Blog: Sweaty nights and lottery wins

This may be too much information… but I woke up in a hot and sticky sweat the other night. Not pleasant.

This happens to me occasionally, I’m sure it must happen to all of us (at least I’m hoping it’s not just me). What causes it varies, but on this occasion it was panic about my own pension planning.

I’m in the second half of my 40s and I’ve worked more than half of a traditional career length. My father’s generation, at my age, were starting to look forward and think “maybe another 5 years and I could retire”. I’d like to but I’m not.

The problem, for me, is that I was not part of that golden generation with a final salary pension scheme. I am reliant (mostly) on DC and I know (a) how much it costs to retire and (b) how much risk there is in the process. I was woken by a panic that I am not doing enough and that I will have to keep working (if I can find work) until I am much older than the 65 that is commonly assumed.

I panicked because I know about the sheer size of the problem I face.

Here are a few snippets I’ve picked up, some old, some new:

·         MetLife did some research which was reported in May 2012. The thrust of the results were:

·         Those born between 1961 and 1981 (I was) on average face a £300,000 shortfall in the capital needed for retirement

·         They (we) have large mortgages to pay off and often our children’s education to fully or partly fund (private schools maybe but almost certainly university)

According to the NAPF (May 2011), 3 million of today’s workforce, that’s a whopping 8%, are relying on winning the lottery to pay for their retirement. A similar number (9%) are hoping to inherit a windfall for the same purpose. One third of the workforce is planning to rely on the state. Clearly, none of these strategies are particularly robust.

In their 8th Annual Report on the state of retirement savings across the nation (May 2012) Scottish Widows revealed that the average pension saving rate (excluding DB members) is 8.9% of total income (down from 9.3% in 2011) and that only 46% of the population is saving enough towards retirement (described as a ‘sharp fall’).

Hargreaves Lansdown have calculated that the average earner needs a fund of around £400,000 to provide enough pension (additional to state pensions) to provide an adequate retirement income.

Finally, as context, an Office of National Statistics report (October 2011) reveals that the UK savings ratio is 7.6% of net income (according to Lloyd’s, this contrasts with Germany at 10% and China at 47%!). The average UK household has just £5,009 of savings and investments available for a rainy day. This is important as low reserves are not conducive with locked away long term pension saving. 

So a few conclusions:

·         I’m not alone. Others should also be worried. Very worried.

·         Flawed as it may be we need to cheer from the roof tops about auto-enrolment. I accept that it’s not the end of the problem, but it is the beginning of the end of the problem.

·         Those of us in the know need to shout, loudly and irritatingly about the importance and urgency of saving for pensions. We need to shout frequently and repeatedly. We all need to become evangelists for the cause.

The other night wasn’t pleasant and I don’t wish sleepless sweaty nights on anyone but I really do think it’s time we raised the public’s anxiety level about pension saving.

11 May: Independent thinking

My clients describe me as a pragmatic trustee. My arguments here all stem from that.

One of the tests in an actuarial review is to compare assets against liabilities. This establishes the funding level and the need for deficit repair contributions (let’s forget about surpluses for now). A deficit is simply the difference between the asset and liability values.

The asset value is an independently audited “factual” number (or semi factual but let’s ignore that for now). 

The liability value is the Technical Provisions (TP). These are calculated using assumptions including those relating to future investment returns and how long we will live.

dictionary.com defines “assumption” as: “something taken for granted; a supposition, a guess’. In short, not a fact.

The assumptions we use usually have an historical or market root. They aren’t plucked out of thin air. That, however, doesn’t change the fact that they aren’t facts.

“Rise up against this pointless, costly exercise”

It follows, therefore, that TPs aren’t factual either albeit also with an historical or market root.  This must then also apply to the deficit: the difference between factual assets and non-factual liabilities.

Despite this we are supposed to (and often do) expend huge amounts of energy debating the assumptions for the TP. If you follow my argument above, you can only conclude that this debate is unnecessary.

Another statutory funding test is the buy out (BO) or solvency position. A solvent employer cannot walk from a scheme (without regulatory consent) without funding to this level.

The BO position is market derived: the money needed to buy these benefits from an insurer. It floats with the market but is factual. It is also a much higher funding standard than TP. It is the risk free position for both beneficiaries and employer.

BO is, therefore, a big but statutory target.

