When I go to schools to talk to children about money I tell them to think of the sums they put into their bank accounts as shape-shifting time machines. Shape-shifting because the first miracle of money is the way in which the global system of trust in the current fiat system means that it can be used to “middleman” anything into anything.
So I can use money to transform writing columns into housing (I earn it from one and use it to pay for the other), talking on stages into school fees, used kids’ clothes into dim sum on Sundays, and time given up to sit on company boards into a couple of years in a nursing home.
Time machines because the second miracle of money is that it can do this transforming over years, decades or tens of decades. I don’t need to use the money I earn today for a nursing home today. But I may well need to do so in 40 years. Money means that I can defer consumption for as long as I want to – which is, of course, the entire point of saving and investing.
So here’s something that worries me: pension freedoms might mean too many people ruin their retirement by deferring their consumption for too long.
At a meeting of fund managers and wealth managers a few weeks ago, I said that I thought the priority of wealth managers looking after pension savings – the ones who really care about their clients, anyway – should be to make sure that most of their clients die close to broke. It didn’t go down that well. There were sharp intakes of breath all around.
I said the same thing at the FT Weekend Live festival last week (thank you all of those who came – I enjoyed meeting so many of you). More sharp intakes of breath. That’s because most managers – and their clients – see capital and income as two entirely different things. Capital is not for spending – even in retirement. Income (in the form of dividends, and so on) is the thing for spending.
So, as far as the industry sees it, a good manager’s responsibility is primarily to make sure that his clients die with roughly the same amount of capital in their accounts as they had when they first signed up.
This is silly. Capital represents the ability to defer consumption for a while, not the obligation to defer it forever. For those living off pension savings there should be no differentiation between capital and income (there isn’t for tax purposes, in any case). It is all just money to be used for living. Why live on cans of tuna, watching daytime telly in front of a one-bar electric fire only to die with half a million quid of capital in the bank?
This is particularly the case today: wealth managers endlessly bemoan the lack of income available from bonds and equities. But it should make no difference to them where the return on a portfolio comes from. We’ve all made an implicit deal with the devil (in the form of our central banks) since the financial crisis: we don’t riot in the streets about the distorting effects of ultra-low interest rates for the simple reason that those same rates have pushed the value of our assets sky high. And we like that.
What’s a couple of percentage points of yield here or there when the FTSE 250 is up 80% in five years? Total return is what matters: the more of that you can get, the more your pensioner clients will get to spend every day until they’re broke. Yield is entirely beside the point.
The problem here is obvious: dying broke is easy; stretching your money out so it is used evenly over your retirement and then dying broke is really hard. Who can get that timing right? This problem used to be solved by annuities – which before pension freedom pretty much everyone had to buy. These made no distinction between capital and income: the whole lot was handed to an insurance company in exchange for an income for life. If that was all you had, you automatically died broke.
The same goes for defined-benefit pensions. There is no capital or income here, just money paid every month until you die. With defined contribution pensions and pension freedom (where we can take as much or as little as we like from our funds) everything is rather harder. What do you do?
There used to be a rule of thumb (based on returns from US markets) that suggested that if you spend 4% of the value of your capital a year you are unlikely to outlive your savings. Is that right or wrong today? That’s a question we really need to challenge the financial industry to help us answer.
I’ve said this here before but it bears repeating: the financial services industry has not yet got to grips with helping people figure out how to de-cumulate. It is time it did – think annuity-style products, funds that distribute percentages of total returns, or a new kind of return-smoothing product, perhaps.
I’ll leave that with them – and even chuck in a little incentive: the first company to come up with a product that helps retirement savers run down their capital effectively and that comes with the strapline Let US help YOU to die broke will get an honourable mention in this column.
In the meantime, if you have an annuity or a defined-benefit pension, do think long and hard before you try to cash it in for a lump sum. If you don’t have the problem I’ve described here, why create it?
There’s a reason why Hargreaves Lansdown has just announced that it is not going to enter the secondary annuity market when the government starts allowing people to sell their annuities next year. That’s because swapping a long-term guaranteed annual payout for the uncertainties of a lump sum is likely to be a “poor decision” for most people. Quite.
- This article was first published in the Financial Times