A looming shift

When I tell the story of what may happen to those of us who are past our prime, the room often falls silent. It’s not a cheerful tale, and for many, it won’t have a happy ending. But it’s time we start talking about it.

Until now, new pensioners across Anglo-Saxon countries and much of Europe generally retired on defined benefits. But within five years, that will change. The majority of people retiring from private sector employment will go on to receive pay-outs based on their defined contributions, rather than their final or average career salaries.

We all hope to enjoy our golden years in good health and relative wealth; it’s no different for this next generation of pensioners. After all, they have contributed diligently, just like their colleagues who retired before them or their parents who showed the path to new-found freedoms in old age.

But theirs will be a rude awakening. While their older peers or public sector friends will still be drawing those generous defined benefit pensions that were the norm for decades, new retirees may find themselves struggling to make ends meet.

We have known that this would happen at some point, but for as long as most new pensioners went onto their defined benefits in retirement, the consequences of that looming shift remained somewhat abstract. It won’t be long until they become very real.

Who knew?

It’s a common problem, affecting Australia, Japan, China, the Netherlands, other parts of Europe, the United States, and Canada. They have all been transitioning from corporate pensions that left companies responsible for paying defined pension benefits, to models that place the responsibility for the size of someone’s savings squarely with the individual, and are subject to the vagaries of markets.

The transition hasn’t happened below the radar; there has been plenty of publicity and media coverage in all cases. But that hasn’t been nearly enough. Such an historical shift should have come with a major educational programme to help individual savers plan for their new financial future. This education has been lacking, leaving many woefully unprepared.

Try to speak to a teenager or young adult about pension planning and their eyes will soon glaze over. It isn’t a topic that younger workers spend much time or attention on; to many, retirement is too far into the future to worry about or too financially complicated to grasp fully. Once in established work, many tick the right boxes but don’t investigate what their options are, or don’t know how to do so. Nor is it obvious how much you will need in retirement to fund an acceptable lifestyle for the remainder of your days.

In these matters, we look to our elders for guidance. The problem is that they’re still enjoying those defined benefits that no longer serve as a guide to the new generation of pension savers. The over-50s are especially caught out; even if they wanted to engage with the problem, they don’t have enough time left to do so.

Plunging pensions

Thirty years ago, it didn’t matter so much which scheme you were in: returns on risk-free assets were high and schemes were generally well funded, resulting in comparable pension experiences. Since then, life expectancy has increased, which means that your retirement money needs to last longer, and returns have shrivelled, meaning your defined contributions will earn you less over time.

Lower returns are an issue for pension funds who manage defined benefit schemes. Their obligations haven’t changed, but asset growth is depressed, which over time results in underfunding. This, of course, is why defined benefit schemes in the private sector are no longer open to new members. But existing members will still receive their guaranteed pensions.

Savers on defined contribution schemes, however, will have to shoulder the entire burden themselves.

Running the numbers shows how much pain this will cause. Take, for instance, two mid-level managers who started on a salary of £12,000 in 1976 and worked their way up to £55,000 by 2016. During this time, they paid 6.8 per cent into their pension pots - one a defined contribution, and the other a defined benefit scheme.

Using an annuity rate from 1990, the manager on the defined contribution scheme would have had a pension of just under £35,000 per year. Their peer with the defined benefit pension would be receiving £39,000 per year.

But here’s the catch. If you use the actual annuity rate from 2016, the first manager is left out in the cold. The retired manager on the defined benefit scheme would still be receiving £39,000 annually, but their alter-ego on the defined contributions scheme would roll off onto an annuity of a mere £6,200.

That’s just 11 per cent of their final salary. It is also well below the poverty line, defined as less than 60 per cent of a country’s median household income. In 2016, that poverty line was at £15,000 in the UK, two-and-a-half times the pensioner’s income - and still regarded as barely sufficient to make ends meet.

Most pensioners will also be able to draw an additional state pension, which will boost their income a little. But state pensions are low and will only fall as governments’ own pension liabilities rise, populations age, and healthcare demands on public finances grow.

Greater pension freedoms in many countries give us other options beyond an annuity in retirement. But when the gap is this large, because of those low expected returns and longer life spans, alternative solutions will not nearly stretch far enough either.

This means many may not be able to retire, forced to keep working well into their 70s to maintain even modest lifestyles. It’s true that older workers are starting to explore flexi-working and gig economy opportunities. But when your retirement income leaves you in abject poverty, it turns choice into survival.

Source: Fidelity and Hargreaves Landsown single life 65 year old RPI linked annuity, five year guaranteed. As of 9th August 2016. Assuming CPI y/y is 3 per cent, Pension fund growth is 6 per cent.

