HOW much money do you need to retire? Depending on your age, it is a question you think about a lot (if retirement is imminent) or barely at all. For younger people, the subject is a combination of too far away, too complex and too boring, and too depressing. When you consider that you might live for 20, 25 or even 30 years after you stop working, it is a pretty important issue.
Say you want to retire on £20,000 a year (not a fortune) and you are 65. The best annuity rate at the moment in the UK is just under 5.2% which means you would need a pot of £385,000 to afford this. But hold on a minute. That is a flat £20,000 which does not account for inflation; if prices rise at 3% a year, the value of that pension will halve by your 90th birthday. To get an income of £20,000 that is guaranteed to rise in line with prices, you would need a pot of £619,000. (For American readers, the dollar amounts won’t be exactly the same, but they will be in the ballpark).
These are very big sums and explain why private sector employers have been dropping final-salary pension plans and why public-sector employers in America face a huge-and-growing bill. The issue turns (all too easily) into a debate about accounting. Low bond yields mean that the cost of buying a guaranteed income has risen sharply. The annuity rates quoted above simply reflect that reality.
But people don’t like reality. In America, hardly anyone buys conventional annuities and in Britain, there were so many complaints about low rates that the government abolished the need to buy them (a reform cunningly described as pension freedom). So far, many seem to have used this freedom to put the money in cash, an option that will give them little yield and no protection against inflation. In America, people tend to stick in some sort of balanced fund and draw down an income; this leaves them vulnerable to the kind of market downturn that we saw in 2008.
One problem is hard to avoid; the annuity rate is risk-free (at least when it is inflation-linked). If you think you can do better, than you have to take risk. And to do a lot better, you have to take a lot of risk.
Many unhappy returns
This issue is just as true when building up a pension pot, as it is when taking an income. The seemingly arcane debate about the discount rate on pension liabilities hinges around this point. When an employer agrees to fund a pension for a worker, the vast bulk of the liability lies in the future—the need to pay an annual income after retirement. To work out the true cost, you have to discount that future liability by some rate to work out how much you (and the employee) have to contribute now.
The tradition has been to discount the liabilities by the expected return on the investment portfolio. One can see that this makes a certain kind of sense. Pensions will be paid by a combination of employer/employee contributions and investment returns. So to work out the right level of contributions, subtract the returns. But there are lots of problems with this approach. First, it is hard to think of another liability that is treated this way. Suppose a company owed $100m to the tax authorities. It could take $60m of that money, and invest it in the stockmarket in the hope this would repay the debt. But it would not be allowed to record the debt as $60m in its accounts. Second, what happens if the company doesn’t earn the assumed return? The answer is that it will still have to pay the pensions anyway. (The company could go bust, of course, but this shouldn’t apply to a government fund; indeed the courts have tended to treat the pensioners as having more rights than other creditors.) Third, the terrible temptation is to assume as high a return as possible; that will keep contributions low. Many people (not just this blogger) doubt whether US pension funds can earn the 7.5-8% they assume, especially when Treasury bond yields are only 2-2.5%.
Financial economists would say that the pension liability is a debt and should be discounted using a bond-like yield. That has been enforced for companies via the accounting standards FRS 17 and IAS 19—they have to use the AA corporate bond yield. This is lower than the old assumed rate of return. It makes the liabilities look bigger and requires companies to contribute more, which explains why so many businesses have stopped offering final-salary pensions. Note that it does NOT mean they necessarily have to invest all their portfolio in bonds. One can believe that equities, property, hedge funds and the like will earn a higher return than bond yields; if they do, there won’t be a problem in the long run.
But returns haven’t been good enough and that is why there is a big pension hole in the US; a hole that would look even bigger if the schemes used the same form of accounting as companies have to. And that creates a further problem; the current accounting approach assumes it is cheaper to fund a public pension than to fund a private one. And that makes no sense.
A wider problem
But all this brings us back to the original problem. It costs a lot to fund a pension. On my trip to America to report on public pension shortfalls, some people argued that I was looking at the wrong issue: many people who work in the private sector lack any kind of retirement security. A 2015 study by the National Institute on Retirement Security found that nearly 40m American households did not own any retirement account assets, and the median account (across all working households) was just $2,500. Nearly two-thirds of working households aged between 55 and 64 had retirement assets equivalent to less than their annual income; clearly that cannot generate a pension that will cover more than a fraction of their needs. Social Security will cover some of their income, of course. But the average benefit is around $16,000 a year; many people would struggle to get by on that (the median wage is around $44,000).
If you are in a defined contribution plan (in the US, a 401(k) or equivalent), the chances are that your employer is contributing a lot less than they would into a final-salary plan. After all, saving money is why they switched. That means you, as an employee, will need to save a lot more. Let us assume you get the average social security benefit of $16,000, you earned the average wage of $44,000 and you want to retire on 80% of your income. So you need an extra $19,000 from your 401(k). If you plan to draw down 4% of your pension pot a year, that means you need 25 times $19,000 or $475,000. To repeat the headline; can you afford to retire?