John’s Blog No. 11 Pensions – Are Current Schemes Effective

The basic aim and purpose of a pension scheme is to make provision for old age and is a very personal and individual affair. Current schemes appear to have lost sight of this.

They clearly divide into the main areas of those in work and able to make self provision; their dependent partners; those whose earnings do not allow adequate provision and finally the welfare dependents.

These borderlines have become confused and together with the loss of clear objectives have led to pensions becoming a responsibility and burden, aggravated by increased longevity. Longevity projections are causing panic, increased costs, reduced benefits, and pessimistic reactions not justified by actual numbers.

Current Pension schemes divide into two main areas unfunded and funded, which further divide into defined benefit and defined contribution.

Unfunded (pay as you go) schemes do not make commercial or common sense and are unsustainable.

They are the basis of the State and Public Sector schemes, which are now showing the basic failings.

In the UK the current in work / pensioner ratio is around three and population projections suggest this will drop to two by 2035; Public Sector are worse at 1.4 reducing to 1, (the effective pension yield factor).

As contributions are spent as soon as received, at a factor one, contributions must equal pension benefits.

Other Pensions schemes are funded, based on contribution savings being invested and growing over a long working life period of some forty years. Even at inflation growth levels the factor is 2.4 and with a good schemes rise to 5 or more, they are also unaffected by demographic changes e.g. population increases.

Defined Benefit schemes give a guaranteed pension as a proportion of income dependent on number of years service, with the financial and other risks borne by the provider. Defined contribution schemes give no guarantees and are subject fully to market forces giving uncertainty and instability and poor returns.

DB schemes now only occur in Public sector (under attack) and decaying large Company schemes

Private schemes have become increasingly dependent on the Financial markets. Up until the turn of the century whist markets were buoyant and returns were high, such schemes prospered and became over generous. However markets became more speculative; greed set in and large funds were attractive.

They therefore need firm foundations to withstand the storms of the financial markets and careful management maintenance and control to ensure they don’t collapse.

Pensions in Europe are more generous than in the UK, mainly due to the policy doctrines pursued there; a greater concern for the elderly and morefamily responsibility. However they appear in a worse state than the UK, due to the higher payment levels, demographic population changes and use of unfunded schemes.

Sweden are now suggesting a notional defined contribution scheme where imaginary funds are deemed to accumulate and grow to give defined benefits. Apparently this is under serious consideration in the UK.

This move into fantasy land, reminds one of children’s nonsense stories and the Emperor’s new clothes.

In America the approach appears one of more hard Business, level headed and realistic. The Public Sector Funded Defined Contribution schemes appear extremely successful (see nasra.org)

Their Public Sector report funds of 2 trillion dollars in both active members and retired funds; investment funds provide 60% of total income and this alone meets pension payments without eroding capital in the retired funds. Target growth rates are 8% but over the past 25 years have averaged 9.25%. Pension benefits are high and the large funds buffer them from market changes.

These show what can be achieved in a well managed scheme and suggest a good role model. (next blog)

Savings     Annuities   Unions

John’s Blog No. 10 Pensions – Simplified (cont)

We previously considered the performance aims of pension provision and arrived at a figure of 50% of current wage in real terms (keeping pace with inflation) as a reasonable minimum income aim.

Of course as your work career advances, your wage should advance faster than the 3% value taken. Your contribution and fund will increase accordingly to match this, giving a higher average salary pension

At a factor five, a 10% contribution should provide this 50% level. Many schemes have contribution levels  of some 17%, reflecting underperformance and the effect of the 25% Tax free lump sum, which increases contributions by a third for a given pension. Tax free lump sums should be outside normal considerations.

Can you afford it is a difficult question and Fund growth and annuity rates play a vital part as does the State pension. Even small increases make a large difference as the table of PYF showed in the previous blog.

Even with Employer contributions and SERPS rebate, current levels at 17 to 20% are not and give poor value for money. The trend towards defined contribution schemes give even poorer returns and increase employee contributions considerably making the whole situation impossible and unacceptable.

The effects of Inflation cannot be ignored, it erodes the value of money and needs to be allowed for over a forty years period. At present running above 3% per year, the target is 2% and 2.5% is a good average.

At an annual inflation of 2.5%, a pound today will be worth some 37p in forty years time, a reduction factor of 2.7, which can be allowed for in any pension projections and is referred to as “real terms”. Inflation does not only affect income but also accumulated funds and both need to increase for any real gain or advance.

Of course the other question which arises is “are they worthwhile” and frankly apart from Defined Benefit Schemes the answer is no, however without pension savings, one is destined to poverty in old age.

Many Pension schemes absorb the State Pension as part of their final benefits and contract Employees out of the State second Pension, showing the NI rebate as Employer’s contributions, which is misleading. It is also debateable whether employees benefit from this practice.

There is a general impression of confusion, whether deliberate or not. Pension schemes are vague and secretive, annual statements give possible scenarios but no guarantees, it is as if the money is no longer yours and has gone into a state of limbo to return in an uncertain condition when you retire.

