Pensions

I have covered this before, I think, but once again pension schemes are coming under scrutiny again about some of the assumptions they make.

The great thing about projections in to the future (where else could they go?) is that by making tiny adjustments to your expectations of, for example, investment returns and inflation, you can make problems appear huge or simply disappear, seemingly at will.  This has always formed part of the tension in the investment world and we have become used to dealing with it with vary degrees of success.

The problem for pension funds is that longevity seems to rise inexorably.  It is not like returns or inflation which may vary but can (rightly or wrongly) be assumed to predictable over the longer term.  Instead, every year it imposes an ever growing burden on the scheme’s resources or that of the sponsoring company or organisation. 

Employers have tackled it by nibbling away at the edges of the benefits the schemes provide, reducing their costs, or by simply closing the scheme.  The fact remains, however, that removing virtually all of the risk from the member and transferring it to the pension is a fearsomely expensive exercise.  I do wonder whether some employees would rather take on board a bit more of the risk themselves for the prospect of a higher pension in retirement.

One of the reasons defined contribution, or money purchase, schemes perform less well for their members is that the contributions made to them are usually considerably lower.  If the debate about pensions was a little more rational a little less politicised, many may do a good deal better.  The problem is that the government with its vast, unfunded pension obligations seems unwilling to tackle the problem on behalf of taxpayers.

QROPS, pronounced, I am advised, Queue-Rops, look set to be quite popular with the more mobile retirees.  If you have not yet heard of them, you are hardly alone but I would expect much to said of them in years to come.

QROPS stands for a Qualifying Recognised Overseas Pension Scheme and is recognised by HMRC for the purposes of receiving transfers in from UK pensions.  There is, as you would expect a bit more to it, but UK legislation allows for those resident overseas to shed many of the restrictions imposed on UK pensions, such as the requirement to provide an income for life and where the funds are invested.  Members may be able to take the whole fund as a cash sum or purchase residential property, for example.

It pays to take advice, of course, because it may be a case of out of the frying pan into the fire, some tax regimes are nowhere near as generous as the UK.  For some, though, particularly the better off, the prospect of getting their mitts on the whole of the fund will be extremely tempting.

It seems to me that the whole basis of ‘Lifestyle Investing’ has been undermined by the twin forces of increasing longevity and the removal of the compulsion to purchase an annuity with pension funds.  I shall start with a quick recap of what I think it means.

The idea of Lifestyle investing is that you are aiming to move completely into cash on a particular date and has been marketed heavily by insurance and pension companies as a solution for retirement planning where it is expected that an annuity will be bought on the day of retirement.  Of course, the last thing anybody wants is for their retirement fund to be exposed to investment volatility, i.e., possible losses, in the run up to annuity purchase.  Better to lock in the gains made over the years of investing by moving the funds gradually to secure investments.  As such, it is hard to fault.

But what if you are not planning to buy an annuity?  If you are expecting to move simply from wealth accumulation to drawing an income directly from your investments, you may not be best served by finding yourself 100% in cash on your 65 birthday.  You may prefer an income yielding balanced portfolio instead, particularly as you may well live for another twenty-five years.  If you are receiving a stable yield of, say, 3% a year as income, it matters less what happens to the capital value of your investments in the short term than that you have a reasonable prospect of being able to maintain your standard of living in real terms indefinitely.

Unfortunately, many Lifestyle funds are bought without any advice so those investing in them may well not have thought through the possible consequences.

The Conservatives are claiming that, based upon figures they have obtained from the Office of National Statistics, one million fewer workers are members of employer pension schemes than ten years ago.  Their argument is that this is due to the present Governments policies, principally the removal of a pension funds ability to reclaim the tax credit on dividend payments.

The Tories are, of course, out to make political capital and this is by no means a recent trend but there is a serious point here.  Employer sponsored pension schemes were, and still are, a valuable source of retirement income and many years of, supposedly, supportive Government policy have done nothing to halt their decline.  My own view is that no cause and effect has been proven between removal of the tax relief and reducing membership (or, perhaps, more accurately, availability) of these schemes, more of a problem has been the increasing protection afforded to members.

