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According to the Office for National Statistics centenarians are the fastest growing age group in England and Wales. They explain it thus:
“The major contributor to the rising number of centenarians is increased survival between the age of 80 and 100 due to improved medical treatment, housing and living standards, and nutrition.” ONS, 2009.
It now seems possible or even likely that living to 100 might become commonplace within our lifetimes. And I expect that could be more true of those who have sufficient resources to live a healthy lifestyle.
People have often suggested in the past that there must be some sort of natural limit to lifespan – a ceiling if you will – but so far there is no sign of it. So where will it end?
Dr Aubrey de Grey of the University of Cambridge has made a very bold claim. “I think the first person to live to 1,000 might be 60 already.” That’s not a typo. he really said 1,000. I sense disbelief amongst some readers. Well, he might not be correct but he’s certainly not a quack. He explains it in broad terms like this:
“Ageing is a physical phenomenon happening to our bodies, so at some point in the future, as medicine becomes more and more powerful, we will inevitably be able to address ageing just as effectively as we address many diseases today.” He’s talking about ongoing scientific trials too, not just vague ideas.
Even leaving aside the idea of living to 1,000 we are still facing the wonderful prospect of living to 100 and beyond. As long as you remain healthy and solvent, what a privelege to experience so much.
When you review your long-term financial plans with your adviser, make sure you are realistic about how long you might live. It could well be much longer than you think. This has an important ramification.
There is a risk that you could run out of money in retirement. These days with our sophisticated lifetime cash flow modelling this can be simulated quite effectively for multiple scenarios, allowing you to see under what circumstances you might run out of money. It could mean the wealth creation part of your life has to last longer, spending less or just adjusting your portfolio.
According to the Office for National Statistics centenarians are the fastest growing age group in England and Wales. They explain it thus:
“The major contributor to the rising number of centenarians is increased survival between the age of 80 and 100 due to improved medical treatment, housing and living standards, and nutrition.”
ONS, 2009.
It now seems possible or even likely that living to 100 might become commonplace within our lifetimes. And I expect that could be more true of those who have sufficient resources to live a healthy lifestyle.
People have often suggested in the past that there must be some sort of natural limit to lifespan – a ceiling if you will – but so far there is no sign of it. So where will it end?
Dr Aubrey de Grey of the University of Cambridge has made a very bold claim. “I think the first person to live to 1,000 might be 60 already.” That’s not a typo. He really said 1,000. I sense disbelief amongst some readers. Well, he might not be correct but he’s certainly not a quack. He explains it in broad terms like this:
“Ageing is a physical phenomenon happening to our bodies, so at some point in the future, as medicine becomes more and more powerful, we will inevitably be able to address ageing just as effectively as we address many diseases today.”
He’s talking about ongoing scientific trials too, not just vague ideas.
Even leaving aside the idea of living to 1,000 we are still facing the wonderful prospect of living to 100 and beyond. As long as you remain healthy and solvent, what a privelege to experience so much.
When you review your long-term financial plans make sure you are realistic about how long you might live. It could well be much longer than you think. This has an important ramification.
There is a risk that you could run out of money in retirement. These days with sophisticated lifetime cash flow modelling this can be simulated quite effectively for multiple scenarios, allowing you to see under what circumstances you might run out of money. It could mean the wealth creation part of your life has to last longer, spending less or just adjusting your portfolio.
There has been very little noise around the Bank of England’s continuing Quantitative Easing (QE) programme. For whatever reason it seems a little beneath the media radar. In this article we’ll attempt to explain what’s actually happening.
Is inflation a good thing?
The government sets an inflation target for the BOE. This target is 2%. Why does anybody want inflation? I hear you ask. Most modern economists agree that modest inflation is required for sustainable economic growth. A steady erosion of the purchasing power of money encourages us to continue spending it now rather than later. It encourages continued growth. It also means that even if interest rates go to zero there is still a cost to hoarding cash – the nominal interest rate is effectively below zero.
