In a damming report, independent policy adviser Ros Altman has slammed
policymakers for lulling people who relied on the power of equity
investment to assure them of a secure retirement into a false sense
of security. The result, stresses Altman, is a need for a radical
change in the approach to retirement saving.
Go deeper with GlobalData
British workers who believed their
retirement would be secured by a reliable pension system have been
grossly misled by policymakers. This is the overwhelming message
permeating a damming report on the UK’s pension system,
Planning for Retirement: You’re On Your Own.
Written by independent policy adviser Ros
Altman, the report was undertaken for MetLife Europe, a unit of US
insurer MetLife, with the objective of examining the reality facing
millions of people in the UK struggling to plan for their
retirement.
Central to her assessment, explained Altman,
is that the entire UK pension system has been based on a bet that
equities would always do well enough over the long term to reliably
deliver good pensions.
“The generous final salary pension promises –
as well as forecasts for good personal pensions – all relied on the
equity gamble paying off, and the expected strong equity returns
enabled successive governments to cut UK state pensions over time,”
she said.
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By GlobalDataWhat she termed the “cult of the equity”
started in the 1960s in UK company schemes and was adopted by
personal pensions in the late 1980s.
“Government forecasts consistently showed the
costs of supporting the dramatic rise in the number of pensioners
would remain very low, because rising private pensions would
benefit from the stock market, offset falling state payments and
leave retirees with a good income,” said Altman.
While the equity market continued to rise all
was well and, noted Altman, resulted in UK pension policy often
being viewed as a model for the rest of the world in the 1990s.
That model comprised a very low state pension, supplemented by good
employer or personal pensions, with pension contributions invested
mainly in the stock market with the objective of producing strong
growth.
Reality hits home
“Every single equity investor was
led to believe that, although markets might be volatile in the
short-term, over the long-run their equity investments would
deliver strong returns higher than government bonds,” stressed
Altman.
Investors assumed they would all
benefit from the so-called equity risk premium, usually considered
to be a 2 percent to 3 percent annual out-performance of bonds, she
added.
This was in line with financial theory which,
said Altman, suggests that on average, over the long-term, equities
should perform better than risk-free bonds. However, she added that
the theory does not say how long it might take for any such
out-performance to occur.
Unfortunately, the collapse in equity values
that began in earnest in September 2008 revealed in dramatic
fashion the high risk of over-reliance on ever-rising equity
values.
“As stock markets have collapsed, pension fund
values have fallen and the result has been devastation for many
pension plans,” stressed Altman. “This significantly increases the
risk of future poverty in the UK’s rapidly ageing population.”
Illustrating the impact of the equity value
slump and lower interest rates resulting from the Bank of England’s
monetary policy consultancy, Aon estimates that a 60-year-old
earning £25,000 ($40,000) a year and contributing 10 percent of his
salary into a pension, saw his total projected pension at age 65
fall by 36 percent during the credit crisis.
Specifically, in September 2007, he would have
expected to retire on a pension of about £17,000 a year, but due to
the falling markets and rising annuity prices, his expected pension
at age 65 has fallen to under £11,000 a year
Highlighting the impact of the equity market’s
slump and dangers of relying on equity to outperform bonds, Altman
noted that in the UK over the past 10 years, £10,000 invested in
the equity market would be worth £8,500, a fall of 15 percent. In
comparison, £10,000 invested in government bonds would be worth
£17,000 – a rise of 70 percent.
The folly of over-reliance on equity returns
is even more vividly illustrated by Japan where over the last 15
years, government bond values have increased by 80 percent while
equity values have fallen by 50 percent.
“So much for relying on the equity risk
premium,” commented Altman.
Disillusioned savers
Dramatic events in financial markets
and the negative impact these have had on retirement prospects not
surprisingly left workers disillusioned with the pension
system.
Backing Altman’s report, MetLife undertook a
survey of attitudes towards pension funds, retirement prospects and
equity investment.
Amongst survey respondents in the 55 to 64 age
group MetLife found that 32 percent who are five years from
retirement are either unhappy with their pension or feel they
wasted their money by investing while 54 percent believe their
pensions will fall short of expectations and are worried about
their retirement income.
Furthermore, only 4 percent of respondents in
the age group said they were pleased with their pension and
expected it to give them a good income while 56 percent said they
would now continue working in retirement, either full-time or
part-time. Less than a third said they will definitely not
work.
In addition, MetLife’s survey revealed that
the credit crisis has adversely affected confidence in equity
investing for pensions among the wider population. Specifically, 65
percent of adults across all age groups now feel less confident in
pension investing with just 9 percent believing equity is a sound
long-term investment.
Defined benefit schemes
fading
Companies that have long offered
defined benefit (DB) final salary schemes are also facing huge,
adverse financial consequences of over-reliance on equity
investment.
“Employers took on huge risks – and costs – in
their final salary pension schemes by offering to pay a specific
level of pension to their employees when they retired – no matter
how long they lived,” stressed Altman.
“These uncertainties have been brought into
stark relief by the credit crisis – during which assets have
fallen, liabilities have increased, and deficits have soared.
Employer schemes generally had no protection against falling equity
markets, falling interest rates or rising life expectancy and this
lack of protection has led to huge funding problems.”
Altman added that employers generally believed
they did not need protection because they expected equity returns
would be high enough to overcome any adverse developments their DB
schemes may encounter.