There are a number of factors that determine how quickly we achieve our funding targets. The most important is “reasonable affordability”: what is the employer willing and able to pay? Most cannot afford to buy out immediately, thus there has to be a negotiated settlement. Critically, reasonable affordability is not affected by the size of TP. It is a statement of semi-fact based on the employer’s financial strength.

So, we have a far off statutory funding target and we are constrained by reasonable affordability. What, therefore, do TPs add? Nothing other than to mislead and distract.

Two examples where the TP debate has shown its insidious nature:

1. Employer A had its own actuary. The actuary didn’t dispute the significant BO deficit but put forward arguments against the TP assumptions. His net result was no TP deficit and so no need to agree to pay any contributions, despite the scheme being clearly in deficit. It took a lot of time to help the employer see the risks inherent in this illusion: not least that they would carry a significant financial risk for a long time unless they aimed for buy out over the medium term.  That time, that process, cost money that could have been used in the employer’s business or in the scheme.

2. With employer B the financial settlement was reached early on, but late in the process they put forward an argument to adjust one assumption by a small amount, reducing the apparent deficit. This didn’t change the financial settlement. The change required work by the schemes actuary, renegotiation with the trustees, calls for more evidence and redrafting of documents. I’d estimate that the time and process costs of this was £5-10,000.  But, it didn’t change the financial settlement!

So rise up against this pointless, costly exercise. Save money, save time, save goodwill.

You have to have TP, but make them consistent with the straight line aimed at BO over what ever period is achievable and logical. Make sure it passes regulatory scrutiny. Otherwise put TP to one side and get on with what really matters.

 

2 April: The ghosts of good men

In 1947 Harry Benjamin (name made up) started Benjamin Gears (also made up) in Ripley (a real place). During the war Harry had had a reserved occupation on the production line for Spitfires. He used that engineering experience to get BG going.

Unbeknown to Harry, Reginald Woodwood (another made up name) was, at the same time, also starting an engineering business: Woodward Ltd. Reg had been in the airforce during the war, in charge of aircraft maintenance in the north of England.

The two became unwitting competitors making components for the growing British motor industry.

Maybe it was his sense of there being a band of brothers which caused Reg to set up a pension scheme. He wanted to look after his staff. It began in 1960, a simple DB scheme.

Harry wasn’t a bad man, in fact he cared greatly for his team of engineers, it’s just that a pension scheme didn’t occur to him. In fact there wasn’t one until the mid-1980s.

Much has changed in the 60 years since. The motor industry grew, contracted and grew again (although in foreign ownership). The pensions world also grew, contracted and is now growing again. Woodward Ltd, however, is still a family run firm supplying the motor industry. Reg’s grandson, Mark, is MD.

Mark is another good man. His is a family firm. He employs 150 people, many of whom have worked for the firm all of their working lives.

It was with regret that Mark had closed the scheme. It had been expensive, yes, but he felt its provision was consistent with the firm’s duty of care. That regret persists even now, although he has also developed a sense of frustrated resignation.

After closure it became apparent that equalisation hadn’t been properly dealt with. The deed effecting the change hadn’t been validly executed. This had pushed the liabilities up by millions, despite all parties accepting the original change to be valid.

This was made worse by increasing life expectancy. Mark realised this was a good thing and no one was to blame, but he still had to live with the increasing liability.

What annoyed him most were the running costs. Each £1 spent on processes reduced the amount that he could spend on benefits. The fixed costs were horrendous and increasing at a rate that he could get no adequate explanation for. To add insult to injury, the trustees had had a data audit. While Mark understood the need for good data, he couldn’t understand why he had to pay the administrator more money for work they should have been doing years ago.

Then there was the PPF levy. For, it seemed, bizarre reasons their credit score was low and so the levy ran to many thousands of pounds.

Every which way he turned, Mark endured increasing process and liability costs. These weren’t crippling the business, but they were seriously hampering it.

Mark is a fictional chap. That said, there are many thousands of MDs like him. Most realise and accept their obligations - albeit with some bitterness.

But here’s the rub: Reg set up the scheme to look after his staff and his family maintained that commitment because it was the right thing to do. The result is a millstone of cost hampering their chances of survival and ability to employ people.

BG, by contrast, has none of this. They overlooked their staff’s retirement security, an accident that has left them in a far better position. Unencumbered by a DB millstone, they can invest and grow.

