WHO BELIEVES IN THE PENSION FAIRY?

One of the biggest problems facing Britain, and other developed economies today is that too many of its grown-ups believe in the pension fairy – a magical creature that will provide them with a pension for life, a pension that will allow them to maintain their pre-retirement lifestyle, no matter how long they live for. A disproportionate number of these delusional grown-ups work in the public sector.

But there is no such thing as the pension fairy. The funds needed to provide us with a pension in our old age will come from a combination of three sources, none of them magical: you, your employer, and/or current and future generations of taxpayers.

The recent closure of the Shell pension plan to new members – until that point, the last FTSE-100 scheme still open to new members – was yet another nail in the Defined Benefit (DB) coffin. In a recent report, the Pensions Regulator estimated that 2.3 million people currently contribute to a private sector DB pension scheme; in the early 1980s the figure was 5.5m.

Employers have withdrawn DB schemes because the burden of funding them has increased so dramatically over the last ten years. People are living much longer, equity markets have delivered double-digit negative real returns since 2000; and bond yields have fallen dramatically. Employers can no longer afford these schemes and also no longer believe in the pension fairy, if they ever did.

So if the cost of providing a decent pension has risen beyond the point of affordability for companies – including cash rich, giants like Shell – it has also risen for individuals that are increasingly left with only their Defined Contribution (DC) arrangements or a private pension plan. In recent research, conducted in collaboration with my Cass Business School colleague Dr Douglas Wright, and supported by the Bank of New York Mellon, we highlighted how difficult it has become for individuals to generate a decent pension.

We looked back in history and worked out how a typical private pension saver had faired. For simplicity we focussed on the lifestyling stage of the accumulation process, that is, the ten years immediately prior to retirement when most pension savers gradually switch their investment portfolios from equities into government bonds. For the purposes of the experiment we hypothesised a representative pension saver, who earned a salary equal to the UK average. For each year when the lifestyling process began (shown on the horizontal axis) this representative worker:

-  was a male aged 55 with ten years to retirement;

-  had a pension pot equivalent to twice their annual salary at that time;

-  made an annual contribution equivalent to six per cent of their annual salary to the DC default fund;

-  had an employer that also contributed the equivalent of six per cent of the individual’s annual salary to the pension pot, and

-  had a starting investment portfolio comprising 100 per cent equities and 0 per cent UK government bonds, but by the time they retired their investment pot comprised 100 per cent UK government bonds. This transformation was achieved over the ten years by selling 10 per cent of their equity holding at the end of every year, using the proceeds to increase their holdings of UK government bonds.

The results of our research are shown in the first chart. They are simultaneously dramatic and depressing. The bars in the chart show the size of the annuity per annum that could be bought with the pension pot at retirement as a proportion of the individual’s final year salary. To calculate this we estimated the performance of the government bond and equity markets for each ten year period, and then used the relevant annuity rates that prevailed at the time of retirement to calculate the gross, annual pension.

The results are quite scary, had an individual begun their lifestyling in 1980, and assuming that they did not take any tax-free lump sum from their fund, they would have been able to purchase a level payment annuity equivalent to 72 per cent of their final salary, or an RPI-linked annuity equivalent to 39 per cent of their final salary. Contrast this with the fortunes of the equivalent individual beginning their lifestyling journey in 2001. This poor soul would only have been able to afford a level payment annuity equivalent to 22 per cent of their final salary, or an RPI-linked payment equivalent to a measly 13 per cent of their final salary.

So whereas our representative person retiring in 1990 might have been able to afford a fancy sports car, a world cruise or an apartment on a golf resort in the Algarve, the same hard working individual, contributing proportionately the same amount to their pension pot, retiring at the end of 2010 would have been lucky if they could have afforded the occasional out-of-season weekend on a New Forest caravan site.

The next chart demonstrates how the challenge of pension provision has risen over the last thirty years from another perspective. We repeated the experiment presented in the previous chart, keeping everything unchanged except for the size of the pension pot at the start of the lifestyling period. We worked out the value that this pot would have needed to have been, relative to the representative pension saver’s salary at the age of 55, to produce a level pension at retirement equal to two thirds of their salary in their last year in work. Again, the chart is very sobering. Our representative pension saver, retiring in 1990 needed a pension pot in 1980 equivalent to 1.8 times their salary at that date to generate a pension equivalent to two thirds of the salary they were earning in their last year in work. The equivalent multiple for the same saver retiring at the end of 2010 was an eye-watering 9.3 times their salary!


The sobering results highlighted in our research are a function of: declining annuity rates since the early 1980s; the poor performance of equity markets over the Noughties; and also the simple-minded approach to asset allocation taken in the final stages of the pension accumulation phase.

Our research shows that we will all have to increase contributions to generate decent pension outcomes for ourselves in this challenging investment environment, or alternatively that we must become much smarter about the way in which we invest for our retirement.

Alternatively we could just close our eyes, make a wish, and wait for the pension fairy!