“This optimism has not paid off and, as
employers try to reduce their exposure to pension commitments, this
leaves workers much more exposed,” said Altman. “If individuals no
longer have a final salary or other defined benefit pension scheme,
they face all these risks and costs themselves.”
She added that it is thus important that
people understand that risks and costs now passed from employers
onto their own shoulders are virtually identical to those companies
with DB pension schemes face.
Risks faced by individuals, noted Altman,
include:
• Investment risk;
• Manager risk;
• Longevity risk;
• Inflation risk;
• Interest rate risk; and
• Regulation risk.
Altman added that employer DB schemes also
took care of the costs of pension provision which include:
• Investment management costs;
• Running the pension fund;
• Actuarial advice; and
• Administering pension payments.
In total these and other costs can absorb more
than 2 percent a year of the asset value of a pension fund, noted
Altman.
Lack of understanding
“As both state and employer pension
provision decline the importance of individual long-term savings
increases,” Altman said. “People will be increasingly on their own
to cope with both the costs and the risks.”
But, she continued, not everyone who is saving
for retirement is aware of the risks of poor equity market or
investment returns. What must be clearly spelt out is that having a
pension fund, is not the same as getting a good pension income, she
said.
To an extent, noted Altman in her report, this
confusion can be attributed to final salary schemes in which
workers could predict what pension they would receive.
“New approaches to pension planning are
required,” stressed Altman. She added that many people want a
measure of security and are not so worried about maximising
investment returns.
Against this background Altman laid emphasis
on a pension option launched recently in the UK by firms such as
MetLife – unit-linked guarantees. In essence, these products enable
savers to benefit from equity market upturns while limiting risk
and providing death benefits.
“Obviously, taking out such insurance has
costs,” conceded Altman. “If the stock market performs well your
pension fund will not get the full benefit, but equally, if
equities fall again, your pension fund will be protected by the
insurance.”
She added: “Compare this with house insurance.
Most people would prefer not to leave their home uninsured, so why
would you not consider insuring your future retirement
resources?”
The attraction of unit-linked guarantee
products was highlighted in MetLife’s survey which found that 43
percent of people would like the idea of being able to pay for some
insurance against losing money in the stock market.
The insurance approach can also give those
saving for retirement an opportunity to lock-in gains periodically
after a rise in the equity market, said Altman. For example, if a
pension fund is worth £50,000 today, the insurance would guarantee
that the fund value will not fall below £50,000 in future.
She added that if after, say, three years the
value of the fund has risen 20 percent to £60,000, the insurance
could lock in that gain. Even if markets then decline the minimum
value of the pension fund would still be £60,000 and that value
would be guaranteed by the insurer whenever the policyholder opted
to retire.
In her report Altman provided an example of
how the concept would have worked in practice in the UK between
June 1987 and January 2009. In the example she assumes two
investments of £100,000 in 1987.
The first is in a conventional insurance
company pension investment fund represented by the Association of
British Insurers’ cautious managed fund benchmark which permits an
equity exposure of up to 60 percent.
The second investment is in a unit-linked
guarantee policy which locks-in equity market gains every three
years. In both investments product, fund management and guarantee
charges are included.
The conventional fund performed well until
1999 reaching a maximum value of almost £180,000. Thereafter
declining equity market values took their toll leaving the fund
worth about £90,000 in January 2009.
The unit-linked guarantee product also fared
well as the conventional fund, reaching a peak value just short of
that achieved by the conventional fund in 1999. However, unlike the
conventional fund the guarantee would have protected the fund from
the equity market fall that followed, leaving the fund value in
January 2009 at its 1999 peak level.
It is no doubt coincidental that Altman’s
report comes at a time when enthusiasm for equity investment is on
the rise following a strong rally in global equity markets.
However, it is sobering that much of this
enthusiasm emanates from analysts who were conspicuously silent
when equity markets were at their most depressed in early-March
this year.
Pensions
DB scheme misery could
worsen
The serious position companies with
defined benefit (DB) schemes find themselves in is starkly
illustrated by consultancy Aon’s estimate that the combined DB
pensions accounting deficit of the top 200 UK companies jumped from
£8 billion ($13 billion) at the start of May 2009 to £40 billion by
month-end.
Responsible for the increase were falls in
corporate bond yields and increases in expected future inflation
which more than offset the benefit of the equity market’s gain in
May.
The situation could become far worse, believes
pensions consultancy Xafinity Corporate Solutions (XCS) which
predicts that the total DB fund deficit could reach £689 billion by
the end of 2009. XCS’s prediction is based on a model covering 93
percent of the UK’s Pension Protection Fund-eligible DB schemes and
some 12.4 million members.
“The potential outlook for defined benefit
pension scheme funding is exceptionally bleak. To put it into
context, a £689 billion deficit is the equivalent to nearly 40
percent of the UK’s GDP,” said Rob Hunt, a director and senior
actuary at XCS.
He explained that at present the difference
between yields on government bonds and corporate bonds is about 250
basis points, the highest since the Great Depression of the
1930s.
“Any significant downward movement in
corporate bond yields will greatly affect the funding and
accounting of DB pension schemes and as a result companies should
not be lulled into a false sense of security at this time with high
returns on corporate bonds keeping their liabilities down,” he
warned.
