Pension and insurance
For many individuals their investing lives are dominated less by issues relating to their rational portfolio, but rather by the options and choices with regard to pensions, life annuities and related products. Wearing the rational portfolio hat, here are some thoughts on these topics.
Defined contribution pension plans
Defined contribution plans have increasingly become the main option for employees at private companies. Instead of offering defined benefit plans or final salary schemes where the companies underwrite the risk that there is a shortfall in the size of the pension assets, companies now let pension plan participants take the investment risk.
Does it make sense to participate in a pension plan? In short, yes, but it depends …
Pension plans are generally a very tax-efficient way to save money for retirement. Depending on rules and jurisdiction, contributions are tax deductible and potentially subsidised or matched by the company you work for. In reality this could mean that for every £100 of regular post-tax income you could put into a rational portfolio, you could effectively put £200 into a pension plan. The potential drawbacks of a pension plan for the rational investor are often not significant enough to negate such a great, effective subsidy of an investment and participating in a pension plan therefore makes sense. In other cases, the investor has no choice in the matter and is forced to participate, which for all its faults at least eliminates indecision.
As discussed earlier, rational investing is all about realising that you can’t beat the market and putting together a portfolio that reflects that while considering your individual risk and tax circumstances. Pension plans are an example of where the tax (or related) benefits of those schemes may make them preferable to investing in the rational portfolio without them. That said there are a few issues to consider before blindly signing up to a pension plan:
- Will you have flexibility to choose the investment portfolio in the pension plan to match the investments you would make in the rational portfolio? If not, does the pension plan contain many expensive investment products or active funds that will negate the savings?
- What are the fees and expenses generally? Some pension funds charge an annual fee of 1% or more which, depending on your time in the scheme, may mean you would be better off without the benefits and investing in a rational portfolio yourself. In my view, one of the great financial scandals of the next generation will be the aggregate charges investors generally face when making pension investments that are sometimes virtually mandated. According to a recent study, an estimated half (50%!) of investment gains will disappear into the abyss of fees and charges for the average pension plan member.1 I find that absurd and shamelessly beyond reason.
- Does the risk profile of the pension fund match your personal risk preference? Do you have any choice in this?
- Can the pension plan easily be transferred to another provider or country if you change jobs or simply find the first one too un-economical? Do you even have a say in this?
- Do you have flexibility to access the capital in your pension if you need to? Even if you do have access to your capital are the penalties prohibitive?
- Does your pension plan have lots of hidden charges, even if they only apply in various cases? One friend’s pension plan discounted his holdings by 50% in case he died before his spouse.
Consider the example where you have the choice of either taking the advantage of your employer matching your contributions and the tax advantages for an investment of £100 into a pension plan, or foregoing all those advantages and only investing £75 into the rational portfolio with everything else the same. Let’s say that you invest 50/50 into minimal risk assets and equities with an average return of 3% and that the difference between the two portfolios is an annual charge from the pension fund structure of 1.5% (ignoring the benefits of flexibility from managing your own money in the rational portfolio).
Over time the benefits of the pension plan may be negated by higher charges (see Figure 13.1). If you can invest as cheaply through a pension plan as you could via a rational portfolio you should obviously take advantage of the tax and other benefits of the pension plan, but there are also cases where things are less clear cut.
I was working at a firm that was setting up an employee pension scheme. The tax benefits from the scheme were such that we would effectively save around 20% in taxes for the amount put in, but we had to keep the money in that scheme for about 25 years. I estimated that there would be an extra 1% charge by having my money invested with the scheme compared to buying a simple index tracker. There was also the benefit of accruing returns on my tax savings which further benefited going with the scheme although I could probably get some of them in any case. I compared the small net savings, estimated after comparing the lower tax and higher charges to doing it myself, against a pretty hefty illiquidity discount in tying my money into a scheme for 25 years, and ended up not going with the scheme as a result; much to my boss’s dismay.
The point is not that you should not save for retirement. Of course you should, and in fact many schemes, like the UK workplace pension scheme that recently came into effect, are compulsory. But you should be conscious of the impact of potentially large fees and expenses that come on top of the lack of flexibility often associated with pension plans, and consider if you can find cheaper ways of achieving the benefits from pension fund investing, or as a last resort save up for retirement outside a pension scheme.
