The corporate world has been on a bumpy ride over the past two years, and anyone currently unscathed could be forgiven for hoping the worst is over. Howevever, it is worth asking whether you will keep the same job you are in until you retire and, secondly, whether you will have a decent pension when you do.
The pensions’ time bomb is essentially the realisation that companies and governments will probably be unable to fund the increased monthly payments required by an ever-growing group of workers reaching retirement age.This realisation is causing companies to drop the benefit schemes currently in place and forcing state bodies to adjust retirement ages.
With the collapse of equity and residential housing markets, over the past two to three years, most people assume the problem lies with the assets side of the equation. We simply haven’t got enough money in the pot to pay for our retirements. That may be true, but in fact, the demand side is as much to blame.
Social policies, leading to extended education, defer entry into the workforce and better standards of health increase our time spent in retirement. UN data points to a five percent fall in the global working population, between 2010 and 2030.
The state is facing the biggest exposure, by funding generous benefit schemes for retired public sector workers and funding the general pensions for an increasingly old population. UK citizens, currently in the workforce, obviously expect to get a state pension, but, of the world’s 193 sovereign states, only 80 provide non-contributory social pensions, and of those that do not, eight are in the EU.
Of those that do, the monthly payouts range from 15 to 30% of average national wages. (Go to www.pension-watch.net to see if you are covered).
Whether you can avoid your own personal pension time bomb, depends on how you approach the problem. You should address in it a businesslike way, controlling your costs and managing your income; managing future expectation and setting deliverable targets.
The average annual salary of a middle manager is £40,000
Indexation is 2% per annum
Employees’ current UK average pension contributions are 2.7%
Employers’ average pension contributions (into a defined scheme) are 6.5%
You are currently 40, will retire at 68 and have a life expectancy of 80
You stay at the same grade for the rest of your career
|Value at 40 years of age||40,000||28,671||5,078|
|Value at 68 years of age||69,641||49,917||8,841|
The objective of good pension planning and provision, is to get you to a net retirement income that is as reasonably close to your last employment net income as possible. In this case £49,917.
Most financial product advisors are regulated to use certain projection rates when selling you their policies. In the UK, these are 7% and 11%. However, over the 10-year period to December, 2009, the average was only 3.2%. For defined benefit schemes, this doesn’t matter to you, as your employer takes up the slack with its contributions. But this funding gap is why most companies are now transferring to defined contribution schemes. What does this look like?
|Projected returns on funds invested||3.20%||7.00%||11.00%|
|Amount accumulated at 68||226,945||420,411||855,441|
|Annuity purchased at 6.7%||25,513||15,137||28,041||57,058|
|With basic state pension added||38,035||24,155||37,059||66,076|
|as percentage of final net salary at 68||65.6%||43.3%||64.0%||110.5%|
If we dismiss the 11% scenario, because exceptional returns are not generally sustainable, this leaves us with a defined benefit scheme and a defined contribution schemes at 3.2% and 7%.
The defined benefit scheme looks quite good, doesn’t it?
Actually, after allowing for your mortgage costs, that 66% of net pay is probably what you were living off. You’ve paid for your home before you were 60, the kids have left home, and yes, that’s a comfortable retirement. You’ll have that one. But you’re only 40, and you have to wait 28 years for it.
In the ‘90’s I worked for a large multinational, as an expat financial controller. One of my colleagues had been with the company 15 years, but had hit the the glass ceiling. For a year, I watched his frustration grow, because he couldn’t leave and look for better opportunities elsewhere, because of his ‘golden handcuff’ pension.
He did eventually leave and hasn’t looked back. My point is, that while a defined benefit scheme will keep you out of the poor-house, it might lock you in a career prison.
So we’re left with the two defined contribution schemes, with the probable returns of 3.2% and 7%. With the 7% scheme giving you the same pension as a defined benefit scheme, but with the career freedom that successful managers need, this looks like the one to go for. And, just as in business, success is about making the possible, probable.
But what about this ticking pension time bomb; is it going to go off? If we go back to the probable DCS outcome of around £21,600, of this only £8,841 is the state pension. If that was all you had to fall back on, you’d suffer a drop in income of 82%. That’s a major lifestyle shock.
There is a real risk of sovereign states being unable to afford decent living pensions in the medium term. The immediacy of this risk can be seen in the current changes to retirement ages, and the subsequent unrest, as seen in France last year.
In the UK, changes to the indexation of basic state pensions will erode their value within a decade. In addition, most state pension schemes are means tested and you should give serious consideration to the possibility of not getting a state pension if your private pension is above a certain limit, putting added pressure on your funds performance and additional focus on portfolio risk management.
So, where are you in all this? Are you only going to hear a loud bang, catch some shrapnel, or are you at risk of being hurt? When did you last look?
The bottom line, is that in order to fund a reasonably comfortable retirement, at 65, you will need a pension pot of liquid assets of around six times your gross annual salary when you retire. Pension planning is like a business; setting priorities, controlling expectation, allocating income and controlling costs by reducing non-essential spend. Jam is nice, but too much of it today and you may not be able to afford the butter tomorrow.