The ghosts of all of the men like Reg, socially conscious and caring, are unintentionally and unfairly haunting their own legacies. We trustees should, where we can, cut them some slack.

 

7 March: DC will not survive in its current incarnation, argues Richard Butcher

Soon after I arrived in my first job in 1985, with the pensions department of an insurer, I was dispatched to the basement to look for some files. It was a cavernous, underground space staffed by sallow people who blinked a lot in the daylight.

My mission was to find an ancient procedure manual for a long defunct product that had one legacy client signed up early in the 1970s. I found it in a rarely visited dusty corner and set about the work of understanding what to do.

The concept seemed simple; each employee had an earmarked account into which their contributions, plus contributions paid by their employer, were allocated. These were invested with the resultant fund, at retirement, being used to buy an annuity. This was known as a ‘money purchase scheme’.

I did my work and passed it to a colleague to check. She had also to read the manual. We laughed at how simplistic and basic this thing seemed compared to the reliable final salary schemes that were the staple of our day and of all the insurers’ salesmen.

Three years later the law changed reinvigorating this old form of pension. The present ascent of money purchase began and the rest, as they say, is history.

Four years ago I was talking to a client. He was a director of a family owned business. The staff’s final salary scheme had just been closed. “It’s a shame,” he had said to me. “These people are loyal and work hard for us. I wish we could continue to provide them with certainty. It’s madness that we can’t, but it would be suicidal for the business if we continued.”

A couple of months ago I was at a dinner with some very eminent pensions people (I was the makeweight). We talked about the death of defined benefit. I asked, “Could you see it coming back to the mainstream at some point, in some form?” I was surprised not that a few of them agreed, but that they all agreed.

It will come back, albeit not in the final salary form that we are used to. It may come back as a DC hybrid offering, perhaps a guaranteed return or annuity rate.

Last month Steve Webb floated the idea of removing statutory pension increases. His remarks were a little misquoted as if to apply to the current generation of DB schemes. They weren’t meant to. He was musing on a new approach (he called it “defined aspiration” or DA) where maybe there could be some form of DB Lite.

All of this stems from the fact that DC, in its current form, doesn’t work. The version that I came across at the start of my career had been abandoned because of its flaws.

Pure DC shifts the risk too far to the employee and it is too difficult (impossible perhaps) to educate everyone sufficiently to be able to make informed decisions.

A new hybrid version of DB/DC (maybe DA) would allow employers to share some of the risk without all of the liability of current DB.

This would make it easier for employers to provide security. It would make it easier for employees to understand what they will get so helping us to deliver good member outcomes.

20 years from now, a young administrator will be digging around in the dusty corners of his employer’s ancient computer system. He will find the admin guide for one of our DC schemes. He and his colleagues will snigger at how simplistic they are. “How could anyone ever think this would deliver a good outcome?”

 

1 February: Richard Butcher considers one forgotten advantage of an effective pension scheme, in the second of a new series of blogs

My best mate’s dad, Colin, is a lovely chap and I begrudge him nothing that came his way.

Up until the mid ‘90s Colin worked as a deputy branch manager at one of the high street banks. He put in 30 years of service at the coal face of the unfashionable (and relatively unrewarded) end of the banking world.

The banks had realised since the late 80’s that their world was beginning a process of dramatic change, and it was now time for this change to happen.

The old model of a bank manager (and his deputy) sat in every high street in every town considering individual customer requests for loans and overdrafts, was passing. The future would be high tech, fast moving and would require rationalisation. They decided to sweep out their businesses to become leaner, more efficient and more modern. 

Colin and his ilk were dinosaurs of a past age that would soon become a drag on profits if left in place. They were about to become redundant.

Fortunately for the banks, the dinosaurs were all of a certain age (there was a long and slow ladder of promotion) and so were offered a deal. ‘Go now and we’ll use some of the DB scheme funding surplus (this was in the days when they were much more common) to top up your pension. You can have now the benefits that we would have given you at 65.’ Colin was 52.

Redundancy and early retirement packages were a very common tool for managing out inefficiency in business. In fact, many HR directors will tell you that a pension scheme is not about attracting and retaining good quality staff, it is instead about ridding the business of uneconomic staff.