The Bank tends to try to control inflation using interest rates. This is a very difficult thing to do as it involves a lot of guesswork about the future and the changes take many months to work. If inflation looks set to rise above target, then the Bank raises rates to slow spending and reduce inflation. Similarly, if inflation looks set to fall below 2%, it reduces Bank Rate to boost spending and inflation. In late 2008 spending in the UK slowed sharply so the Bank cut Bank Rate substantially to mitigate against the risk of inflation falling well below target further down the line. This didn’t work.
QE – just another tool?
So here’s where QE comes in. Bank Rate is already at an all-time low of 0.5%. The Bank has effectively run out of room to manoeuvre with interest rates and needs another tool to increase inflation. Now, in order for something to remain valuable it needs to remain scarce. By creating more money the Bank reduces the value of the money already in existence.
Right now the Bank is creating money and using it to buy government debt and a small amount of corporate debt. Here’s what they say:
“The sellers of the assets have more money so may go out and spend it. That will help to boost growth. Or they may buy other assets instead, such as shares or company bonds. That will push up the prices of those assets, making the people who own them, either directly or through their pension funds, better off. So they may go out and spend more… banks will find themselves holding more reserves. That might lead them to boost their lending to consumers and businesses.” Bank of England, QE Pamphlet, 2009.
Effects of QE and interest rates
Despite these brave words and the pretty pamphlet the Bank has kindly produced to help explain the situation, banks are repairing balance sheets rather than lending. Those consumers who can afford to repair their balance sheets are also doing so. It doesn’t seem like there’s a lot of extra consumption going on.
What we have seen is an enormous rally in risk assets like equities and this seems far removed from the real economy where companies are still suffering and unemployment is rising. So is the QE money just going into the stock market?
With interest rates at just 0.5% there’s less temptation to keep cash in the bank. It’s just not earning enough interest. Further, with the inflationary effects of QE eroding cash savings people are keen to be in hard assets rather than lose more of their buying power. The pound has been slipping against other major currencies recently too. Add into this mix a rising market that makes those not participating fear missing out on a bumper year and there’s even more pressure to get into the markets.
This is perhaps part of the reason why stock markets have done so well this year despite the clearly awful market conditions.
QE funds government spending
Paul Tostain of Bullionvault puts it like this “The British Government has no money to fund its massive public spending program and ongoing debt repayments, and so it has made itself the only recipient of all the money which it requires the Bank of England to print, and then lend at rock-bottom rates.” October 2009.
Under the gold standard, national governments had to regulate the issue of money by the discipline of convertibility into gold. In other words if you didn’t hold gold to back the money you couldn’t create the money.
And gold can’t just be magicked into existence: “The total amount of gold in the world is 160,000 tonnes and it is worth about $5 trillion. Formed into a cube it would have an edge of 20 metres and would not cover a tennis court. The size of the cube is growing slowly at about 11cm per year, as miners extract more gold from the Earth, and the annual rate of growth in the weight of the cube is 1.5%.” Paul Tostain, Bullionvault, 2009
With the barrier of the gold standard removed long ago there is a great temptation for those who can make money out of thin air to do so. And they often succumb to that temptation. But this debases the money the rest of us hold. They are effectively making more money for themselves at our expense.
Where does money come from?
So where does money normally come from? Well, without going right back to the origins of trade itself, let’s start with banks. They used to keep reserves of gold and give a credit note that could be exchanged for that gold. After a while they realised they didn’t need to hold all the gold since it would be unusual for all the people to want their gold back at once. So the reserves were reduced to a fraction of the total amount outstanding. Knwoing this, if customers lose confidence there can be a run on the bank – as we saw several times recently, starting with Northern Rock.
But there’s actually something a little more incredible going on in banks these days. When you borrow money from a bank you’re not really taking money from the deposits of other customers. And you’re not borrowing money from the bank either. The bank actually creates the money you want to borrow out of thin air. The very fact that you promise to repay the money is what supports its creation. This is a major reason why credit creation has been so vast in recent years.