The rules regarding pension investing and the tax consequences vary greatly between jurisdictions and over time.2 Considering that rational investing, to a great extent, is about saving pennies it is well worth your while to educate yourself about the best way to be efficient about achieving the benefits from pension schemes.
If you are uncertain about your pension plan options this is an area where the expense of an adviser is probably well worth the cost. Given the choice, I would encourage you to pick a no frills and very cheap pension plan where you are free to select your own mix of securities. This would allow you to keep all the tax and other potential benefits of the pension plan while investing in a rational portfolio and would be a clear win/win situation.
Defined benefits schemes
Defined benefit schemes are increasingly rare, especially in the private sector. If you have a defined benefit scheme I would encourage you to consider who the guarantor of the future stream of cash flows is. Depending on the scheme you may be receiving benefits 30–40 years from now, and who knows what companies will be in business that far in the future. Is your scheme backed up by guarantees from your government (many such schemes are required to buy insurance that is backed by the government) or, if not, what happens to your pension if the company fails with an underfunded scheme?
The issue of failing pension schemes will be bigger in a poor economic environment, which may be exactly when you particularly don’t want your pension scheme to fail (there is probably never a good time though). More companies fail during recessions and as this is also typically when investment markets have performed poorly, the risk of a company default combined with an underfunded pension scheme has gone up significantly.
In future, I think there will be huge issues with underfunded pension schemes, both public and private. In the relatively benign environment of good markets and higher interest rates that prevailed prior to 2008 some schemes used too optimistic assumptions on future returns and had too few reserves as a result. The pension funds use a discount rate to predict how much money they need to fund their future obligations. If they need to pay someone £1,000 in 20 years’ time the amount needed now will be around £550 with a discount rate of 3%, but only about £375 with a discount rate of 5% – and it’s easier to ask someone for £375 than for £550. This may seem like a spreadsheet abstraction until the day someone tells you that you will receive less from your pension than what you were promised because someone used the wrong discount rate and was too optimistic about the future.
Unless the coming decades see benign markets and interest rates to help rectify the issue of underfunded pension schemes I predict there will be many failing schemes. Governments will then have to step in to protect the retirement payments of many pensioners, at a time when they are already facing other pressure from high debt and an ageing population. If you are in a defined benefit scheme and expect to receive payments in several years hence then make sure you know where you stand if this calamity happens.
Annuities and insurance
Annuities are an important and sometimes dominant part of the investment portfolio for millions of savers. While in some cases there is a requirement for pension scheme participants to put a part of their pension savings into an annuity many other investors find great comfort from having a secured cash flow until they die (some annuities continue payments for dependants).
I certainly don’t have a problem with annuities. There is great intangible value to be had in knowing that you are going to be OK in your old age, regardless of how old you become. Particularly if you have an annuity that is adjusted for inflation (some adjust for changes in the retail price index), you have a very good picture of your spending power in retirement, without worrying about the oscillations of the markets or dying with a lot of money that you will have no use for (you’ll be dead …).
But there are a few things you need to think about when purchasing an annuity:
- Who guarantees your payment in the future and what is their credit quality? Keep in mind that you will be expecting payments many years into the future. If you buy an annuity at age 50, with some luck you’ll be looking for a payment up to half a century into the future, and at that time your quality of life may greatly depend on actually receiving that payment. In most cases annuity providers are insured by a government-backed scheme, but you want to make absolutely sure that this is the case. You certainly don’t want to be in a situation where a Lehman-style bankruptcy means that you are left with nothing in retirement when your earnings potential has greatly diminished. (Keep in mind that annuity providers are likely to be struggling exactly when markets are tough and you probably need the money the most.)
- The price of the annuity may be very high – be sure you need it! You are essentially lending money to the insurance company for a very long time. You can try to figure out at what rate in the following way for a standard (non-inflation adjusted) annuity:
Figure out expected return on a standard annuity
- Figure out your life expectancy. There are many life expectancy calculators on the internet (I used a couple including one from University of Pennsylvania: wharton.upenn.edu/mortality/perl/CalcForm). It will be more accurate if you can incorporate where you live, etc. This will give you a good idea of how long the insurance company expects you to pay your annuity for (make sure you tell them all the bad health stuff – as morbid as it sounds, in this case you want them to think you are going to die soon). I was surprised by how long I can expect to live, which according to a friend in insurance is a common reaction.
