A thought triggered by this:
Encouraged by regulators and pushed by the actuarial profession, pension funds shifted wholesale into supposedly risk free assets. In growing numbers, companies would seek to distance themselves from their pension liabilities by selling them off to bulk annuity providers, further accelerating the shift into gilts.
Solvency II, which enshrined mark to market accounting in the pensions and life insurance industry, sealed the deal – mad though it is to insist that very long-term liabilities of the type found in pension funds should at all times be matched by the discounted value of assets.
Such practice more or less rules out high exposure to volatile equities, even though over time shares provide a much better rate of return and therefore hedge against inflation, than government bonds.
Let’s think about the P³’s pension scheme with Colin Hines in Finance for the Future.
All pensions are to be in bonds, which pay 1% – that’s the “high” rate he has suggested. Also, you can’t sell the bonds. Because a healthy part of the critique is that far too much is merely the trading of second hand pieces of paper. Much too much not really investing into real investments in the physical world. So, no secondary trading – that’s one of the things they’re trying to do away with.
Now let’s try plugging those two assumptions into a pension plan.
I don’t know what the general assumptions are. But let’s say that you want a pension income of 30% of working years income. Just to assume something. Mortgage is paid off, no kids, seems a reasonable enough guess.
So, you make 1% on your pension pot. Because that’s what the interest rate is on your bonds. We’ll also assume, just to make it easier, no inflation (Har, Har). How much do you need to save in order to gain 30% of working year income at 1%?
I get 3,000% of working year income. That is, out of a 40 year working life you’ve got to save 30 years of that money to give you a pension.
OK, we can talk about reinvestment of that 1% coupon stream but that’s going to be what, 15% on average of the pot? 30 years of 1% divided by two given that the pot starts small and grows larger? Then compound?
That 3,000% is driven partly by that insistence on no secondary sales. For a pension – in order to provide an income – eats the capital. Which you cannot do if you cannot sell the bond. Saying that it’s all to be done by annuities doesn;t solve this problem. Someone, somewhere, has to be able to sell the bonds in order to free up the capital so it can be eaten. We have to have that secondary market.
Or, pensions pots must be 3,000% of annual income.
The other driver is that of the 1%. Reasonably managed (I see my widowed mother’s portfolio occasionally) seem to gain some 5%. That’s capital and also dividend, of course (note that the first Finance for the Future paper showed bonds with capital and interest, stocks with capital only, no dividends). The difference between 5% and 1% over 20 years – the pension pot average addition period – is massive. At 1% then £1 becomes £1.22. At 5% it’s £2.65.
Approximately, and very roughly, that difference between 1 and 5% means a halving of the savings necessary. 1,500%, not 3,000% of income must be saved in order to provide the 30% of income pension. Being able to eat the capital reduces the requirement further.
These figures are very rough and I know we’ve more than one pensions actuary around here (that’s the excitement vibe this places gives off) and it would be very fun to see more realistic calculations.
Assume zero inflation, no secondary sales, 1% returns – what’s the size of the pensions pot, in years of annual income, required to produce the pension that it’s normally assumed folk would like to have?
Because I get crazed numbers like in order to gain a 50% pension then people have to save more than their entire lifetime income.
And surely even the P³ isn’t crazed enough to be suggesting that, is he? Or perhaps he and Hines have just never run through the numbers?
Murphy is working at the age of 64, continually hustling for grants, and appealing for donations on his blog. I wonder if he has taken his own advice and invested his pension in 1% bonds.
There’s so much wrong in the statement that it’s hard to know where to start.
Pensions didn’t move wholesale into risk-free assets, what LDI did was allow them to use risk free assets like government bonds and swaps to hedge liabilities and through the use of leverage still have money available to invest in risky assets like equities, property and credit.
As the liabilities have matured and cash outflows been more significant, the allocation to more volatile, less liquid assets has reduced.
Similar, Solvency II had little impact on the UK Annuity market as the framework was built on the existing UK regime which was already primarily a mark-to-market regime.
Finally, in a competitive marketplace (which it very much is) bulk purchase annuity providers would not be able to invest in government bonds and still provide attractive pricing, hence the majority of assets held are Investment grade liquid and illiquid corporate debt.
But apart from that, Murphy has it spot on 🙂
You have to remember that Murphy is going to be receiving a DB pension linked to his public sector work, so it is us taxpayers who will be paying for the vast majority of this.
Why would he care about whether the numbers make sense, if he is not the one paying the premiums?!
And if you can’t eat the capital, what happens when you die?
I don’t think it’s quite that bad.