Envy and bitterness do not make good bedfellows

Such low retirement incomes certainly leave no financial room for luxuries, travel or entertainment, and barely enough to cover living costs. Later on, care will become unaffordable, shifting the burden to family members and local authorities.

It is quite the shift in spending power. New retirees will barely be able to make ends meet; neighbours who retired on defined benefits just a few years earlier might be ticking exotic adventures off their bucket lists.

What’s more, public sector workers in many countries remain in defined benefit schemes, often with early retirement options. So, while private sector workers will have to wait until they’re 65 or older, public sector employees could be retiring much younger, sometimes even from 55, on considerably more generous schemes, despite not having paid more.

One could argue that public sector workers have foregone more lucrative private sector remuneration during their careers, deliberately making this pay-off. But patience may wear thin when the gap is so large that private sector workers can’t afford to retire, yet still have to pay the taxes that allow public sector workers to retire early, and on enviable incomes.

The widening income gap is already an issue in many countries. Vast differences in income at retirement, and the perceived inequality in outcome for similar contribution levels, will only add to social inequality. It’s quite possible this will lead to considerable social unrest.

No time to lose

We can’t afford to wait for that pressure to come to bear. Individuals need to save more, and do so now, putting time to work. Delaying that decision by 10 or 15 years may mean there won’t be enough time left to deal with the problem.

It’s not an issue that we can leave to politicians to tackle. Retirement horizons are much longer than democratic cycles - in other words, much longer than a typical politician’s timeframe. And once the problem manifests itself, it’s too late to deal with it. What’s more, most politicians are themselves in defined benefit schemes, with little incentive to change the system.

So it’s down to companies to find solutions. There’s a big role for the asset management community to help them with education, training and ultimately product provision. And we need to start early, teaching kids in schools how to plan and save for the long-term.

It’s hard to overstate the importance of this. In our ageing societies, our economies will need to become more flexible as people need a different way of working towards the end of their traditional working life. If we don't have that flexibility, productivity will suffer because we have too many older workers and not enough younger ones. That will lower the potential growth rate so the real growth rate of assets will fall, depressing investment returns for everyone, and the ability to pay pensions will shrink further.

Technological innovation could help boost productivity, but there are offsetting effects. When younger people lose their jobs, and aren’t put into high-productivity work when retrained, technological progress may not raise productivity after all.

A new reality for companies, too

Traditional pension saving plans may start to look rather less attractive once the new retirement reality emerges. Companies may find themselves under pressure to raise their sponsored contributions, or top up existing schemes.

Older people are less trouble for companies, so companies may well prefer them. In Japan, for instance, 3 million new jobs have been created since 2009 overall, but there were 3.2 million new jobs among those over 65. Younger people suffered significant job losses. In the US, there are twice as many over-65s in the workforce as teenagers.

That means there’s an obligation on companies, in addition to their educational duty, to ensure sufficient flexibility to enable their older employees to operate in a new way. They can’t escape these considerations, because older people statistically have more sick days and their current death-in-service benefits could easily bankrupt some companies. It’s a little morbid, but a lot more people die between 65 and 75 than die up to the age of 65.

Source: Fidelity International, Statistics Bureau of Japan, July 2018.

Asset managers must innovate

Individually, many of us will be stuck between a rock and a hard place. We can either retire later, save more throughout our working lives, accept a lower standard of living in retirement - or raise the growth rate on our savings.

It’s obvious that raising returns in these circumstances is essential. It naturally leads to more risk taking in pension schemes’ investment strategies; a trend we are certainly observing in the retirement industry. But as asset managers, we also have to create alternative products that are suitable post-retirement.

Historically, typical retirement products offered flat payments, sometimes with added inflation protection. But that’s not what most of us need, because the required income profile through retirement is not a straight line at all. This is where new ‘decumulation’ strategies can help.

New retirees tend to have higher spending, for example on foreign holidays. When they move into the middle stage of retirement the focus often turns to cheaper pastimes like crossword puzzles or jigsaws. I’m generalising of course, but increasing fragility usually puts a stop to much of that earlier discretionary spending in the later years. At the very end of life, around-the-clock care often becomes necessary, requiring significant funds.

Time to act

When we are faced with seemingly insurmountable difficulties, new solutions often emerge that weren’t captured by long-term forecasts. Maybe lifelong careers will become a thing of the past, mature apprentice schemes and industry switch training common, mid-life sabbaticals popular, and retirement unrecognisable.

Longer term, these shifts will be exciting, with ample new opportunities for us all to benefit from. In the meantime, however, we need to deal with those underfunded pensioners. Urgently.