I would argue, as many before me have, that bubbles would be much smaller and less damaging if credit were limited in the first place. Now back to QE…
QE as a form of theft?
The Chinese made a lot of noise about this earlier in the year. Not that they were particularly concerned about our own QE programme measured in the billions. Their concern is the US money creation running into the trillions. The Chinese are holding a lot of dollars and thus are understandably a little peeved that the americans are debasing their currency and eroding their debts.
Alan Greenspan wrote back in 1966 “In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.” Gold and Economic Freedom, 1966.
He was saying that creating new money to fund government spending is a sneaky way to take money from citizens. Taxation would be so much more overt and liable to reduce chances of re-election.
What happens when QE stops?
What happens to this extra money once inflation is on the up again? Well the Bank of England states that it will “put downward pressure on spending and inflation by raising Bank Rate and removing the extra money by selling the assets it previously purchased.” Sounds easy but nobody knows how or if it will work. We just don’t know what market forces will be in operation at the time or how they will interact. A reminder that economics is not as scientific as some would have you believe.
When QE ends and interest rates rise again this will remove the current stimulus to the stock market. Some say that the current rally is just another bubble. But really that’s just how markets operate and the only question is how long they last. The stock market valuations of companies are guesses about the future value of those companies, guesses about their future earnings. When they turn out to be wrong we get corrections and afterwards it all looks so very obvious.
None of this should be interpreted as a tip to time the market. Timing the market is unwise for most people. Don’t try to jump in and out of the market, rather be strict and disciplined with yourself and ensure that you have a balanced portfolio designed to meet your long-term goals.
When you realise where money comes from, that it is created from nothing, you might well wonder why we don’t just use the leaves on the trees instead.
There has been very little noise around the Bank of England’s continuing Quantitative Easing (QE) programme. For whatever reason it seems a little beneath the media radar. In this article we’ll attempt to explain what’s actually happening.
Is inflation a good thing?
The government sets an inflation target for the BOE. This target is 2%. Why does anybody want inflation? I hear you ask. Most modern economists agree that modest inflation is required for sustainable economic growth. A steady erosion of the purchasing power of money encourages us to continue spending it now rather than later. It encourages continued growth. It also means that even if interest rates go to zero there is still a cost to hoarding cash – the nominal interest rate is effectively below zero.
The Bank tends to try to control inflation using interest rates. This is a very difficult thing to do as it involves a lot of guesswork about the future and the changes take many months to work. If inflation looks set to rise above target, then the Bank raises rates to slow spending and reduce inflation. Similarly, if inflation looks set to fall below 2%, it reduces Bank Rate to boost spending and inflation. In late 2008 spending in the UK slowed sharply so the Bank cut Bank Rate substantially to mitigate against the risk of inflation falling well below target further down the line. This didn’t work.
QE – just another tool?
So here’s where QE comes in. Bank Rate is already at an all-time low of 0.5%. The Bank has effectively run out of room to manoeuvre with interest rates and needs another tool to increase inflation. Now, in order for something to remain valuable it needs to remain scarce. By creating more money the Bank reduces the value of the money already in existence.
Right now the Bank is creating money and using it to buy government debt and a small amount of corporate debt. Here’s what they say:
“The sellers of the assets have more money so may go out and spend it. That will help to boost growth. Or they may buy other assets instead, such as shares or company bonds. That will push up the prices of those assets, making the people who own them, either directly or through their pension funds, better off. So they may go out and spend more… banks will find themselves holding more reserves. That might lead them to boost their lending to consumers and businesses.”
Bank of England, QE Pamphlet, 2009.
Effects of QE and interest rates
Despite these brave words and the pretty pamphlet the Bank has kindly produced to help explain the situation, banks are repairing balance sheets rather than lending. Those consumers who can afford to repair their balance sheets are also doing so. It doesn’t seem like there’s a lot of extra consumption going on.
What we have seen is an enormous rally in risk assets like equities and this seems far removed from the real economy where companies are still suffering and unemployment is rising. So is the QE money just going into the stock market?
