Pensions: THE TRUTH
I believe it is vital that we all get a better understanding on pensions as there is, as we all know, a burgeoning pension crisis in the United Kingdom – and indeed across much of the developed world.
The truth is – and for the reasons I set out below – unless we take proactive responsibility for our retirement planning during our working lives, we are likely to have to make some very stark lifestyle choices when we hit 65.
The good news is that there are lots of measures that can be taken to avoid getting a nasty shock and/or having to make those depressing decisions about potentially downsizing retirement ambitions. And with this in mind, in this blog post we’re going ‘back to basics’ on pensions and we will look at how we, as advisers, can really add value in this area.
What is a pension?
A pension is simply a method of putting money to one side now so that the amount saved may replace the income lost from your salary when you decide to retire. Retirement is the longest holiday of your life and it’s down to you to build up funds and map out what your retirement will look like. Do you want a Barbados-style holiday or a wet and windy Skegness?
The UK government is keen for you to save for retirement and actively encourage and support you by offering tax incentives to reward saving.
In reality, income in retirement is likely to be made up from several sources with the state being one of them. The state pension is currently £168.60 per week i.e. £8,767.20 per annum – which would not get you far leading to a ‘Skegness’ style retirement.
This is why people who are determined to retire early or enjoy financial freedom in retirement will focus on savings and seek financial advice to take control over their retirement planning.
In 1590, the Chatham Chest was established to provide pensions to wounded seamen of the Royal Navy. This was probably the first funded occupational pension in the world. Each month 5 per cent was deducted from seamen’s wages and paid into the chest. Pensions were payable on a fixed scale according to the degree of injury. The pensions were payable for life but were regularly reviewed and could be reduced or terminated if the pensioner was found to have recovered sufficiently to be capable of employment.
In 1672, a state superannuation scheme for retired naval officers was introduced, and is believed to be the first occupational pension scheme in the world to provide lifetime pensions on retirement due to old age. There was no fixed retirement age, and the pension, which was 100 per cent of salary and allowances, became payable to any officer who became unfit for performing his duties because of age, provided he had completed at least 15 years’ service. That might be considered generous by today’s standards, but would you really have wanted to be in the Navy back then?
Pensions have, naturally, evolved since then and indeed the UK government is seemingly continuously altering the rules and legislation.
The Main Two Pension Scheme Types
1. Defined Benefit Schemes:
Defined-benefit schemes usually provide a pension income based on:
- The number of years in which you’ve been a member of the scheme – known as ‘pensionable service’
- Your pensionable earnings – this could be your salary at retirement (known as ‘final salary’), or salary averaged over a career (‘career average’), or some other formula, and
- The proportion of those earnings you receive as a pension for each year of membership – this is called the accrual rate and some commonly used rates are 1/60th or 1/80th of your pensionable earnings for each year of pensionable service
These schemes are run by trustees who look after the interests of the scheme’s members. The employer contributes to the scheme and is responsible for ensuring there is enough money at the time you retire to pay your pension.
Example of a defined-benefit scheme
Dave belongs to a defined benefit scheme. The accrual rate is 1/80th. This means Dave can expect a pension of 1/80th of his pre-retirement pensionable earnings for each year he belongs to the scheme.
Dave retires at 65 on a salary of £30,000 a year, having been in the pension scheme for 10 years.
His pension is: 10 x £30,000 divided by 80 = £3,750 a year (unless he takes any cash lump sum, which will change the sums slightly).
2. Defined Contribution:
Defined contribution pensions build up a pension fund using your contributions and your employer’s contributions (if applicable) plus investment returns and tax relief.
If you’re a member of the scheme through your workplace, then your employer usually deducts your contributions from your salary before it is taxed. If you’ve set the scheme up for yourself, you arrange the contributions yourself.
It helps to think of defined contribution pensions as having two stages.
Stage 1 – While you are working
The fund is usually invested in stocks and shares, along with other investments, with the aim of growing it over the years before you retire. You can usually choose from a range of funds to invest in. However, remember that the value of investments can go up or down.
It is important to get proper financial advice to help make the correct decision on what to invest in.