Final Salary Schemes now afford statutory protection to their members, meaning that their benefits are, in effect, underwritten by taxpayers.  There is a bit more to it than that but that is the gist.  Protection, of course, comes at a price and it seems that the price for most of us is no scheme.  The dwindling band of final salary scheme members sail off into the sunset secure in the knowledge that the rest of us are guaranteeing their future whilst we of the less fortunate majority are left to rue our loss.  It is a shame that we are turning into a nation of haves and have nots when it comes to pensions and another example of the unforeseen consequences of well meaning responses by politicians to call to ‘do something’.

For those of us beavering away in the private sector and faced with the effort of building up our own retirement pots, it is a little galling to hear that we are each going to have to pay, in addition, for a public sector pension liability of around £30,000 each.  For this analysis, I am indebted to Steve Bee of Scottish Life who publishes an excellent blog on all matter relating to pensions.

Now, the good news is that this will be painlessly extracted from us in future taxation.  The bad news is that the Government seems unwilling to tackle the problem.  It did try to reform the Civil Service Pension just before the last election but backed down in the face of untimely threatened strikes just as they were asking for our votes.

Of course, the real problem is partly that most public sector schemes are deeply in the red (not great news for Council Taxpayers) but mainly that the Civil service Pension is unfunded.  There is no Civil Service Fund, as such, retiring members simply continue being paid on a reduced salary, so there is no chance of investment returns helping in any way.  The Government is set to introduce a poorly designed National Pension Scheme in the next few years and to exhort us to contribute, it would be well to think of nibbling away at the Public Sector deficit by starting to save towards that as well.  In the short term, costs rise,but the longer term savings should make it worthwhile.  The other option is for Civil Servants to have ordinary pension schemes like everyone else but that seems unlikely for now.

It looks as if future pensioners will find it harder than ever to buy an annuity which provides sensible value for money.  As with many things in life, there are a number of forces pulling in opposite directions with unforeseeable consequences.

For those with investment based pension schemes, whether company sponsored or not, the choice on retirement is to buy an annuity or draw an income directly from the investments in the pension scheme.  Buying an annuity provides certainty of income whilst drawing on the investments allows greater flexibility with the possibility of a higher level of income but with the continued investment risk.  There are many reasons why one or other route may be the most appropriate decision for an individual but the government seems resolutely wedded to the idea that annuities are better.  Current rules seem to favour those buying an annuity as the government seems reluctant to let go of the control it exercises.

Not for the first time, however, it seems that the market could scupper government plans.  The great thing about an annuity (supposedly) is that mortality is pooled, i.e., no one is exposed to their own life span.  If you happen to live for longer than average, you will not have had to have a lower income or have run the danger of running out of money because those who died early will have subsidised you.  Whether or not you are happy with this cross-subsidy is another matter.  If you only live for a few years in retirement, your family may not feel that they or you have received value for money.

The purchase of annuities, though, is becoming increasingly exposed to competitive forces and the regulator is encouraging this for obvious reasons.  This means that the insurance companies who sell annuities are having to create a competitive advantage and to do so they are slicing and dicing the pooled mortality to give some a much better deal.  At the moment, they mainly do this by allowing some with a health problem or dangerous lifestyle to opt out and get a better rate, i.e., receive more money quicker because they will not be around for long.  Insurers are now starting to assess people on the basis of where they live; we all know that those in Surrey outlive those in Glasgow.

the next step is to take into account former occupation to a greater degree and, perhaps, genetic testing.  Great if you are not going to be around for long but bad news for the wealthier, healthier retiree.

Buying an annuity is already a fraught and risky business; what is your view of future inflation for the rest of your life, are you likely to have a dependent when you die in thirty years, etc?  It is set to be a good deal more fraught in the future.  How then will tomorrow's retirees view the seemingly arbitrary restrictions on how they draw pension income?  My guess is, not very positively.  The government has proved fairly unsuccessful at modelling people's behaviour, partly because it is not very good at determining the best type of behaviour and partly because people are a good deal less persuaded by the merits of it than the government assumes.  It could be that we will see the reworking of pension rules over the coming years and tomorrow's pensioners will have to get used to the idea of drawing an income form an investment portfolio with all of the attendant risk and effort required to do it successfully.