With interest rates at just 0.5% there’s less temptation to keep cash in the bank. It’s just not earning enough interest. Further, with the inflationary effects of QE eroding cash savings people are keen to be in hard assets rather than lose more of their buying power. The pound has been slipping against other major currencies recently too. Add into this mix a rising market that makes those not participating fear missing out on a bumper year and there’s even more pressure to get into the markets.
This is perhaps part of the reason why stock markets have done so well this year despite the clearly awful market conditions.
QE funds government spending
Paul Tostain of Bullionvault puts it like this “The British Government has no money to fund its massive public spending program and ongoing debt repayments, and so it has made itself the only recipient of all the money which it requires the Bank of England to print, and then lend at rock-bottom rates.” October 2009.
Under the gold standard, national governments had to regulate the issue of money by the discipline of convertibility into gold. In other words if you didn’t hold gold to back the money you couldn’t create the money.
And gold can’t just be magicked into existence:
“The total amount of gold in the world is 160,000 tonnes and it is worth about $5 trillion. Formed into a cube it would have an edge of 20 metres and would not cover a tennis court. The size of the cube is growing slowly at about 11cm per year, as miners extract more gold from the Earth, and the annual rate of growth in the weight of the cube is 1.5%.”
Paul Tostain, Bullionvault, 2009
With the barrier of the gold standard removed long ago there is a great temptation for those who can make money out of thin air to do so. And they often succumb to that temptation. But this debases the money the rest of us hold. They are effectively making more money for themselves at our expense.
Where does money come from?
So where does money normally come from? Well, without going right back to the origins of trade itself, let’s start with banks. They used to keep reserves of gold and give a credit note that could be exchanged for that gold. After a while they realised they didn’t need to hold all the gold since it would be unusual for all the people to want their gold back at once. So the reserves were reduced to a fraction of the total amount outstanding. Knwoing this, if customers lose confidence there can be a run on the bank – as we saw several times recently, starting with Northern Rock.
But there’s actually something a little more incredible going on in banks these days. When you borrow money from a bank you’re not really taking money from the deposits of other customers. And you’re not borrowing money from the bank either. The bank actually creates the money you want to borrow out of thin air. The very fact that you promise to repay the money is what supports its creation. This is a major reason why credit creation has been so vast in recent years.
I would argue, as many before me have, that bubbles would be much smaller and less damaging if credit were limited in the first place. Now back to QE…
QE as a form of theft?
The Chinese made a lot of noise about this earlier in the year. Not that they were particularly concerned about our own QE programme measured in the billions. Their concern is the US money creation running into the trillions. The Chinese are holding a lot of dollars and thus are understandably a little peeved that the americans are debasing their currency and eroding their debts.
Alan Greenspan wrote back in 1966:
“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.”
Gold and Economic Freedom, 1966.
He was saying that creating new money to fund government spending is a sneaky way to take money from citizens. Taxation would be so much more overt and liable to reduce chances of re-election.
What happens when QE stops?
What happens to this extra money once inflation is on the up again? Well the Bank of England states that it will “put downward pressure on spending and inflation by raising Bank Rate and removing the extra money by selling the assets it previously purchased.” Sounds easy but nobody knows how or if it will work. We just don’t know what market forces will be in operation at the time or how they will interact. A reminder that economics is not as scientific as some would have you believe.
When QE ends and interest rates rise again this will remove the current stimulus to the stock market. Some say that the current rally is just another bubble. But really that’s just how markets operate and the only question is how long they last. The stock market valuations of companies are guesses about the future value of those companies, guesses about their future earnings. When they turn out to be wrong we get corrections and afterwards it all looks so very obvious.
None of this should be interpreted as a tip to time the market. Timing the market is unwise for most people. Don’t try to jump in and out of the market, rather be strict and disciplined with yourself and ensure that you have a balanced portfolio designed to meet your long-term goals.
