Rex Cowley discusses the modern age of pensions, which is undergoing fundamental changes to deal with issues such as an ageing population, low annuity rates and the demise of the defined benefits pension.
With an ageing population, state pension provision changes, low annuity rates and the demise of the defined benefits pension, the retirement landscape in the developed world is undergoing fundamental changes.
The most dramatic of these changes is the shifting of risk from governments and employers directly to the individual which is most pronounced in the expatriate sectors. In short this is a seismic shift from an environment that has provided certainty and dependability for the last 200 years to a position of uncertainty and no dependability.
This might sound dramatic and in reality it is. This article looks to identify what these changes mean in practice for the management of personal pensions. It also explores the risk facing this new era of retirees as they leave behind the certainty of defined benefit pension for money purchase or defined contribution investment linked solutions. This article draws on research that has been carried out with international pension providers who specialise in the provision of such services to reveal the data behind the theory.
Extract of International Pension Study
The following findings are a result of an international insight study which engaged 14 international pension providers from the primary offshore jurisdictions who offer money purchase investment linked solutions to expatriates. The products offered by these providers include Qualifying Recognised Overseas Pension Schemes (QROPS), Qualifying Non UK Pension Schemes (QNUPS) and International Pension and Retirement Savings Plans (IPPs).
The purpose of the study was to gain an understanding of the market in terms of what client segments are involved, the level and source of pension contributions, how contributions are being invested and the expectations that the invested monies will meet the desired outcome – financial security in retirement[i].
Funding of International Retirement
The research found that 55 per cent of the market is represented by the 45 to 55 year age group followed by the 55 to 65 year olds at 39 per cent.
Given the significant number of retired expatriates, a question mark could be raised over these results as population distribution across the expatriate sector is skewed to the older member ie, 65 plus. However, the factor driving these results is that the study only focuses on money purchase schemes and the older age groupings were found to be in defined benefit schemes or have annuitised, which excludes the majority of them from the study.
Diagram 1: Ownership of money purchase investment linked pension and retirement schemes by age grouping
The split between defined benefit (DB) and defined contributions transferred to international pension schemes was 78 per cent defined contribution and 22 per cent defined benefit transfers.
The research further found that it is common for international pensions to be funded by multiple pension transfers and consolidation of pensions under single international schemes was a well-defined and growing trend with consolidation being as frequent as two out of every three. Of these a DB component is also common. However, the value of defined benefits schemes varied significantly meaning financial advisers operating in this market will need to be well equipped to deal with advising on such transfers, particularly given the risk outlined further on in this article.
Diagram 2: The split between defined contribution and defined benefit pension transfers
The research aimed to gain an insight into how contributions are invested in terms of investment type, portfolio construction and approach to on-going management.
The research identified that offshore life bonds played a significant role as a wrap or investment platform from which investment is made. Whilst this provided operational efficiency and gave access to a wide variety of investment funds it has a negative impact on investment return and hence reduces the years until ruin, ie, the life-time of the pension.
Of those providers interviewed 65 per cent reported using the life insurance bond as the primary investment with 35 per cent seeing direct investment.
Diagram 3: The split between investments going via an Offshore Life bond vs direct
Respondents provided a high level picture of the kind of underlying investment into which pension contributions are ultimately invested. Collective investment schemes were by far the most popular investment choice and represented 80 per cent of investments used with structured notes that 15 per cent and direct stocks and shares at only five per cent. These results were somewhat skewed as smaller valued portfolios, which were more numerous than larger valued pension, typically used collective investments where larger portfolios had direct exposure to securities.
Diagram 4: The allocation of investments across collectives, stocks & shares and structured notes.
72 per cent of portfolios were found to be ‘self-managed’ by the financial adviser with 28 per cent being outsourced to a third party manager. This was either via a segregated discretionary investment portfolio or a managed fund solution.
Diagram 5: The split between financial adviser managed and financial adviser outsources investment management
On-Going Investment Risk
Respondents sighted the single biggest risks to pensions was investment risk and increasing life expectancy. Put another way, the ability of the assets of the plan to provide the level of benefit required for the lifetime of the member.
The research also found that on average the split of client portfolios was 53 per cent balanced, 41 per cent cautious and six per cent growth. Given the earlier findings on the age groupings of clients, it raises questions as to whether the pension will deliver returns sufficient to overcome extended life expectancy and the effects of inflation?
Diagram 6: Spread of portfolio type in pension and retirement plans
In order to try to answer this question, pension providers were asked for their view on the likelihood of client portfolios to meet the client’s future retirement funding requirements over the long-term given inflation, longevity and the outlook for the markets.
Diagram 7: Product providers’ expectation of investment portfolio’s ability to meets clients’ needs over their retirement.
33 per cent of pension portfolios are not expected to be able to generate the level of benefit required to meet the member’s needs over the longer term. This was attributed more to the fact that financial advisers are not as active as discretionary fund managers in terms of on-going stock / fund selection and asset allocation rather than a lack of faith in the capital markets. This highlights the issue of investment risk and raises the option of outsourcing investment decisions to reduce the risk for financial advice practices and the potential for third way retirement products.
Currency risk was also seen as a component of investment risk, particularly where an income is derived from a currency other than the currency in which the client pays their expenses. Respondents noted that the effect of currency fluctuation is often underestimated, which can create significant issues in terms of cash flow and affordability.