Stage 2 – When you retire
Normally, when you retire you can take some of your pension as a cash lump sum and then convert the rest into a retirement income. This is known as an annuity although you do also have the option of leaving the monies invested and drawing down part of the fund as income.
The amount of income you’ll get will depend on:
- How much you pay into the fund
- The time frame you save for
- The amount, if anything, that your employer pays in
- How well your investments have performed
- What charges have been taken out of your fund by your pension provider
- How much you take as a cash lump sum
- Annuity rates at the time you retire
- The type of retirement income you choose
You will be offered a retirement income based on your fund, but you don’t have to take this. It should not be forgotten that you have the option to shop around for a better rate, or even consider using ‘income drawdown’.
The challenges facing pensions
There are not enough people are saving towards retirement. Why is this?
- Research carried out by Aviva estimates there will be a £10,300 per annum shortfall for all those retiring over the next 40 years. This equates to a staggering £317,000,000,000 per annum
- Affordability is often cited as a reason
- People think the state will provide for them
- They feel that retirement is a long time away and that they don’t need to think about it yet
- People find them complex and difficult to understand
There is a movement by Companies to offer ‘defined contribution’ pension schemes to employees as opposed to ‘defined benefit’ (final salary). This is a shift generally from highly funded secure pensions to riskier less funded schemes with market risk.
Scandals ruining the reputation of pensions and making people shy away from saving.
- The collapse of company final salary schemes
- Equitable life established in 1762 and once the largest mutually owned insurers in the world with 1,500,000 customers reneged on their promise to pay out guaranteed annuity rates in the year 2000, substantially reducing its pension holders pension incomes
Under-performing stock markets hitting final salary scheme pension pots ultimately helping to close many and impacting on those with defined contribution schemes with smaller pension funds and thus incomes
Falling interest rates impacting on retired peoples savings interest which they rely on for income
Subsequent falls in annuity rates meaning smaller pension incomes
The UK has an ageing population, meaning that the population of people who have retired is growing whilst the working population is reducing.
This isn’t a problem if you have a defined contribution personal pension arrangement but for the state pension and defined benefit schemes this becomes a huge issue. This means the cost of providing pensions becomes the responsibility of less and less taxpayers who are supporting for a growing number of retirees.
Life expectancy is increasing:
The balance of our population is tipping toward retired people versus working. Having those that are of pensionable age living for longer creates a huge strain on the pension provision in the UK. For example, did you know that there are more people over 40 in the UK, than under? Also the fastest growing segment of the population is the over 80s.
A combination of the shift in demographics and challenges that pensions are facing has led to the recent examples which we see every day in the press.
- Equalisation and the increase in the state pension age
- Auto enrolment for employees
- Teachers pensions being moved to a career average basis
- Removal of the requirement to offer a spouses pension
How can advisers add value?
- By encouraging clients to act now
- Educating clients on the fundamentals and explaining that pensions aren’t complicated
- Outlining to clients what their retirement will look like should they fail to plan
- Reinstalling confidence in pensions by ironing out misconceptions
There can be no denying that people have less confidence in pensions than they used to. But pensions remain, arguably, the best way to secure one’s financial freedom later in life – something to which we all ultimately aspire.
As such, as advisers, whose overarching aim it is to have clients reach their long-term financial objectives, it is our responsibility to encourage greater engagement in this vital area of financial planning and to promote a wider fundamental shift in the attitude of working age people towards savings and pensions. Failure to do this will, unfortunately, mean that more and more individuals will face an impoverished retirement and that further pressure will be put unnecessarily on the already overstretched State.
I hope this blog has positively increased your understanding on pensions. Another blog that may interest you is “Being money aware in retirement will pay off ”
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Mike Coady is an award-winning financial expert and a well-known leader in the financial industry.
Having taken two of his previous firms to Chartered Status in the UK and also achieved the prestigious National IFA of the Year Award – Highly Commended.
Mike is qualified to UK Financial Conduct Authority (FCA) standards, a member of the Chartered Insurance Institute, a Fellow of the Institute of Sales Management (FISM), and a Fellow of the Institute of Directors (FIoD).
Blog published by Mike Coady