I don’t think it’s controversial to say that spending cuts are on the way. In mid-September the Institute of Fiscal Studies (IFS) issued a press release regarding leaked spending cut plans. They stated “This would be the tightest squeeze in spending on public services since the UK was negotiating its spending plans with the International Monetary Fund in the late 1970s. The Treasury has said that the second half of the tightening could come either from further tax increases or from further spending cuts.”
Does it matter who’s in charge?
And it won’t matter which political party is in power at the time. “They’re not wrong to be planning cuts, they’re wrong to try to cover up their plans for cuts,” said Mr Cameron.
Will it stunt the recovery?
The worry is that fiscal tightening reduces the amount of money in people’s pockets, potentially increases unemployment and thus reduces consumption and worsens the recession. This would be compounded if other nations, in better fiscal health than ours, continue to stimulate their economies.
Borrowing costs
The issue is complicated by the fact that if UK plc starts to look like a bad credit risk then, just like everybody else, it will have to pay more to borrow money. Even a small increase in borrowing costs can have a huge effect on the total debt accrued.
So it’s a balancing act between being seen to borrow responsibly and not starving the economy at the worst possible time.
The winter of our discontent?
Are you, like me, old enough to remember the winter of discontent? At the time I was eating lunch from a Star Wars lunch box so I didn’t feel quite the same impact it had on adults. But still, I remember the closed down shops, drab peeling paint and strikes just as vividly as the water shortages and sunshine in the summer of ‘76.
Political hot potato
No political party wants to preside over such a state of affairs and it appears Labour want to paper over the cracks for as long as possible. If the Conservatives got in it might make sense for them to get it over with as quickly as possible while still in a position to blame it on the previous government. They have been making some of the right noises but predictably they are light on the details.
In the meantime, those of us who remember the 70s will be making sure that they take precautions to guard against the coming cuts and increased taxes. One precaution is not taking on debt you can’t afford to service and there’s evidence that, for whatever reason, debt is reducing.
This July, personal borrowing fell by £600m, taking the total owed by individuals down to £1.457 trillion. This is the first time the total amount of personal debt in the UK has fallen since records began in 1993. This dip is not just because of reduced mortgage activity but also includes other forms of debt such as bank loans.
The Bank of England stated “Weak consumer credit is consistent with the decline in household consumption this year, and trends seen in the previous recession.” Trends in Lending, September 2009. So we’re spending less but are we saving more? According to the Building Societies Association balances held in savings accounts at building societies fell £202 million in August 2009. That’ll be a ‘no’ then.
Potential tax increases
If government wanted to raise more money rather than just cut spending it might decide to make a few changes to existing taxes:
“By way of illustration, increasing i) the standard rate of VAT, ii) the basic rate of income tax or iii) the main rates of National Insurance Contributions for employees and the self-employed by 1p would each raise roughly £4½ billion or 0.3% of national income in 2011–12. Increasing the higher 40p income tax rate by 1p would raise roughly £1.4 billion. Freezing the income tax personal allowance in cash terms in 2011–12, 2012–13 and 2013–14 would raise roughly £3.7 billion if retail price inflation evolves as the Treasury has assumed in its Budget 2009 forecasts.” IFA Briefing Note BN87, 2009.
All the indications are that both spending cuts and tax increases are coming our way. It is crucial that we make proper preparations for these difficult economic circumstances.
I don’t think it’s controversial to say that spending cuts are on the way. In mid-September the Institute of Fiscal Studies (IFS) issued a press release regarding leaked spending cut plans. They stated:
“This would be the tightest squeeze in spending on public services since the UK was negotiating its spending plans with the International Monetary Fund in the late 1970s. The Treasury has said that the second half of the tightening could come either from further tax increases or from further spending cuts.”
Where will the cuts be? Housing and transport look like softer targets than the NHS...
Where will the cuts be? Housing and transport look like softer targets than the NHS...
Does it matter who’s in charge?
And it won’t matter which political party is in power at the time. “They’re not wrong to be planning cuts, they’re wrong to try to cover up their plans for cuts,” said Mr Cameron.
Will it stunt the recovery?