Hence, a mismatch between the currency used for living expenses and the currency of the benefit paid can have a significant impact on the purchasing power and real value of an expiates pension. Therefore currency should be considered carefully by advisers and clients alike.
Overview of the risks and influencers of postmodern retirement
This is the risk of outliving one’s money as people are living longer. In 1950 the average American retired at age 68 and died at age 72. Managing money in retirement was less of an issue than it is now as the demand on retirement funds was typically only four years. According to the US Census Bureau, the fastest growing age segments are those aged 90 and over and according to the 2010 actuarial tables, a person age 65 today has a 57 per cent chance of living to age 85 and a 29 per cent chance of living to at least age 92. In addition we are retiring earlier with the average retirement shifting from 66 to 64 years and even lower where semi-retirement is taken which typically occurs between age 55 and 59. The results are somewhat staggering when put into context. Retirement was around four years in the 1950’s, a mere 50 years on and its now on average 25 years or an increase in life expectancy of 525 Per cent. The question is: are we saving sufficiently to fund for this extended life?
Inflation has a relentless erosive effect on the purchasing power of income and the value of one’s capital over time. For most, retirement means exiting employment to follow other pursuits and this places a significant reliance on the wealth that one has accumulated over their lifetime. The reality is that after having stopped work it is highly unlikely that an individual will return to work and their ability to earn is significantly reduced.[i] .
For many, retirement may last from 20-35 years given the increase in longevity and the compounding effect of inflation is one of the main factors that erode wealth and key consideration when saving for retirement.
The table below demonstrates how the purchasing power of a level pension of US$20,000 pa is eroded by inflation at a mere 2.5 per cent pa.
This example helps illustrate, 2.5 per cent inflation leads to almost a 40 per cent reduction in purchasing power after 20 years. When inflation is five per cent pa, the reduction in purchasing power is in excess of 60 per cent after 20 years – this is a serious issue, and the development of alternative approaches to funding retirement and the management of pension funds are essential.
Sequence of Returns Risk
The following extract from the work of JW Jordan, D Weinberger and J Franks of MetLife’s Behavioural Finance and Income Strategies explains the risk of timing and the relative impact of the ups and downs of markets when drawing a pension from a money purchase investment linked plan. They explain that market timing has a completely new meaning during retirement.
Younger workers are better positioned to ride out a market downturn and have portfolios that can recover because gains and losses are really only on paper and they will not be using the money until many years later during retirement—hence the importance of cost averaging and on-going savings and portfolio rebalancing.
On the other hand, a sharp loss closer to, or in, retirement can have a profound effect on the amount of retirement income a retiree can expect to generate. This reverse of cost averaging (selling more shares when the market is down to generate the expected income needed), can mean running out of income far earlier than expected, even when practicing the rules of a safe withdrawal rate (four per cent with three per cent inflation in exchange for a 90 per cent chance of success over 30 years.)
As shown in the table below, which is an excerpt from a white paper, The Impact of Sequence of Returns, written by Moshe A Milevsky, PhD, a thought leader on retirement income, even with the same average rate of return, the overall sequence changes the outcome.
Initial wealth= US$100,000; assumed spending per year: US$7,000 annum adjusted for inflation (The “Impact of Sequence of Returns, written by Moshe A Milevsky, PhD)
The table observes four retirement portfolios with an initial worth of US$100,000 and assuming US$7,000 annually adjusted for inflation. It assumes that the average rate of return was eight per cent, but the actual sequence of returns fluctuated between bear and bull markets: -20 per cent (the first year), +17 per cent (the second year) and +27 per cent (the third year), etc. It also assumes that this order was different for each of the four portfolios.
JW Jordan, D Weinberger and J Franks explain that the result is that the gap between the ages of ruin varied from age 82.25 to age 94.5. Hence, when asset value increases during the early years, chances are assets will last longer. The lesson learned: timing is everything when it comes to retirement planning.
Gains and losses don’t mean so much on paper when clients are in the accumulation phase because they aren’t real. However, when the time comes to start taking money out, a loss may result in a significant reduction in spending power and the overall life time of the pension plan.
The certainty of defined benefit pensions and government state pensions are gone or going and retirement provisions rest squarely on our own shoulders. There is no magic potion to make assets stretch further or last longer and it simply boils down to ensuring that one is saving at the right level and that this level is adjusted regularly to compensate for market losses and professional money management is an essential.
It is also clear that diversification of pension fund monies across an actively managed multi-asset portfolio is only part of the answer. Advisers will need to blend other options, such as protected products to create improved levels of certainty for capital or income or use traditional annuities or third way products. But these options bring with them their own set of risks and costs.
Retirement should be our golden years and, given that the only certainty is uncertainty, one can’t go far wrong by using a cautionary approach to retirement provision by preparing for the worst… but living in expectation of the best.
[i] NewDawn Consultancy & Research, Global Pension Study 2012.
Rex Cowley is a co-founding member of the specialist international pension provider Overseas Trust and Pension and active pension and retirement practitioner. He is also an authority and author on international pensions and the founder of the consultancy and research practice NewDawn. Rex sits as an independent on industry expert panels and expatriate financial clinics and lectures on retirement and pension provision around the world.