Chapter 1
Why Should You Save for Retirement?
Act today for a better future
‘You can be young without money, but you can’t be old without it.’
Tennessee Williams
Introduction
Why should you save for your pension? If you are reading this, you probably know the answer; it is obvious. When you work, earning an income, you have a regular source of money. You spend it on essentials, such as food, housing and education. You spend it on recreational activities, such as holidays, hobbies and entertainment.
After retiring, you still need a source of income to maintain a decent standard of living. You want to enjoy your retirement. If you have your health and wealth, being a pensioner can be sweet. You can take a long trip, pick up a new hobby and enjoy the dividends on your children – your grandchildren. Having enough money allows you to be a cool grandparent. This is the reason to save all your working life. Simply put, act today to secure your financial future.
In the past, most workers were members of defined benefit (DB) pensions. A DB pension (final salary) pays its pensioners a monthly income for the rest of their lives. The income is determined through either a formula considering some average of their salaries whilst they were working or the amounts they and their employer paid into the plan during their career.
Pensioners do not need to worry about how to invest the amount saved in their pension. The company or employer offering the DB pension (sponsor) assumes the risks. If the pensioner lives longer than expected (longevity risk), the sponsor pays more. The sponsor guarantees the income. If assets in the pension are not enough, it is the sponsor’s liability. The sponsor needs to top up the shortfall. This is sponsor risk.
The pensioner’s risk is the sponsor’s insolvency – the sponsor can go bust, unable to make pension payments. The word guaranteed in financial services always comes with small print.
Since sponsors could not or did not want to take the liabilities and risks of DB pensions, many schemes closed to new members. This means the DB scheme continues to pay to its pensioners and will pay to existing members when they retire. But it does not accept new members and, in some cases, existing members stop accumulating benefits. Instead of DB pensions, employers now often offer defined contribution (DC) pensions.
Typically, in DC pensions, the employer and, perhaps, the employee contribute a percentage of the employee’s salary into the plan every month.1 Contributions are exempt from income tax as they come out of gross salary. If the member makes additional contributions or is self-employed and contributes to a pension, a tax relief ensures the contributions are tax-free. Whilst within the pension, interest and capital gains are tax-exempt.
DC pensions incentivise saving with truly valuable tax benefits.
But there is a catch. Once the money is in the DC pension, your responsibility is how to invest it. If you do not choose how to invest, in some cases the money may be invested in a default fund. If your investment choices or the default fund perform poorly, when you retire the pension pot might be insufficient to sustain your desired standard of living. You are accountable; neither a sponsor nor the Government. There are no safety nets.
Another catch is that only when retired, normally at least at the age of 55, you can access the money in the pension. In effect, pensions force long-term saving in a tax-efficient way. That is not bad – you cannot blow the money on a red Ferrari when having a midlife crisis.
When retiring and starting to draw retirement benefits, you can take a quarter (25%) of the money immediately as a tax-free lump sum. As for the remainder, take it when you wish. However, it is taxed at your marginal tax rate every tax year, so you should pace the drawings, minimising your tax bill.
Since you can live long and prosper after retirement, you must decide what to do with your pension in order to have enough to support you for the rest of your life.
And that is it.
Your employer does not need to pay you any income, unless you are a member of a DB pension. You bear all the risks of how much money is in your DC pension and whether it is adequate for the rest of your life. Do not expect anyone to save you, neither your employer nor the Government. Currently, State Pension is probably less than £119.30 a week, which is hardly sufficient. It is entirely up to you.
New UK legislation makes it mandatory for every employer with at least one member of staff to automatically enrol all eligible employees to a workplace pension scheme, unless they opt out, and to contribute towards it. Often, employees are not even aware they are members of a pension and their savings are invested in a default fund.
A default investment strategy may be appropriate.2 However, it is designed to meet the common objectives of most savers. You may have different financial needs and often it does not adapt to your changing circumstances. Therefore, you should and can make your own saving and investment decisions.
