately about, and in many ways my different careers have followed those passions, albeit in a geeky and slightly esoteric manner. Financial education is one of those soapboxes I have and a desire to be able to help others understand their way around managing their money better. And it would certainly seem that the number of people who can’t manage their money very well seems to significantly outnumber those who do it competently!
Pensions are no exception. There is very little else where people are shelling out 5-20% of their monthly salary without really having the first foggiest what it is in aid of. It’s sort of a ‘black-box’ thing that people are paying into because it’s ‘what you’re supposed to do’. Yet ask most people what a pension is, and they won’t be able to tell you.
This post will try to explain:
- What a pension is
- the different sorts of pensions
- the impact of living longer on the cost of pensions
- the impact of lower rates of return
Now there are a load of approximations in this post purely to help you get the gist of what is going on, not least explaining how pension liabilities are calculated and what the numbers are based on. To do the job properly would take a lot longer than most people would be prepared to read! Hopefully it will demystify some of what is going on.
What actually IS a pension?
OK let’s keep it simple. When you retire at whatever age that’s likely to be (generally 55+) you stop earning a salary. If you have a pension, it pays out a monthly amount (more on that in a bit) for the rest of your life. Sometimes it will continue to pay an amount to your spouse after you die.
How much pension would I get?
This is where things start to get a little bit more complicated with some of the words bandied about in the media being used.
What I want you to do is imagine that on the day you retire, there is a suitcase full of money which is going to be used to pay your pension for the rest of your life. Effectively as you start to receive your pension that suitcase is providing the payments and the last payment you get before you die sees that suitcase empty.
Now with a MONEY PURCHASE pension, also know as DEFINED CONTRIBUTION pension, you (personally) are going to know what’s in that suitcase. It’s all your contributions that you’ve made, your company has made (if they’re involved) and any investment returns. In this situation imagine yourself taking your suitcase to a pension provider and asking them what the suitcase will buy.
The other approach in the UK is a DEFINED BENEFIT pension such as a Final Salary Pension or Career Average pension. In this scenario the amount of pension you receive each month is known because it’s been worked out by a formula. Effectively with this, your company is going to a provider and asking to buy a pension of that size – you don’t know what’s in the suitcase as that’s somebody else’s problem. You’ve put your bit in and your company tops up the rest.
So, are pensions really that expensive?
Well, in a word, yes they are.
I’m going to use a really really simple example to show this. What I’m going to do for this is to make 2 really rash assumptions
- There is no inflation, bank interest or anything like that
- You are going to live precisely 20 years from the day you retire.
So it’s pretty fundamentally flawed, but it’ll show you how it all adds up.
Keeping it very straightforward then, imagine for each of those 20 years, you’re going to get £1200. So if you needed to give someone £1200 each year for 20 years, that’s a total cost of 20 x 1200 = £24,000!
Can you see where this is going? £1200 is only £100 per month and isn’t going to last beyond a couple of Starbucks and a burger each week.
Say you wanted £12,000 each year, so that’s £1,000 every month. Well you’ll need a fund of 20 x £12,000 = £240,000 – almost a quarter of million pounds. That’s a big suitcase!
And this is the problem.
Obviously the two assumptions above are really unrealistic. Prices are going to generally go up over time, banks will give a bit of a return on the money they hold and then there’s that bit about how long are you going to live…
Grim Reaper – you’re going to have to wait a bit longer……
Life expectancy has steadily increased over time.
On average, a new-born child could expect ON AVERAGE to live for the following years (based on World Bank data).
- 1960 – 71 years (number of years after age 65 = 6)
- 1970 – 72 years (number of years after age 65 = 7)
- 1980 – 74 years (number of years after age 65 = 9)
- 1990 – 76 years (number of years after age 65 = 11)
- 2000 – 78 years (number of years after age 65 = 13)
- 2010 – 80 years (number of years after age 65 = 15)
There are plenty of factors which would affect these numbers (sex, lifestyle, occupation to name a few) and on the whole as average numbers they actually look quite low. But it’s the changes that are important when looking at pension periods.
Someone born in 1960 may only have expected to receive 6 year’s of pension after age 65 meaning the contents of their suitcase only needed to provide for them for 6 years. Yet for someone born 50 years later, a suitcase with the same amount of money in it would have to last 15 years, that’s 2.5 times longer!
This aspect is one which has driven up pension costs. Let’s look at the other big one now.
No interest in savings!
One part of the jigsaw is the length of time people are living. The other one is financial. Let me explain.
When someone is about to retire with their suitcase of money, that money hasn’t just suddenly appeared there overnight. No, it’s been building up for many years.
Pension funds invest in all sorts of things which are going to be too complicated for this simple guide. Instead I’m going to use a much simpler model to explain why the cost of pensions has gone up so much.
Let’s think about the interest you can get in your bank account. At the moment, it’s not very much. Let’s say you’re managing to get 1% each year.
So if you invested £100 today, in a year it would be worth £101.
To put it another way, if you needed to have a suitcase next year of £101 you would have to put aside £100 now.
Back in the 1990s, interest rates were in double figures, so a lot more than they are now.
In 1990 at a 10% interest rate, putting £100 aside would give you £110 a year later. A lot more than the £101 you’re getting now.
The reason this is important comes down to how much money is going to be in the suitcase when you retire. Imagine you’re wanting that £24000 suitcase to feed your starbucks and burger habit in retirement and you were going to put aside enough money now so that it would grow to the £24000 at retirement. How much would you need to invest now?
Let’s pretend you’ve got 20 years to wait until you retire.
You would need to put aside £3567 today if you were to get 10% interest each year for the 20 years. So that doesn’t seem too bad does it – pay £3567 now and come back at retirement and it’s worth £24000.
But what happens if you have your £3567 now and you only get a measly 1% interest each year? Well it would get bigger, but even after 20 years, it would be only worth £4,353!!!!! Or to put it another way, if you wanted £24,000 still in 20 years time, rather than investing £3567, you’d have to set aside a shocking £19,669 instead.
Now obviously you don’t put some money aside once and forget about it, nor to pension funds invest all your money in the local bank’s ‘easy saver’ account, but the method of working out the cost of providing a pension in the future follows a similar principle.
Putting it all together
I’ve thrown a lot of information at you so far. Sorry, but this is the minimum I think I can get away with.
We’ve seen that over time people are living longer and as a percentage of time after retiring, this is a big increase. We’ve also seen that with falling rates of investment returns that the money you need to put aside now is a lot more than it used to be to provide the same benefit.
With me so far?
So the old defined benefit schemes are now hit by both of these aspects. You go along requesting your pension of £12000 per year to which you are entitled, and it’s suddenly costing a lot more than it would have done 20 years ago. Companies have as a result huge pension commitments in respect of benefits that have been earned in the past and it’s costing a lot more than anyone expected when the schemes were set up. Greater regulation and ‘insurance’ to prevent schemes imploding further adds to the cost.
In the world of Defined Contribution, all it’s meaning is that in order to get that pension you dreamed of, you’re going to have to budget a lot more than you might have needed to do in the past. Otherwise your suitcase will be lacking and the burger and Starbucks lifestyle is looking ever bleaker.
A final thought
OK that was a whistle-stop sledge-hammering of the nut which is pensions and hopefully you’ll now have some idea about some of the stuff in the news. There are plenty of other things to know and I’m happy to keep tweaking this post and adding to the series if there are any things you’d like explained. Now I’m not allowed to give financial advice (you need someone regulated by the FCA for that) but I’m more than happy to try to explain things in simple terms
You may also wish to visit the Pensions Advisory Service website for more information.