Assuming: Pay of 100 units per year (so that results are in percentages)
No pay rises
40 years of work
No inflation
Investment Returns at 1% per annum (calculated monthly)
Annuity rate of 6.338% (most generous example from https://www.sharingpensions.co.uk/annuity_rates.htm – assumes retirement at 65, no spouse pension, no increases in retirement, no guarantee period)
I get that 10% contributions would provide a pension of 31.2% of salary. (Which kinda makes sense – they’re contributing 10% per year, which adds up to 400% by the end of the period anyhow – with returns that’s 492 units by the end. Even without buying an annuity and stretching it over 30 years, you’d get 16% of salary per year)
Now, if we took the same scenario, but with returns at 1% and annual pay rises at 3%, and we look at a pension with 3% escalation and a spouse pension attached, we get a 10% contribution providing 10% of final salary.
The bit that makes the real difference is buying the annuity. If you can’t sell the bonds, how do you turn them into income at all? If we assume that you just have to stretch the value over 20/30 years, it’s a rather different picture.
Ritchie? Numbers?
There’s your problem, right there…
@Bill Chao, he’s only been an academic since 2015, and some of that has been part time, so he won’t be getting a big final salary pension.
@Rational Anarchist, your last paragraph has the realistic numbers – and who can live on 10% of their final salary?
Other investment options are available to save for retirement. When pensions offer a poorer ROI then people will just use those instead. Many already do due to pensions lock-in risk.
Therefore, the 1% comparison is not reasonable, as financial advisors are always going to recommend the long-term highest rate of return for a given risk appetite, and that isn’t going to be 1% fixed rate bonds!
@Mike Finn
“Other investment options are available to save for retirement”
There’s your mistake. In Spud land, there will be no alternatives to 1% Green Bonds. Anything else is wasteful speculation with no benefit to society
To be fair, I have a pension solely because the company I work for matches my contribution and I get pension tax relief, so my money has nearly tripled before I even look at investment returns. If the returns were less than inflation it would still make sense for part of your career (towards the end) but a lot less at the start.
“And surely even the P³ isn’t crazed enough to be suggesting that, is he? Or perhaps he and Hines have just never run through the numbers?” Both, I suspect.
“he’s only been an academic since 2015, and some of that has been part time, so he won’t be getting a big final salary pension.”
Heh, heh: if his pension scheme is USS then it may not see him out anyway. Badly run for years, was USS. But if he didn’t work for proper universities he’s probably in some different scheme.
I was going to query that 3%/yr salary assumption there, then did the numbers. 30th root(now/then). Oh! 1.033… So, what I’m on now could be considered the “same” (for certain definition, etc.) as what I was on 30 years ago.
There is absolutely no way he or Hines have run numbers for any of this. The only ‘numbers’ he has ever run would be those in his demented scribblings. We’re talking about someone that paid someone else to take his accountancy exams (or alternatively has the memory of a goldfish). His ignorance of general accountancy principles is truly astounding for someone allegedly employed by a big four firm.
BIll Chao is on the money. It’s shocking how the uninformed can get a media hearing when one is aware of how uneducated they are. Mind you I get that from listening to most people opining on ‘tax cuts for the rich’ when they are one of the little people who believe the tiny amount of tax they pay makes any difference at all.
Taxation, the environment and most things to do with finance are where people are shockingly badly informed. The next is anything foreign and anything historic. The most informed areas are those affecting ordinary lives, like work, sex based rights and employment rights. In those areas one does not have to be an expert to see the issues.
You can just look at the annuity rates. For a man aged 60, inflation ‘protected’ (protection usually capped at 3% or maybe 5% if you’re lucky), half to surviving spouse (all of which would have been fairly typical for a DB scheme, albeit maybe starting from 65); each £1 of pension costs ~£40. So a pension pot OF £1 million buys a pension of ~£25k. You can certainly live on it (the state pension being in addition), but it isn’t going to be paying for several cruises a year, if that’s what you’re hoping for in retirement.
“jgh
October 5, 2022 at 8:19 am
And if you can’t eat the capital, what happens when you die?”
The government takes it, of course. Why do you think the NHS is so important;)
At 1% interest, the accumulated sum after 40 years is 48.88 times the annual payment. What that gives you in the way of pension obviously depends on life expectancy – let’s say 20 years at age 66 so divide by 18.04 giving 2.71 (assuming the annuity provider has no expenses and seeks no profit) – reasonably optimistic figure would be 2.5.
Someone wanting to top up the State Pension could devote 10% of his/her income for 40 years to increment it by 25% of his/her salary BUT the Gordon Brown trap the Guarantee credit imposes a tax of 100% on small private pensions (reducing to 70% for a tranche before returning to 100% and then normal income tax rates for larger pensions). So mostly they are stuck with a zero return from Murphy’s bonds.
Once you say that the bonds not only are unsaleable *but also have no maturity date* you can move to your mad scenario with an annual contribution of 1 every year for 40 years gives you a pension of, roughly, 0.5 for twenty years.
That isn’t quite stealing the poor guy’s income but in morality terms it comes close.
“Or perhaps he and Hines have just never run through the numbers?”
Given the amount of verbiage they spew I’m pretty sure they have not. When would they have the time?