At a conference organised by one of the big pension consultants, the audience was asked: what is the key issue for the sector?
Almost without exception, there was one thing on their minds. People were not investing enough, or not investing at all, in their pensions. Nudging them did not appear to work – or not sufficiently well – and one after another, the audience said that there should be much more financial sector education. People must understand pensions, because only then will they realise how much they will need and for how long. Only then will people invest more and earlier.
This was not the first conference, nor will it be the last, where such thoughts have been mentioned. But it is not how a capitalist economy is meant to function. If pension providers offer products, and the public turn up their noses at them, then the providers should scrap their existing products and think of something else – or go out of business. Leaving the products in place and saying that the buyers need education, or re-education, is a dictatorial solution, not one for the market economy.
It is also a problem of our time. Traditionally pensions were provided by the state out of taxation and everybody benefited. Additionally, those lucky enough to have a benevolent employer also paid contributions (along with their employers) to secure a proportion of their final salary after retirement in what was a second pension. The amount depended on the time the individual was enrolled in the plan, but with that caveat, the benefit was guaranteed. It was called defined benefit. The individual did not really have to take any investment decisions. The pension came regardless.
But pensions have changed. State schemes are still there but are often inadequate. People and employees still put money in second schemes but there is no certainty as to the outcome. The amount of money saved – the pension pot – is just that; it is a lump of money which may or may not be sufficient for the retiree’s needs. The schemes are known as defined contribution, meaning that the risk of such an outcome is firmly on the employee, whereas with defined benefit the employer had to make good any shortfall.
Joseph Stiglitz, one of America’s most feted economists, says that the major insight of behavioural economists is that individuals are not good at savings and risk decisions. The theories of economics where people are rational and have all the information are just wrong, and many individuals are in fact preyed upon with billions of dollars lost. He says that individuals have not got the resources or the knowledge to manage the risk well – and financial education is not going to change that for the mass of the people.
An annuity from an insurance company provides secure cash flows but the individual has no say thereafter in what happens
Lionel Martellini, a professor at EDHEC Business School and the director of its French Risk Institute, is focusing on this particular problem. The decumulation phase, when the pension proceeds are spent not saved, concerns him. So few pension providers engage in this aspect and yet it is probably the key issue.
Current products are not sufficient, he says. An annuity from an insurance company provides secure cash flows but the individual has no say thereafter in what happens. It is secure but there is no freedom once the choice is made, and as Benjamin Franklin, one of the signatories of the American Constitution says, “security without liberty is prison”.
Additionally, the British have proved that most people do not want annuities, particularly at a time when low interest rates mean the cash flow from annuity providers is poor. The pension freedom legislation three years ago, which meant that annuities were no longer mandatory, caused the business to more than halve in the UK.
On the other hand, investment products – which are the opposite of annuities – have freedom but no security. People are free to invest where they choose but they could end up with substantially less than they put in. It follows that the drawdowns of pension pots may also not be good – or they may be okay at first but get progressively worse as time goes on. So this is not a free lunch either.
The problem, as Martellini says, is that we have to manage our cash flows but we have no way of knowing how long for because we don’t know when death will be.
However, he thinks he has a solution – or part of one at any rate. He advocates splitting the pension pot in two; a retirement bond portfolio first and a late life annuity second. The retirement bond would mature in, say, 20 years at 80 or 85-years-old; the late life annuity would then kick in from 85 till death. (This is for illustration – obviously the actual split and the length of the retirement bond would depend on individual circumstances.)
He then uses financial engineering to cope with the volatility of the fund so that a portfolio of equities with a volatility of more than 30% is transformed into a target date fund of just over 13%.
The bond (more realistically bonds), should not be more volatile because the portfolio is hedged and the life of the fund is finite. The life time annuity should give a decent return to pensioners as they have less time to enjoy it, being closer to death. And the result is a better outcome for the members.
Anthony Hilton FCSI(Hon) is the award-winning former City editor of The Times and the London Evening Standard.
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