- Search around for the best annuity and be sure that the payments are in fact guaranteed by someone other than the annuity provider’s general corporate credit. Assuming you are buying an annuity for £100, what will your yearly payments be?
- Figure out the internal rate of return (IRR) on your payment. Your IRR is the rate at which the insurance company effectively borrows from you. So year zero: −£100, year 1: +3.75, year 2: +3.75, etc. You can do this in Excel. Keep in mind that unlike a bond you don’t get the principal back at the end (there are annuities that do this, but the interim payments are just lower to reflect this).
- Figure out the average time to future payments (the duration – also use Excel). Depending on your circumstances it will perhaps be 15–20 years. If you start receiving the annuity payments now this will be half the years you are expected to have left to live.
- Compare your IRR to a government bond of a maturity similar to the duration and in the same currency (your average time to payment in 4 above).
- Apply some sort of discount to the annuity IRR to reflect the inflexible nature of the product and perhaps stiff penalties if you try to get out of the annuity.
- Consider any tax advantages of the annuity; these are at times significant.
As an example, when I did the above exercise as a potential annuitant, the IRR I received on my investment was slightly lower than the equivalent UK government bond. So essentially I would be lending money to the annuity provider decades into the future at a lower rate than I would the UK government, ignoring the flexibility I would have in trading the UK government bonds if my circumstances changed. In other words, the insurance I received from the annuity provider against running out of money in very old age was very costly.
It is not surprising that the IRR for your annuity is not great. Annuity products are expensive to manage, and not necessarily great business for the insurance companies as they deal with the administration of cash transfers to thousands of annuitants, in addition to marketing, overheads, re-insurance that the annuity provider will be able to pay you, and the profit and capital requirements of the annuity provider. Just think that it costs money every time someone calls up to complain that they have not received their £300 and multiply that by a million customers – even if you are not the costly customer you share in paying for those costs by being on the same annuity platform.
My conclusion on annuities is that if you don’t have a lot of savings and worry about having enough into old age, annuities are well worth the poor return they promise on your investment. If you don’t have a lot there is great value in knowing exactly what you have and that it will be enough. An annuity can give you that.
If you have more assets and are highly likely to leave an estate for your descendants then perhaps reconsider annuities. After adjusting for potential tax or other benefits the return on the assets you put into an annuity is quite poor and you could make more money investing on your own. You will of course not have the guarantee of additional payments if you live beyond your life expectancy, but considering your other assets you will be fine even without that additional money. Also, annuity providers make large sums from the hefty penalties from changing or cancelling annuities and if there is any chance that you may be doing that then take it into consideration when evaluating an annuity (a lot can change in decades ahead so even if you consider that unlikely now, that may change in future). This could include if you wanted out because you no longer considered the future annuity payments secure. Just imagine how you would feel if your old-age living cost was promised by a Greek insurance company that was backed by the Greek government. You would hopefully have run for the hills a long time ago.
As shown by the IRR on the annuity, the return profile is extremely low risk/return and that may not suit your risk profile – if you can afford greater risk in pursuit of greater returns in your portfolio an annuity may lock you in to lower return expectations for decades ahead.
Buying insurance
In very rough terms the world of insurance is divided into life and non-life insurance. Non-life insurance is for things like your car, house, travel, business and other non-life things. We all know how it works. You pay £500 to insure your car against a number of things, including for example theft. Let’s say it’s a £10,000 car. In simple terms, the probability of making a claim against the full value of the car in any one year has to be 5%. Without necessarily doing it in those terms, most buyers of insurance probably consider that about right and therefore worth it.
The reason I would not buy the £500 insurance on my £10,000 car (other than the third party insurance which is required by law) has to do with my knowledge of the insurance company’s combined ratio. The combined ratio is the sum of the claims and expense ratio. The claims ratio is exactly that – what the company pays out in claims to people whose cars were stolen or damaged. And the expense ratio is all the other costs of the insurance company; marketing, administration, overhead, etc. Insurance companies can have combined ratios over 100%; if claims don’t come due for a while the insurers earn an interest on the premiums they collected until the claim falls due. But since car insurance is typically a one-year policy the combined ratio for this policy should be below 100% to be profitable.
