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Pension decisions cast a very long shadow. So, any system has to be stable, as well as effective in ensuring livelihoods in old age. Alas, the UK’s falls far short of what is needed.
We need to understand that choice and competition do not work well in pensions, because ignorance and myopia are so deep-seated. Moreover, individuals cannot easily bear the investment and longevity risks on their own.
These realities are of particular importance in the UK. In this country the state pension replaces only 22 per cent of average earnings. So, supplements are essential. But the old defined benefit (DB) system is collapsing, except in the public sector. Yet the main alternative, that of defined contribution (DC) pension plans, in which 49 per cent of employees were enrolled in 2020, is an inadequate substitute.
Above all, the median rate of contribution to DC pensions is a mere 8 per cent of earnings. While the median contribution of employers to a DB plan was 19.5 per cent of pensionable earnings in 2020, their median contribution to a DC plan was only 3.4 per cent. With these low contributions and even quite optimistic return expectations, the pensions available at the end will be inadequate. I calculate that, after 40 years of savings, at a real annual rate of return of 3 per cent, the annuity purchasable at age 65 would deliver less than 30 per cent of career average earnings without protection against inflation, at today’s interest rates. Contribution rates must rise substantially.
The high cost of annuities reflects today’s ultra-low interest rates. But the latter do not only affect income in retirement. They also lower expected returns on investment prior to that point. This is because it is advisable to move into bonds, as retirement approaches, in order to manage the short-term volatility of equities. But this decision will lower wealth, because returns on equities are higher than those on bonds, in the long run.
Collective defined contribution plans are able to address some of these problems. Because the fund is permanent, multi-generational and, ideally, very large, it will have low costs, can hold a diversified portfolio and is not under pressure to de-risk its portfolio by arbitrary dates. The CDC fund can also provide pensions until death, again backed by its portfolio returns and the inflow of new contributions.
In effect, generations whose investment returns turn out to be exceptionally good subsidise those whose returns are exceptionally bad. But nobody knows in advance which fate their generation will suffer. Many will want this protection, because it allows all of them to take on more risk in their plan, together.
Unlike in DB plans, there is no institutional sponsor able to fill holes in the funding. But that protection has turned out be an illusion. The only sponsor credibly able to do this is the government. So, in a CDC, the trustees, whose sole responsibility would be to manage the fund in the interests of members, would have to adjust promises from time to time in light of experience.
Provided they were cautious, adjustments, especially downward adjustments, would not happen often. People could have reasonable confidence that the pension they expected would be paid. The experience of the Dutch system supports this expectation: even after the 2008 financial crisis, it reduced pensions by only 2 per cent on average. In general, adjustments should fall more on younger members, because they will find it easier to make losses up over a lifetime. But succeeding generations would then protect them in turn.
Because the CDC portfolio can hold assets that are likely to generate higher long-term returns more safely than individuals can, pensions should be substantially larger. A study by the Royal Society of Arts suggests that “CDC will give at least a 30 per cent higher retirement income than a conventional DC scheme with an annuity.” These will largely be the benefits of expanding risk-bearing capacity from that of one individual’s lifetime to that of many people over multiple generations. While all should be better off in the long run, there will be transfers from lucky to unlucky generations. That is the point.
As with any collective arrangement, it is essential to create trustworthy institutional structures. The government would need to be active in this. It will be a complex task. But with the end of DB pensions, except for government employees, inadequate contributions to DC schemes, and the lack of intergenerational and interpersonal risk-sharing, the outcome is bound to be disappointing. The CDC alternative must now be introduced, because the status quo is so unsatisfactory.