Pension schemes divide into two categories unfunded and funded; the State and Public Sector are unfunded, where contributions are spent as soon as they are collected and effectively the State issues an IOU promise to pay these when due. Of course it has to be able to afford it in 20 to 40 years time as it has no accumulated funds available to do so and increasingly it has found itself unable to meet its liability.
This is the underlying reason for the current dispute with the Public Sector workers, where the Government wants to increase contributions and reduce benefits to make ends meet, in spite of recent renegotiated terms.
In funded schemes the money is accumulated and invested to build up a pension fund, which should be there on demand to give a stable and secure pension provision, besides the guarantee advantage over unfunded schemes there is also the investment income which can equal or even exceed the contribution income.
This should therefore in practice halve the cost of providing a given pension income, which should also be boosted by the longer working life compared with that in retirement. One should therefore expect that saving a quarter of one’s income would yield a full wage on retirement in a funded scheme.
That this does not occur is one of the major failures of modern pensions and this will be considered more fully later, however one of the main reasons is that pension contributions are not treated as personal and individual savings, which in fact they are and therefore should be protected as such.
The basic mechanic of funded pensions are not difficult and involve straightforward calculations of money accumulation and compound growth,, similar to savings and mortgages. One can obtain simple factors relating annual contributions to final fund and even pension values allowing one to establish expected pension from given contributions, or savings needed for a pension need.
For example if one saved £1,000 per year for 40 years then £40,000 would accumulate plus any interest or investment income earned, if this was at 6% then average interest would be 20 years at 6% on £40,000, giving a factor 88 times annual savings ((1+1.2) x 40).
This would be in actual values, but one is really interested in its spending power at today’s values, i.e. in real terms. If wages and hence contributions together with Fund growth keep pace with inflation, then in real terms after 40 years the fund yield factor would be 40, if this fund then paid out at a rate of 6% pa then the pension yield factor would be 40 x .06 =2.4.
This is therefore the minimum factor to make savings worthwhile, otherwise you are losing money in real terms, i.e. spending power is reducing with time, which happens with many schemes. The factor increases as the investment income or growth exceeds inflation, over 40 years at 4% it is 3.4, rising at 6% to 5.7.
It is easy to use, £1,000 per year over 40 years at 4% should give a pension of £3,400 per year, rising to £5,700 at 6%, or in percentage terms contributions of 10% pa should give a pension at 4% of 34% of wage or at 6% 57%, all in real terms. This is for all contributions made and assumes wages and hence contributions keep up with inflation.
Current schemes rarely meet these levels due to several reasons :-
· Tax Free Lump Sum which increases contributions by a third taking a quarter of final fund
· Poor Annuity performance and overgenerous payments
· Excessive Costs and charges, Protection levy, dividend and other taxation including VAT.
On normal savings, interest returns are quoted after all costs, i.e. nett and this also occurs on investment funds, annuities and payments, but not for pension savings. They are also charged as a cost on total Fund value, which becomes increasingly excessive as the Fund builds up and can include setting up charges to ensure early income. Charges on well managed schemes can however be very low and competitive.
Pension protection levy arose due to the commercial failure of some major schemes and subsequent loss of pension funds; this was a failure of State regulation and control and would have been less likely if funds had been treated as savings making it a full criminal offence, readily pursued.
Taxation is a short sighted Government policy, prompted by greed and leading to the steady demise of good pension schemes. The next blog will deal with Investment returns and sustainable annuities and payments.
Savings Annuities Public Sector NHS Teachers Police Local Government State Work Benefit Social Education
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