Risk in retirement: it pays to protect
The diet always starts tomorrow; we will go to the gym next week; and stop drinking after New Year. But when it comes to planning for retirement, most of us prevaricate for even longer.
As a result, many advanced economies face huge funding and savings gaps that threaten to turn into a real pensions crisis with every year that passes.
For countries relying primarily on ‘pay-as-you-go’ state systems, where current contributions fund current pensions, this is likely to express itself in a rising tax burden on present and future employees, particularly when exacerbated by changing demographics. Japan and much of continental Europe are in this boat and will at some point need to restructure the inter-generational bargain between (younger) workers and (older) pensioners.
The fact is, however, that countries that rely on private pension systems to provide the main source of retirement income, such as the US, UK and Australia, are not always in a better position. And given that “Pillar 1” state pension in those nations is often minimal, the plight of their future pensioners may even be worse.
Caught in the headlights
The UK, a nation where the savings gap was USD 8 trillion in 2015 and is expected to rise to USD 33 trillion by 2050 (1), is a telling example of this. “Phasing out defined benefit pensions, the unintended consequences of pensions freedom legislation, and resistance to change in the savings industry threatens to increase pensions poverty to significant levels,” says Onno Vleeshouwer, Global Co-Head of Insurance at Societe Generale in London, whose team has produced an in-depth study of the looming crisis.
There is no question that the generous final salary pension schemes originally offered by most private companies in the UK were proving unaffordable. However, the switch to defined contribution plans has led to a wholesale shift of the big risks that surround retirement from employer to employee. Longevity risk, investment risk, inflation risk and market timing are all risks most individuals are not equipped to manage.
On top of that, the pensions freedom legislation in 2015 suddenly confronted individuals with even more choices. “Most people have reacted like a rabbit caught in the headlights”, says Mr Vleeshouwer, and were too often not engaged, made no decision or ended up taking too much or too little risk.
The US, where the move away from defined benefit plans began in the 1970s, faces a similar dilemma. State pensions will likely provide minimal income for most retirees, and it is not clear that reforms to the DC-based ‘401k plans’ which make them both portable and tradeable have prompted individuals to save enough or invest in the appropriate risks. More choice doesn't necessarily lead to better outcomes, argues Alan Skandan, Head of Investor Solutions, Pensions Endowments & Foundations at Societe Generale New York, recognising many individuals are ill-equipped to make such important investment decisions. Equally, the idea of requiring a level of minimum contribution would be political anathema.
It pays to pay for protection
Better engaging and protecting savers is essential to avoiding pension poverty. Research shows that two main factors determine the outcome of someone’s pension. First, contributions: how much they put in and how soon they start; almost universally, people save too little too late. Second, financial market or “sequencing risk”. For example, in financially vulnerable moments for the saver, such as in the years before retirement, the current model of shifting defined contribution plans from equities to ‘safer’ bonds still exposes savers to significant financial market risk. The rising interest rates of the past year, for instance, will have severely diminished these pension pots – losses they will never be able to make up unless they continue to be risk-on into retirement, far from an ideal scenario.
There is a crying need, therefore, to protect late-stage pension pots against capital loss. Such insurance products do in fact exist in other sectors and, in principle, much of the savings industry acknowledges their benefit. In practice, however, each industry stakeholder sees their introduction as someone else’s responsibility. And the sector remains stuck on achieving the lowest possible fees rather than value-for-money, says Mr Vleeshouwer, so products, which require a premium to protect, remain sidelined across the pensions industry.
An urgent need for change
The issue of pension pot exhaustion is everyone’s concern. However, any lasting change will have to start from the top, beginning with duty of care for the consumer by company boards and management across the pensions value chain.
Equally, value-for-money, rather than a fee cap, to allow protection to be incorporated into savings products must be prioritized. Currently, there is still little sign of advocacy to overcome the bind that the industry is stuck in, that low fees deliver better outcomes for savers.
Meanwhile, if we are going embrace a value-for-money approach, product providers have work of their own to do to explain in simple terms how these policies guarantee some part of individuals’ pension pots. Given the size of the savings gap, it is urgent that we make a start.
(1) Samans, R. (2017) We’ll live to 100. World Economic Forum.