The worry is that fiscal tightening reduces the amount of money in people’s pockets, potentially increases unemployment and thus reduces consumption and worsens the recession. This would be compounded if other nations, in better fiscal health than ours, continue to stimulate their economies.
Borrowing costs
The issue is complicated by the fact that if UK plc starts to look like a bad credit risk then, just like everybody else, it will have to pay more to borrow money. Even a small increase in borrowing costs can have a huge effect on the total debt accrued.
So it’s a balancing act between being seen to borrow responsibly and not starving the economy at the worst possible time.
The winter of our discontent?
Are you, like me, old enough to remember the winter of discontent? At the time I was eating lunch from a Star Wars lunch box so I didn’t feel quite the same impact it had on adults. But still, I remember the closed down shops, drab peeling paint and strikes just as vividly as the water shortages and sunshine in the summer of ‘76.
Political hot potato
No political party wants to preside over such a state of affairs and it appears Labour want to paper over the cracks for as long as possible. If the Conservatives got in it might make sense for them to get it over with as quickly as possible while still in a position to blame it on the previous government. They have been making the right noises but predictably they are light on the details.
In the meantime, those of us who remember the 70s will be making sure that they take precautions to guard against the coming cuts and increased taxes. One precaution is not taking on debt you can’t afford to service and there’s evidence that, for whatever reason, debt is reducing.
This July, personal borrowing fell by £600m, taking the total owed by individuals down to £1.457 trillion. This is the first time the total amount of personal debt in the UK has fallen since records began in 1993. This dip is not just because of reduced mortgage activity but also includes other forms of debt such as bank loans.
The Bank of England stated “Weak consumer credit is consistent with the decline in household consumption this year, and trends seen in the previous recession.” Trends in Lending, September 2009. So we’re spending less but are we saving more? According to the Building Societies Association balances held in savings accounts at building societies fell £202 million in August 2009. That’ll be a ‘no’ then.
Potential tax increases
If government wanted to raise more money rather than just cut spending it might decide to make a few changes to existing taxes:
“By way of illustration, increasing i) the standard rate of VAT, ii) the basic rate of income tax or iii) the main rates of National Insurance Contributions for employees and the self-employed by 1p would each raise roughly £4½ billion or 0.3% of national income in 2011–12. Increasing the higher 40p income tax rate by 1p would raise roughly £1.4 billion. Freezing the income tax personal allowance in cash terms in 2011–12, 2012–13 and 2013–14 would raise roughly £3.7 billion if retail price inflation evolves as the Treasury has assumed in its Budget 2009 forecasts.”
IFS Briefing Note BN87, 2009.
All the indications are that both spending cuts and tax increases are coming our way. It is crucial that we make proper preparations for these difficult economic circumstances.
This is more of a quick reminder than a post but it is important to mention it. A minimum pension age of 55 will apply by 6 April 2010. Until then it is age 50. Quite a jump. If you are 50 now but don’t take your pension until after April 2010 then you will have to wait until you are 55 to do so.
I’ve just seen an article in Mortgage Strategy that claims public trust in financial services is not at an all time low.
Nottingham University Business school has put together the latest Trust Index on behalf of the Financial Services Research Forum which measures how trusting consumers are of the industry.
It found that brokers and advisers received the highest rating on trust and trustworthiness at 81.67.
Shockingly, the banks are not quite at the bottom of the list as the life insurance companies and credit card companies just beat them to it. Perhaps some of the respondents didn’t understand the question.
I’m not at all surprised that brokers have come top of the list in financial services – that’s presumably because the individual develops a relationship with the adviser who works on their behalf whereas product providers are simply there to sell their products. In fact, I’m more surprised that the score for advisers wasn’t higher but I suppose if you were to ask people if they trust their mother you would not get 100% saying yes. On the other hand, ask people if they trust politicians and I’m fairly certain that the politician’s mother will be the only one saying yes!
It’s also interesting to see that financial services generally are certainly not at the bottom of the heap.
