The Bank of England’s chief economist, Andy Haldane, told us this week that, despite being “moderately financially literate” he is not able to make “the remotest sense of pensions”.
I have two things to say on this. First, he is being far too modest in describing himself as “moderately” financially literate (or he puts up a damn good show in conversation). And second, I haven’t the remotest sense of what he is talking about.
Everyone thinks pensions are complicated – and the pensions industry has an enormous interest in getting us to continue to think so (the more hysterical we are about pensions, the more they can charge to “help” us with them). But they aren’t. Today’s pension system is remarkably simple.
There are two types of pension. The first, which Haldane has at the Bank of England, is almost absurdly simple. You work and earn a salary. You also and earn the right to a pension – linked to inflation every year until you die – based on your final salary. If you are the pensioner (rather than the pension trustee), there’s nothing to understand here: you just get the money.
The second is an itsy bit trickier. You work. You earn money. You put some of that money – up to a perfectly adequate maximum of £40,000 a year – into a pension before any income tax is taken off it (your company may even do that bit for you under the new auto-enrolment rules). Then, when you hit 55 you get to have the accumulated cash. You can take 25% tax free and the rest as and when you like, as long as you pay income tax on it. This is known as a “defined contribution” pension. If there is any pension left when you die, your kids get it free of inheritance tax.
And that, in a nutshell, is how today’s pension system works. It is simple, straightforward and, as pensions minister Ros Altmann told me a few weeks ago, really rather “brilliant”.
I accept that there are complications in the system given the amount of change there has been in the past decade. I also acknowledge that there are far too many acronyms used in the business (the alphabet soup includes TEE, EET, LTA, DB, DC, SSAS, Sipp, etc) and that this can lead to confusion. And yes, there are a few complications yet to be removed such as the tapered annual allowance for those with annual income greater than £150,000 and the lifetime allowance for those whose pension pots are bumping up against £1m.
However, given that these two rules are very obviously stupid and that the pensions minister seems to realise this, I suspect that they will both be long gone before most people have to worry about them.
So there you have it. The new improved pension system – for the vast majority of people – just isn’t complicated at all. That isn’t to say that there aren’t problems here. There are (although they aren’t a complication of the system itself, and they aren’t problems that anyone enrolled in the Bank of England pension scheme will have).
Those of us with the second kind of pension described above have to make some very big decisions. We have to decide how to invest our money or how to allow our money to be invested over our working lives. Regular readers will know that most of my columns address this in one way or another (top tip: invest it cheaply) and it is an issue I will (obviously) keep coming back to.
And then we have to figure out how to make that money last for our entire third age. This is less discussed – but it is where things get really difficult. The key question is this: if you have just retired and reckon you have 30 years of life left to finance, how much of your retirement fund can you safely draw down each year if you want to be sure you don’t end up miserable for a few years before you die destitute?
There used to be a rule of thumb for this – 4%. So if you had £100,000 in the fund, everyone agreed it was all right to take out £4,000 in the first year and the same amount adjusted for inflation every year for the next 30 years. Capital growth would make up the difference between the original sum and the total withdrawals (£120,000).
Unfortunately, they don’t agree that any more. That’s partly because the 4% rule came from US research and it isn’t a given that markets in the UK behave in the same way (historical returns have been a little lower). It’s partly because the original analysis didn’t include any costs. And it’s partly because with life expectancy increasing some of us might still be going strong after 35 years of retirement. Plus, today’s markets are likely to offer returns that are very different to any kind of historical average – in a bad way.
The loose monetary policy of the last decade has so distorted market returns that it is hard to find a chart that isn’t hinting at a bubble. The great boom in government bonds that we have seen over the past 30 years cannot conceivably last another 30 and, as Andrew Lapthorne of Société Générale points out, markets across the world look pretty iffy in valuation terms: global earnings are 14% off their 2014 peak, but equity prices are 25% higher. To quote Mr Lapthorne: “Gravity beckons.”
Morningstar has just had a look at all this with a view to figuring out what the new safe withdrawal rate for UK pensioners should be. Its conclusion? “The generous capital returns of the prior century” that once “bolstered a comfortable and long-lasting retirement portfolio” just aren’t as likely this century. Assuming a portfolio that is 50% in bonds and 50% in equities, the conclusion is that you don’t want to risk taking out much more than 2.5% to 3% per year.
• This article was first published in the Financial Times