For car insurance, the risks are somewhat predictable and the insurance company is likely to have a good idea of the number of claims and expenses it will face (insurers can reinsure risks they don’t wish to hold fully themselves). Using very rough numbers the insurance company might have a combined ratio of 95% for these policies made up of a 70% claims ratio and 25% expense ratio (my friends in insurance will bemoan this simplification). So, essentially, if you are an average risk customer, every time you pay £100 in premium on your car insurance you get £70 back in claims and it costs £25 for the insurance company to make it all happen, and they take a £5 profit. In other words, you are paying £30 for the peace of mind of having the insurance. You obviously don’t get £70 back. Most of the time you get nothing back as you didn’t make a claim on the insurance company, and then when misfortune strikes you get your £10,000 back; but on average you get £70 back.
So the reason I don’t buy insurance is that I don’t want to pay the 30% in cases where I can afford the loss (25% expenses plus 5% profit to the insurance company). Obviously it would really stink to have my car stolen or damaged to the tune of the full £10,000, but I see this as a risk I can afford to bear and don’t need to pay to protect against. Importantly, I don’t think that I save the full £500 in annual car insurance. I think that I save the 30% difference between what I paid and the average claims. In my view the insurance company knows as much about my risk as a buyer of insurance as I do, and if they set the average pay-out for me at 70% of a £500 policy then that is probably about right. So using this case of car insurance to extrapolate how I think about insurance in general, on average over all the insurance policies I don’t buy I would expect to have a loss of £350 (70% of £500) on my car in any one year, and have saved £150 by not buying insurance (30% of £500).
Not buying insurance against things we can afford to replace or have happen does not mean that those things don’t happen. It just means that instead of having the small bleed of constantly paying small premiums for lots of small things we will once in a while be paying out larger replacement amounts for things we did not insure against. Personally, I also think the whole hassle of keeping track of insurance policies is a pain I would rather avoid and I also seem to constantly hear stories about insurance companies that either fought claims or made claiming on a policy a huge headache.
Without being scientific about it, including all insurance forms that I don’t buy (including life insurance) I think I save about £500 per year in expense ratio and insurance company profit. Assuming that I took this money every year for the next 30 years and invested it in the broader equity markets and was able to return 5% on that money, my savings from not buying insurance over the period would amount to around £35,000 in present money. This is money I have instead of it being in the insurance company’s pockets in 30 years. Importantly this saving does not assume that I don’t have accidents or have my car stolen. In fact it assumes that I’m at risk of those things exactly with the same probability that the insurance companies assume.
There is probably going to be a massive ‘always seek expert advice’ or ‘don’t try this at home’ disclaimer from my publisher in the front of this book, and here it really applies. You should not save on insurance premium payments in instances where you can’t afford the loss; and everyone is different in terms of what they can afford to lose. Almost nobody could afford to lose their house in a fire so they should insure against this possibility (you probably couldn’t get a mortgage if you didn’t). Most people in countries without national health services couldn’t afford episodes of bad health so should get health insurance. Many can’t afford to have bad things happen to their car or have their homes broken into, so they should insure against that. But most people can afford to lose their mobile phone, having to cancel a flight or holiday, or an increase in the price of their electricity bill, and they should not insure against those things. And even if there are things you need to buy insurance for you should always get a high deductible, which in turn will lower the cost of the insurance policy. Over time, having no insurance or a good discount when you do will save you quite a bit of money, and that should make you sleep better at night. And perhaps you will look after that mobile phone just a little bit better because it’s not insured, which in turn will lower the risk that you inadvertently lose it.
Similarly there are many instances when life insurance makes sense. As with the case of annuities, many life products have an investment component to them, but obviously also a life component. If you are in a situation where your death or disability will cause unbearable financial stress on your descendants then the premium you pay on these policies makes sense. As with the example of car insurance, you should do so when you or your descendants can’t afford the loss. Whether they can or not is obviously a highly individual thing, but bear in mind that as with all insurance products there is a tangible financial cost to the intangible peace of mind many people cherish by being insured. Make sure it is worth it.
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1 www.telegraph.co.uk/finance/personalfinance/pensions/9407283/Fees-that-can-halve-the-value-of-your-pension.html
2 For UK specific thoughts on financial planning and pensions I recommend Jonquil Lowe’s Be Your Own Financial Adviser (Pearson Education, 2010).