Section1.2 – The Great Pension Robbery

Section 1.2 -The Great Pension Robbery

A great many people reaching pension age today have had a nasty surprise. They are finding out that the pension they get is nowhere near what they had been expecting. Those approaching it have a sinking feeling that it is not going to work out as expected.

For example, let me tell you about my own experience. In summary, I was given to expect that I would get a pension for of around £14,500 a year for life, and what the plan actually yields is about £2,400 a year. Almost everyone I talk to is getting similar shortfalls.

I still have the letter that the salesman (sorry, I mean the financial advisor) sent me when I took out my pension plan in 1984. What he said was that by paying £70 a month I could expect my retirement fund to be £161,727.00 by the time I retired. This was assuming a 12% growth rate, which he said was conservative. This fund would provide a £40,431.75 lump sum, and leave £121,295.25 to buy an annuity which would give me an income for life of £14,555.00 a year, assuming an annuity rate of 12%.

It’s worth pointing out the £14,555 would have been quite a substantial income in 1984 – equivalent to about £43,000 a year today according to the official inflation figures, which are hopelessly understated anyway. Even though wouldn’t be worth nearly as much today, I would still be delighted if I were getting £14,000 a year from the pension now.

But the reality of the situation is this: when I got to retirement age I found that the fund hadn’t grown by anything like the 12% he had suggested. Instead of the projected £160,000, it had £58,000 in it – giving me a lump sum of £14,500 and leaving £43,000 to buy the annuity. But the real kicker was that the annuity rate is nowhere near 12% now – it’s somewhere around 5.5% at best, and so the actual income that I get is only about £2,400 a year!

The financial people just shrug their shoulders and say “Well that was only an estimate! We didn’t guarantee that it would work out like that.”

Let’s have a look at how these pension schemes are supposed to work in theory… In fact it’s exactly the same process as any honest form of wealth generation: there is an accumulation phase and a payout phase.

• In the accumulation phase you pay a portion of your earnings into a fund that is invested in income-earning assets.
• All the income that those assets generate is re-invested back into the fund, so that it grows much faster than it would by your payments alone, by “the miracle of compound interest”.
• In the payout phase, the income that the fund generates is paid out to you, rather than being re-invested.

For pension schemes, it is normal practice for the fund to be invested in an annuity for the payout phase. This is like a life insurance policy in reverse; instead of taking your monthly premiums while you are alive and paying out a lump sum when you die, the provider takes a lump sum at the start and pays out a monthly distribution to you as long as you live. This generates a slightly larger income than if you had just invested the capital yourself in a “safe” investment (such as government bonds). However in that case, your capital would have remained intact at the time of your death for distribution to your heirs. In the case of the annuity, the balance goes to the insurance company when you die. If you live less than the average expected time, it’s a very good deal for them! And I’m sure they have worked out the sums so they don’t do too badly, however long you live.

All this is a re-run of the Endowment Mortgage Scandal, which came to a head in the 1980s. In the late seventies and early eighties, most people buying houses were persuaded to take out endowment life assurance policies that were intended to pay off the house purchase loan at the end of the agreement, and also produce a surplus bonus payment. In the late eighties it became apparent that the estimates of the investment performance had been ludicrously over-optimistic, and the payouts were going to be nowhere near large enough to pay off the loans.

It’s not only personal pension plans that are running into trouble. People who are relying on company schemes which promise 2/3 of the final salary for the rest of their lives might be in for a nasty shock too. The funds that the companies have been paying into are running into exactly the same sorts of problems that the personal ones are showing. They may be paying out as agreed at the moment, but further down the line the cupboard might turn out to be bare.

There are a lot of issues raised here which I’ll discuss in much more detail later, for example:

• Just look at the ridiculously precise figures he quoted me, given the speculative assumptions that the calculations they were based on. Isn’t it absurd that he quoted the final value of the fund to eight significant figures, when it turned out to be over 63% off at the end of the day? (I call this the delusion of spurious precision – this is a whole subject in itself, that I’ll deal with in a later section:  How to Avoid Number Bafflement, within the ‘Patterns and Numbers’ theme). That wasn’t his fault – he just punched the numbers into his computer and quoted the figures that it spat out (as no doubt he was trained to do by the company). And how successful would an advisor be who said “You might end up with about 160 grand, give or take 100 grand”? But he would at least have been honest!
• Was the 12% a year growth rate he suggested completely fanciful? Given that the UK stock market index went from 1040 in 1984 to over 6400 in 2013 (a compound growth of over 7% annually), and that most of the blue chip companies paid annual dividends of about 4%, I would have been able to get around 11% annual growth myself by simply investing directly in a cross-section of major industrials and re-investing the dividends. Where did the rest of it go? It went into the pockets of the practitioners of the financial system.
• The 12% annuity rate he quoted was at least representative in 1984, but how come it has gone down to 5.5% or less now, with such disastrous effect on the pensions of people now reaching retirement age?
• Why has inflation reached such epic proportions in the last few decades? And who wins? And who loses?

This is Section 1.2 of my forthcoming book The World in 2100: What might be Possible for Humanity? within the ‘Finance’ theme. When we return to this thread, the next topic will be The Nature and Meaning of Money. 

If you haven’t already done so, you can register to receive a free review copy just before it goes on general sale later this summer. Registering will also take you straight to Chapter 1 – The Foundations which will give you more idea of what the book will cover.