It looks as if insurance companies are keen to hasten the demise of annuities, a product upon which they are very dependent.  L&G are piloting a scheme which may see people living in poor areas a much better deal on their pension because the have much shorter lives.

Annuities work for two reasons; firstly they provide a guaranteed level of income, there is nothing to worry about; secondly, they pool the lifespan risk.  Those who die early subsidise higher incomes for those with longer longevity.  Insurance companies, desperate for a marketing edge are busily chipping away at the benefits of this pooling.  In my view they may end up by killing the goose that laid the golden egg.

If wealthier pensioners continue to abandon annuities in favour of unsecured income (drawing down on the investments directly), driven there by falling annuity rates, this will only accelerate the process.  Now, it is entirely plausible that the insurers are looking to build a business model focusing on selling annuities to poorer people, but I would be surprised.  It is more likely that this a just an example of their lack of their short termism, something they seem unfailing to display.

In new research published by the insurer Skandia, only 3% of people retired because they could afford not to work, half were forced to retire through ill health.  For those around retirement age, the majority said that they had money worries.  19%% retired because they had had enough of work, 10% were given an early retirement package and 8% were made redundant.  Only 7% said they had retired when they did because they had reached state pension age.

Most people assume that they will dictate when they retire but, in reality, most will not have control over the timing.

Just when you thought you might be able to work forever, the European Court of Justice has ruled that mandatory retirement ages are no discriminatory and your employer can cast you aside at 65.  It may be a good idea to put some money into a pension, after all.  This particular issue will probably rumble on there are plenty of older people who will become disgruntled at being treated differently to their younger co-workers.

In fairness, if employers were faced with an increasing number of employees suffering from diseases of old age, such as dementia, it may make life harder for their colleagues.  I wouldn't want to trivialise the issue but could a firm force a dementia sufferer to take sick leave or retire if they were happy to carry on?  It looks as if society is going to have to face some interesting dilemmas thrown up by our longevity and lack of adequate pension provision.

Zombie Funds, so called because the money in them is living in a dead fund, have been hitting the business headlines of late.  In particular, Resolution Life has become the subject of a tug of love between Pearl and Standard Life.  For millions of savers this is of more than a apssing interest because Resolution takes care of many billions of pounds of their money and is itself worth more than £2bn.

Resolution was formed as an acquisition vehicle for funds lying in closed life funds with insurers such as the Royal and Sun Alliance.  These companies had decided that they would be better off getting out of the business of running pension and life funds and simply shut up shop.  Having decided to abandon their many policy holders they then sold off the funds to save them the bother of running them and dealing with disappointed investors.

Whether I would be happy with my life savings being in a Zombie Fund is a moot point, it hard enough keeping track of who exactly is running this unloved pot of cash, let alone being sure they are acting in your interests.  Whoever owns it, it seems to be more profitable than being an investor.

Everyone knows that Final Salary (Defined Benefits) Company Pensions are better than their poor relations, the Defined Contribution, or Money Purchase Scheme.  After all, Final Salary Schemes provide members with a guaranteed benefit based upon their earnings and now this guarantee is Government, i.e., tax payer, backed.  What is less often discussed is quite why DB schemes are generally better; employers contribute a good deal more to them.  In fact, employers pay in almost three times as much to DB schemes as they do to DC schemes, so it is hardly surprising that the benefits are superior.

Scheme members are often wary of investment based DC schemes, rightly so, in many cases, but they should be concerned more about how much is contributed than where it is invested.  Final Salary schemes are invested, after all, its just that they are often cautiously invested and make up for it with high contributions.  Although, it helps to invest wisely, the lesson seems to be that successful pension planning has much to do with shovelling in a lot of money.