Pensions are a crucial issue on a global proportion. In many developed countries, such as the UK, the USA, Germany and Japan, the population is aging. People live longer and low fertility rates mean families are now smaller than in the past. The workforce is shrinking whilst the retired populace is growing. State pensions are running into bigger deficits. The burden of paying into pensions is becoming heavier.
Maintaining DB plans is more difficult and rare. Too many people are not saving enough or at all in their DC pensions. If people do not start taking saving seriously, the world will head towards a global pension crisis. Only by increasing the awareness of pensions and taking action can we all alleviate this crisis.3
Article 1.1
1.4m risk inadequate retirement income, says report
By Josephine Cumbo, Pensions Correspondent
Financial Times, 16 March 2015
Up to 1.4m people are at risk of not having enough income in retirement as they are given the freedom to spend their savings as they wish, warns a new report.
The study, published just weeks before radical pension reforms are due to come into force, examined how the policy change will affect retirement income levels for pensioners over the next three decades.
The new freedoms will allow people aged 55 and over new flexibility to take savings in a defined contributions (DC) pension as a cash lump sum, with no requirement to turn the pot into an annuity.
Due to low savings levels, 1.1m people in England risk not having an adequate income in retirement, even if they bought an annuity with a DC pension pot, the report warns – that is, unless they claim additional pensioner benefits, or use their non-pension assets, such as savings or investments.
Up to 1.4m in total run the risk of inadequate retirement income, if they “blow” their pension pot on big ticket items such as a car or a holiday.
“Evidence from abroad suggests that consumers in countries that have liberalised retirement income markets often squander their hard earned savings, favouring consumption today rather than smoothing it over their lifetime,” said Baroness Sally Greengross, chief executive of the International Longevity Centre-UK, which prepared the report.
“And while recent UK consumer research has shown that those approaching retirement would favour a guaranteed income for life, many consumers are confused about what their options are and have low levels of financial capability.
“The potential for a mismatch between what people might want and the products and services they ultimately access with their money is high.”
The report assessed retirement income adequacy using the “replacement rate”, which is a ratio of income before and after retirement.
The report found average projected replacement rates would be almost 70% if savings were annuitised, or less than 40% if the savings were blown on big ticket items.
“While we do not advocate that everyone should take a particular course of action, our analysis clearly highlights the benefits of annuitising for those individuals who have a high concentration of wealth in DC savings,” said Ben Franklin, senior research fellow with the ILC-UK.
“Annuities are generally misunderstood and the group who stand to lose the most from spending everything too early also score relatively poorly on financial capability, making them particularly susceptible to poor decision making. Without the appropriate support including a new default strategy, these individuals could end up significantly worse off in retirement.”
Source: Cumbo, J. (2015) 1.4m risk inadequate retirement income, says report, Financial Times, 16 March, www.ft.com.
© The Financial Times Limited 2015. All Rights Reserved.
Saving and investing
This book covers two topics: saving and investing.
On saving, we will review throughout the book how you can tax-efficiently save for your retirement. The focus is on pensions, Individual Saving Accounts (ISAs) and residential property.
The three main points on saving are:
- Start saving early and regularly.
- Maximise tax-efficient savings.
- Buying property with a mortgage is a type of saving as well as investing. Paying off your mortgage forces disciplined saving.
Chapter 2 introduces the background for savings, including taxes, ISAs and pensions, and Chapter 11 is dedicated to residential property.
On investing, we will review what you should know to design and manage your investment portfolio. When managing investments it is helpful to follow an investment management process. It is a framework of all the steps and considerations at each step. By following a process, you will know what to do now, what to do next and what your endgame is. It adds structure and discipline, aiming to minimise emotions and poor investor behaviour.
The process spans four steps:
- Establishing objectives.
- Setting an investment strategy.
- Implementing a solution.
- Reviewing.
The book’s chapters on investing follow the order of this four-step process, which forms a roadmap for the book.
Always start with establishing objectives. Investment objectives represent your financial goals and needs. Think what outcome you want to achieve from investing, what risks you can take and what the constraints are. The desired outcome must be aligned with the risk level and fit the constraints; otherwise, it is not achievable.