Revenue restrictions due to the tax relief do not help, divorcing owner and money, which allows the relief to be absorbed by charges. There is a steady erosion of contributions and funds by charges: the 5% bid – offer differential, commissions, and fund Taxation have a major impact on Fund growth and performance.

Defined contribution schemes are the worst offenders and appear a waste of money. Yields are uncertain and fluctuate wildly, even in the final stages of realisation, because the risk is borne solely by the members.

Defined benefit schemes, now regrettably on the decline, are a complete mystery, with little or no information available on the Funds or their performance, only complaints of being unaffordable. Yet this is the only real way forward, properly managed and run on a fully funded basis and should be the future aim.

The whole process is speculative, with members losing and is not helped by the lack of a stable non negotiable Bond. As a result annuities vary wildly and are undervalued by some 2 to 3%. In 1991 they offered a non-sustainable 16% and are now at 6% or below. Increased life expectancy is given as one reason for this fall, however it can be shown that this has only a minimal effect of some 0.5% on rates.

An annuity increasing by 2.5% per year against inflation and protected against increased longevity in retirement can be sustained at a 6% level with a modest 4% investment income and give the major gains shown earlier on benefits and contributions. Fund continuity into retirement should occur.

The next blog will consider current schemes

Savings     Annuities   Unions

John’s Blog No. 9 Pensions – Public Sector Pensions – Time for Action

This blog is another diversion from the main course, but I feel that there is an urgent need to respond.

The attack on Public Sector Pensions increases daily with many misleading  and incorrect statements designed to brainwash the public to believing that they are paying these pensions directly from their own pockets as a taxpayer’s burden.

This is untrue and not supported by the facts, yet there is little rebuttal of these claims or a counter attack within the public sector or the unions or representatives.

Of course all public sector costs come from taxation; the Prime Minister could be considered as a burden on the taxpayer.

PS workers are being warned of contribution increases of up to 3%, effectively a pay cut, in addition to a proposed two year pay freeze, a further pay cut of some 6%.

Yet pension contributions overall are similar to the private sector, and benefits are considerably lower. The State accounts bible, the 2009 blue book shows PS contributions as:-

Employers - £7.85bn;    Employees - £6.69bn;   Imputed Social - £5.12bn;  Total - £19.66bn

Average Employee contributions are 6.5%, giving Employer at 7.3% and Social at 5% (SERPS rebate).

These contributions are Employment costs and not direct Taxpayers costs. 

2009 Gad report shows the largest, the NHS, has an average wage of £20,900 and average pension at £5,200, just 25%, Teachers are similar; half the return on contributions of a funded private sector scheme.

This is not value for money, even with current poor pension returns, increased contributions make it worse.

The Taxpayer’s burden arise from the subsidised Civil Service, Armed Forces, higher earners and MP’s pensions, which should be treated as Department costs. The other major schemes have some £5bn surplus.

The root problem and threat to PSP is the unsustainable “pay as you go” nature of the scheme.

Contributions from hard earned wages, which should build up and grow are being spent immediately on existing pensioners (see Blog1). With a worker / pensioner ratio of 1.4 , this requires a 37% wage contribution to yield a 50% .pension, an impossible and unaffordable scheme.

This costs three times the equivalent funded scheme and is of questionable legality, being a criminal mis-use of personal pension savings and funds, arising from your own and employment contract contributions and SERPS rebate from NI. Change to a funded scheme would give larger benefits and major savings.

Public sector pensions are just the start, they also include Local Government and University pensions. The State pension has the same unfunded problems and the second pension is under attack and will disappear.

There is a need for a secure, well managed funded universal defined benefit pension scheme to replace all the failing, outdated and uncertain schemes and the speculative investment base they depend on.

It is time for action and protest; not the street demonstrations which can be taken over by hooligans, but in this high tech electronic age by E-demonstrations.

E-mail your MP; the Prime and deputy Prime minister; DWP; your union/confederation representative; NHS or Teacher boards. Contacts  can be found on directgov.uk. Use Facebook and similar sites.

Strongly object to the contribution increases, the use of your pension savings and SERPs rebate to pay another’s pension and subsidise non contributors; query the legality; poor return and unfairness of the unfunded scheme. Make your voice heard! People power is effective as recent events have shown.

The Big Society starts here by Public Sector employees and all others demanding a fair deal from the coalition. We may all have to tighten our belts but it needs to be fair and justified.

  .

Savings     Annuities   Unions

John’s Blog No. 8 Pensions – Simplified

Pensions are difficult even to the experts, but they can be simplified.

Part of the complexity is the experts themselves. The basic pension mechanics are straightforward arithmetic, which although boring can be carried out on a simple spreadsheet.

However like mortgages you do not have to know or understand the details but just the results.

The main questions that one needs to ask are:-

·         How much do I need to save and for how long to get a reasonable retirement income?

·         Can I afford it? And what about State Pension?

·         What will be a reasonable income when I retire? What about inflation?

