The subject of pensions must be one of the most boring imaginable, but one thing that is even less appealing is a long retirement lived out in grinding poverty. Yet all over the developed world, pension schemes are going through major reforms in response to a common threat. This threat is funding or, rather, the lack of it: many pensions schemes face the prospect of running out of money unless something is done to increase their ingoings or reduce their outgoings, or both.
In the UK, this issue manifests itself in a shift away from traditional Defined Benefit (DB) schemes (schemes in which a member’s entitlements are specified, such as final salary schemes) to Defined Contribution (DC) schemes in which the member builds up their own pension pot and gets the pension income this pot is worth. This change solves the problem of pension funds running out of money by transferring risks to the plan member, who now has to take the daunting responsibility for their own pension and run the risk of an impoverished retirement if they get this wrong. The days of generous DB pensions are over – except for those already on them or high-level public servants whose benefits are taxpayer financed.
With the shift to DC, the first issue that arises is the contribution rate: how much should people save towards their pension plan? This is where the fun begins.
For a start, few people appreciate the scale of the contributions needed. Most people would expect a pension in retirement equal to perhaps two-thirds or three-quarters of their final salary, which is the norm for people recently retiring in DB schemes. However, they imagine that can obtain such pension with impossibly low contribution rates. To give an example, if a typical man aged 25 saves, say, 5% of his salary in a DC pension scheme over a 40-year horizon, illustrative simulations of my PensionMetrics DC pension model suggest that he can expect a pension equal to around 21% (yes, twenty-one percent: this is not a typo!) of final salary. The results for women are worse – and sometimes much worse.
Then you have to the problem of improving life expectancy: life expectancy has been growing strongly in recent decades. Higher life expectancy might be a good thing for the people who live longer – assuming that they have a decent pension to enjoy it – but it is a bad thing for the pensions schemes that have to pay out for longer. Indeed, perhaps the biggest problem currently facing DB schemes is what is cheerfully known as the ‘toxic tail’ – the risk that granny will not die as expected in her mid to late 80s but will survive well into her 90s. This risk is potentially fatal to the pensions industry.
There is also the issue of charges – the dirty secret of the pensions industry. One thing the industry is very good at is charging its clients: there are fixed charges, charges for assets under management, charges for periods when the individual is not contributing, charges for leaving a pension schemes and various other charges too, my favourite being ‘Total Expense Ratio’ charges which are meant to summarise all charges but often don’t. The industry is also very good at hiding charges from members so they don’t realise how much they are actually paying. Not surprisingly, there is currently a lot of pressure on them to cut charges and make them more transparent: the Pensions Minister, Steve Webb, recently warned the industry that on the charge issue he was ‘watching them like a hawk’. The industry’s response is reminiscent of a child being dragged to the dentist.
Now add in longevity risk and realistic charges, and our 25 year old male is now looking at a pension income equal to only just over 12% (!) of his final salary. One can’t help wondering why he would bother: perhaps he should take President Obama’s advice to ‘seize the day’, i.e., eat, drink and be merry and forget about pensions altogether.
The government’s response is to encourage people to join DC schemes by offering tax concessions and just recently, by introducing Auto-Enrolment, in which millions of employees without private pensions will be automatically enrolled in their employer’s pension plan unless they explicitly opt out. However, the tax concessions would seem to be pointless: a private boast within the pensions industry is that they can extract all these for themselves through cleverly designed charge regimes. As for auto-enrolment, there is a very real danger that many people least able to afford it will find themselves contributing to pension schemes that deliver little back.
On balance, it is probably better to see the government’s role in pensions as part of the problem rather than the solution. Over the years, the government has periodically chopped and changed the system, often pulling the rug from those who had relied on previous government promises. It has also gone in for policies that my friend, the journalist Martin Hutchinson, aptly described as sado-economics, in which the government punishes groups it dislikes: a notorious example being the ‘euthanise the rentier’ policy of the post-war years, whose aim was to destroy the real incomes of those who lived on their savings – a policy which succeeded magnificently and pauperised many who had done the right thing and saved for their pensions. The government has also regularly raided pension funds when it suited it (one thinks of Gordon Brown’s famous ‘pension raids’ of the late 1990s), and since 2009 the Bank of England has been undermining pensions through its quantitative easing policies, which are literally killing the returns that pension funds can deliver.
One also has to consider the debt that the government has been issuing in vast amounts since at least the late 1990s. We are not talking here of just the ‘official’ debt – this has just passed 80% of GDP and is bad enough – but this is merely the tip of the iceberg. The unofficial debt – commitments entered into, but not provided for; think of the Private Finance Initiative, for example – is much bigger. Respectable estimates put it some between 500% and 1000% of UK GDP. All this represents a very big can kicked down the road for younger people to pick up.
Nor should one see the state pension system as the solution. The state pension system is massively under-funded and its obligations are a major component of the unofficial government debt just mentioned. Fans of state pension schemes should also consider the fate of the Soviet state pension system, one of the glories of the socialist system: this was very generous and promised pensions in some cases of 100% of final salary. However, after the break up of the USSR the state pension systems in ex-Soviet countries collapsed and many pensioners found themselves with nothing to live on. This highlights the point that any pension system is only as good as its solvency.
So what should young people do? One option is saving more and retiring later, and there is certainly something to this. Low and transparent charges are also important and will make a big difference to DC pensions. Then there is the DIY peasant pension plan: save, stash your wealth where predators can’t find it and have a big family to look after you when you are old. This has been widely used for thousands of years and so presumably must have something going for it.
There is no question that young people are getting a raw deal: the norm these days is that they are saddled with college debts, have difficulty landing a good job, have little realistic prospect of getting on the housing ladder until well into their thirties and face a lifetime of rising taxes to pay off all the cheques that their elders have written on them. And now we are telling them that they don’t have any realistic prospect of a decent pension either. Not your fault, son, but if you wanted a good pension you should have been born earlier
This is a good recipe for an ugly and protracted intergenerational war – and one senses that young people are beginning to wake up. After all, why should they pay for all the benefits their elders will have enjoyed when the system they paid into won’t be there for them when they retire? Or, rather, if they retire: most won’t be able to afford it.
From a pensions perspective, this is just a return to the long-run historical norm. From this perspective, a decent pension is largely a feature of the 20th century. Most people before the 20th century never got one and most people after won’t get one either.
Kevin Dowd is a partner in Cobden Partners and Professor of Finance and Economics at Durham University. This article is forthcoming in the Durham Business School Alumnus magazine.