For example, you want an average return of 8% per year with a risk of not losing more than 5% in any year and a constraint that your time horizon is two years. Alas, this does not work.
Unless you are lucky, to generate an 8% average return you need to accept higher risk over a longer time horizon. A more realistic set of objectives is an annual 5% average return with a risk of not losing more than 10% in 19 out of 20 years over a 10-year time horizon.
One of this book’s aims is to help you formulate your realistic investment objectives and decide which expectations are reasonable and which are not. Saving and investing require trade-offs. The target value of your portfolio at retirement, the income you plan to draw from it after retirement and your life expectancy all compel trade-offs to minimise the risk of running out of money.
Your investment objectives are personal – they fit your unique financial needs, tailored to your specific circumstances. As your circumstances change during life, so do your objectives – they are not static.
When young you may seek high returns and accept high risk. As you get older and approach retirement your objectives change. You may accept lower risk since you cannot afford large losses just before stopping work. When retired your objectives may switch to seeking regular income from your portfolio with modest growth, emphasising capital preservation and keeping pace with inflation.
The minimum is reviewing your objectives at important milestones in life.
Chapters 3, 4 and 5 cover how to establish return and risk objectives and investment constraints.
The second step in the investment management process is setting an investment strategy. Investment strategy is the plan of what you are going to do to maximise the chances of meeting your investment objectives. The strategy must be aligned with objectives.
Formulating a strategy needs an understanding of the characteristics of the investments available to you and how to blend them at different phases of your life. The strategy is dynamic. It should change with your objectives and market conditions.
Chapters 6 to 15 review how to formulate an investment strategy, the characteristics of major asset classes and how to mix them to form an asset allocation matching your objectives.
The third step in the investment management process is implementing a solution. Here, you translate your strategy into a portfolio of actual investments. You select and buy securities or funds.
The implementation step also includes portfolio maintenance. For example, periodically rebalancing your portfolio to keep it aligned with your strategy and managing cash flows.
Chapters 16 to 22 go over how to implement your solution, including active asset allocation, selecting investments and managing your portfolio.
The fourth and final step of the investment management process is reviewing. In this step you review everything. You monitor the performance of your portfolio and funds. You assess whether it is on the right track towards achieving your objectives. You think whether your objectives and strategy are still valid or need updating. And you follow financial market conditions, deciding whether the characteristics of investments have changed.
The key is to be dynamic and adapt to the changing environment, including both your personal circumstances and general market and economic conditions. The entire process is a never-ending loop. You need to follow all the steps cyclically, ensuring everything is up to date.
Chapter 23 covers reviewing.
Investing is probabilistic, not deterministic. Nothing is guaranteed or certain. All you can do is make the best decisions with the information available to you at the time of making them. Doing so increases the probability of success. Tax-efficient saving and a disciplined investing approach can prevail despite adversity.
Summary
- The shift from DB to DC pensions means more people assume responsibility for saving and investing for retirement.
- The three main points on saving are: (1) start early and save regularly; (2) take advantage of tax-efficient saving in your pension and ISAs; and (3) buy property with a mortgage if it is appropriate for you to do so.
- On investing, follow a four-step investment management process of: (1) establishing objectives; (2) setting an investment strategy; (3) implementing a solution; and (4) reviewing.
- The process is never-ending, as everything needs reviewing and updating as and when necessary.
Notes
1 According to the 2014 ‘Occupational Pension Schemes Survey’ run by the Office for National Statistics, for private sector DC schemes, the average contribution rate was 2.9% for members (employees) and 6.1% for employers.
2 Default funds normally aim to offer a diversified investment strategy with a minimum charge. This usually means static asset allocation and using passive index trackers. This might be inappropriate for all investors, missing opportunities to enhance returns through active management.
3 For free and impartial guidance on workplace and personal pensions contact The Pensions Advisory Service (TPAS) at www.pensionsadvisoryservice.org.uk. Pension Wise at www.pensionwise.gov.uk provides guidance on DC pensions. The Government plans to merge TPAS and Pension Wise to create a new pension guidance body.