Of course, not all employers had access to a good quality pension scheme to manage this liability. Instead they had to rely on a disciplinary procedure (messy, unpleasant and potentially expensive), paying someone off or, as a long stop, the mandatory retirement age.

So, what’s my point?

The mandatory retirement age has now been scrapped and DB funding surpluses, indeed DB schemes, are a thing of the past. The employer has been denied access to two critical resource management tools. Had the bank wanted rid of Colin now, they would have had to have either (a) given him a large wedge of cash or (b) found fault with his work, given him written warnings and verbal hearings. The parting would have been, at best, acrimonious and, at worst, heading for a tribunal or court.

Stories of inadequately funded employees begging their HR director not to get rid of them are already starting to emerge.

The days of DB funding surpluses are not going to return (for most of us anyway) but that doesn’t mean that a pension scheme cannot help an employer with this problem. A well-governed DC scheme aimed at delivering a specific outcome (as opposed to being based on either the lowest contribution possible or the ‘sector average contribution rate’) will give employees improved clarity and allow them to make informed decisions. This will aid and reduce the cost of managing people out of a business. It will also reduce the acrimony and risk of litigation.

That pension schemes can be used in this way seems to have been forgotten. Employers need to be reminded well ahead of their next clear out.

And Colin? He took the deal. He moved north and these days spends his time playing golf and walking in the Lake District. He is a very happily managed profit drag.

 

9 January: Richard Butcher considers one way to improve DC, in the first of a new series of blogs

Trustees have to look after the financial interests of their members. Recently, in the context of defined contribution (DC) schemes, the Regulator has been helping trustees to focus on this by setting an objective of ‘delivering good member outcomes’.

The regulator’s intent is good (albeit not terribly well defined) but they also miss the point.

When you drive a car, you look at the road ahead and use the controls to achieve your objective. You do not look at the controls with an objective in mind and then drive the car. If you did you would crash. Probably before leaving your drive.

Yet we ‘drive’ DC schemes in this way: we look at the controls of contributions and investment with our objective only vaguely defined. 

To achieve good member outcomes this has to change. We have to focus on the objective not the controls.

Professor Robert Merton spoke about this at the last NAPF investment conference, coining the phrase ‘managed DC’. A similar set of arguments were put forward in research carried out by the Cass Business School and by Lord Hutton.

How could managed DC work in practice?

In principle it’s not difficult. We ask the member to define what benefits they want (say, a pension of £100) and when they want it (say age 65). We ask them what margin of error they could tolerate (say +/- £10).

“We have to focus on the objective not the controls.”

Under the bonnet we stochastically model that objective. The result is the level of contributions required. If the contributions are too high (and the member can now make an objective decisions about contributions), they have to lower their target, lengthen their plan or increase the margin for error (i.e. take more investment risk).

The modelling wouldn’t be a one off. It could be web based and done, in real time, at any time. The model would imply a cone along a time line, narrow at the point of retirement and progressively wider before. Progress along the cone would be tracked. Near the bottom and more contributions may be needed. Near the top and you can relax. Out of the cone, time to reconsider the objectives.

Under the bonnet, this approach would lend itself to, for example, dynamic derisking, derivative usage to manage down side risk, target date return funds and many of the other innovations that are now common in DB investment.

It sounds complex but it isn’t. All the member would see upfront would be £100, +/- £10 and age 65 = £x a month. When they review it all they see is, ‘You are currently on target to hit £98’ (or whatever).

“DC doesn’t work well. This is one very effective way of fixing it.”

A sceptic may argue that we would be creating a DB scheme by the back door, but this wouldn’t be the case. It isn’t beyond our ability to make the model pretty good and to come up with a form of words that makes it clear there is no guarantee. In any event, the approach is far better than just driving in the dark (as we do now).

Nor is this approach intended to remove choice. This is aimed at the 95% of members who end up in the default fund. Those who want to play with their pension investments still can. In other words, this is entirely consistent with the objectives of providing robust and proactive defaults in an environment where members can make informed decisions.

DC doesn’t work well. This is one very effective way of fixing it. If we don’t fix it we will end up with dissatisfied and possibly even litigious members. If we don’t fix it, we are heading for a car crash.

Richard Butcher is an independent trustee, managing director of Pitmans Trustees, and founder of the Association of Member-Nominated Trustees (AMNT)