·         How secure are my Pension Savings

·         Are they worthwhile, will they give good value for money

Pension contributions accumulate year by year; if properly managed these savings also grow on a compound interest basis, so the longer you save the better and you can never start too early.

The timescale is long, 40 to 50 years, and in this rapidly changing world, a lot can happen in this time.

The need to look after oneself however does not change and all at some time feel the urge to put something away for a rainy day. This is never more important than in pensions for retirement.

The amount one needs to save can be simply expressed by a Pension Yield Factor linking total percentage contributions to pension income required in either real or final salary terms for number of years saved. Although dependent on many external factors, these can be specified and reasonable values taken.

If wages and growth of the accumulated fund keep up with inflation/ living costs, the real term position is that over forty years, at 10% total contributions, you will have saved four times your annual salary, which if drawn at a 6% income will give a pension of 24% final real salary; a factor 2.4 up on contributions.

This is the least target that pensions should aim for. Wage increases are usually above inflation, on average 3%; annual Fund growth should be some 6%, (some schemes take 8% as a basic aim). 6% growth increases this factor to 5.7 in real terms. Of course tax free sums require extra savings of a third higher.

The PYF, assuming inflation at 2.5% and wage growth at 3%, and payment/ annuity/ drawdown at 6% is:-

    Years of contributions         10           20             30               40

Fund growth    3%                  0.64        1.34           2.11            2.96

Fund Growth   4%                  0.67        1.38           2.46            3.64

Fund growth    6%                  0.74        1.83           3.42            5.72

Fund Growth   8%                  0.82        2.29           4.9              9.4

The factors derive from compound growth calculations and show the need for long term saving.

Unfortunately many schemes, particularly Defined Contribution barely keep pace with inflation.

The new NEST scheme aims to give a 15% pension for 8% total contributions, a poor factor of 1.9.

How much pension income is needed depends on the living standard you are used to. A simple way to determine this is from your current earnings, after Tax, NI, Pensions and other deductions, take away mortgage, child and work related costs to arrive at your basic living costs. Generally this will come out at 40% and should be your retirement living costs; 50% of current wage in real terms is a reasonable aim.

This will be continued in the next blog, however apologies for the necessary Arithy bits.

John’s Blog No. 7 Pensions – The Reality of Current Schemes

The State Pension scheme based on NI contributions has been the backbone which the population in work relied on. Companies had Private schemes for Directors and Management to enhance this.

As the State scheme progressively failed, these Company schemes expanded and Public Sector schemes grew up. These were all on a Defined Benefit basis in which a guaranteed pension based on number of year’s service was given and were treated as part of the employment contract or voluntary.

Private schemes also started in which individuals made their own contributions in what were Defined Contribution schemes, where funds built up but with no guarantee of final outcome.

The State and Public Sector schemes were run on an unfunded “pay as you go basis”, which means that contributions are spent on existing pensions as they arise and Funds never build up.

Funds that build up in Pension schemes can be large amounting to trillions of pounds, that is twelve noughts and their size is therefore difficult to appreciate.

They are also big business, these large amounts attract predators, particularly the State, and are therefore vulnerable, with funds being eroded, even disappearing and generally giving poor value for money.

 The main problem is that Pension funds lack ownership and protection. Contributions are deducted from wages and disappear into a black hole to re-appear, if lucky, forty years later in an unknown state or value.

Funds are individual personal savings taken from wages or as part of the employment contract and should be treated, protected and accounted for as such. Any misuse, abuse or speculative loss should be treated as a criminal offence, which would insure that funds would be treated with the care they deserve.

Some private individuals have invested in property, with a rapid growth in buy to let; bought wisely at the right price, these can form the basis of a sound pension scheme without, of course, the tax relief advantages. However most of the recent major losses, including the Banks, have been in property.

Equity release is becoming more popular, basically you are mortgaging your property with no repayments, which steadily erodes its value. The cost outweighs the gain and it is a last resort (more later).

In general funds are invested in the Stock market and the number of UK investment funds runs into thousands (see http://www.trustnet.com/ ) , they are therefore subject to market fluctuations and rely on market growth to progress. Major Companies use their own Investment Managers, but in the UK other Funds tend to be run by the Insurance Companies, who also run Annuities, effectively a closed shop.

Well managed funds should be transferred to more stable investments as they approach maturity from Age 50 on, into Government Stocks and Bonds, but recently these investment have been subject to speculative investment and have therefore become less stable and reliable.

Pensions are in turmoil. Funded Defined Benefit Schemes are the only reasonable scheme but are in decline due to a variety of reasons, the main reason being the large deficits they have and the Company investment required to reduce these. Why these deficits appeared is not apparent as schemes are shrouded in secrecy.

The impression is that these are associated with regulations on projected liabilities and population increases. The pension industry overall is still suffering from over generosity in the 1990’s, when payment and annuity rates were an unsustainable 16%. This would have exhausted available funds in seven years, leading to substantial commitment losses running into 2025 plus the loss of investment income.

Pensions appear not fit for purpose and drastic changes are needed.