Overall the sector earned a trust rating of 75.02, and was deemed more trustworthy than institutions such as the National Health Service and the BBC.
To put it in perspective, the NHS and BBC scored 53 and 61 respectively.
The research also showed higher ratings for advisers who are independent than for those who are tied.
OK so your final salary pension is in trouble and you think it might end up under the Pension Protection Fund (PPF), how much compensation would you be owed if your pension actually went bust?
1. For individuals that have reached their scheme’s normal pension age or, irrespective of age, are either already in receipt of survivors’ pension or a pension on the grounds of ill health, the Pension Protection Fund will pay 100% level of compensation. There is a cap on this compensation which, at age 65, is £31,936. Unfortunately this means that people who have been in fairly senior positions or have a substantial benefit entitlement might lose some of their pension.
2. For the majority of people below their scheme’s normal pension age the Pension Protection Fund will pay 90% level of compensation. In broad terms and in normal circumstances, this means 90% of the pension an individual had accrued immediately before the assessment date plus revaluation in line with the increase in RPI between the assessment date and the commencement of compensation payments (subject to a maximum increase for the whole period calculated by assuming RPI rose by 5% each year). This compensation is subject to an overall cap which will be adjusted according to the age at which compensation comes into payment.
How much could you lose?
So, if you have not yet reached retirement age you would lose 10% of your pension at the very least. This is true even of somebody who is approaching age 65 at the time the assessment period commences. And those who are significantly below the retirement age will be capped at a lower rate according to a scale that is applied depending upon your age. So at age 50 the maximum compensation is £22,721 and at age 60 it is £26,032. If your scheme goes bust when you are 50 but you wait until you are 65 before retiring then your maximum compensation goes back up to 90% of the compensation a 65 year old would have received at the time.
High earners really need to be careful too. Those with substantially more benefit entitlement than the maximum compensation need to think carefully about the health of their pension scheme. Had RBS gone to the wall, rather than be propped up by the taxpayers, then Sir Fred Goodwin would have received compensation close to £21,000 (under last tax year’s compensation calculations).
Compensation is index linked to protect against inflation but this may be at a lower rate than your original scheme. No indexation is paid in respect of pensionable service prior to April 1997. Only compensation derived from pension service on or after 6 April 1997 will be increased in payment. Indexation follows RPI but is capped at 2.5% per annum.
If your defined benefit pension includes life assurance cover providing a lump sum this will be lost entirely as soon as the assessment period starts.
Transferring out is tricky after collapse
Once your pension scheme has entered the PPF assessment period there are more conditions attached to transferring out and indeed you might not be able to do so. Those considering a pension transfer, especially if their scheme or employer is in trouble, could request the transfer value now. Once received this is still no protection – the member has to accept the value in writing and have designated a scheme willing to accept that transfer value. Even then, the pension transfer would only go ahead if the PPF consider your transfer value corresponds with the compensation payable if you remained in the scheme operated by them. In other words you could be offered a lower transfer value. Once the scheme has been transferred to the PPF it is even more restrictive:
“…a member would not be entitled to a transfer payment unless pensionable service was ended by the start of the assessment period and at that time the member had less than 3 months’ pensionable service in the scheme.” Pension Protection Fund, 2009
Should I stay or should I go?
If your employer and their pension scheme are in poor shape then you really need to think hard about whether or not to transfer out. And don’t forget that you may have pension entitlements with ex-employers’ schemes too.
In fact the issue of whether or not to transfer out is a difficult one even if your scheme is in good shape and can only really be answered after considering your individual circumstances. Even if you are approaching retirement and are old enough to benefit from 100% protection of your pension, taking it in the form of defined benefit may not be the best option.
If you are single you could be needlessly paying for the facility to pass a portion of your pension onto your spouse or other survivors should you die. If you are in poor health then an impaired life annuity may deliver a greater income. If you want to maximize lump sum death benefits then drawdown might be a better option for you. The only thing you can be certain of is that leaving it to chance is not your best option.
If you joined a company recently then it is quite likely that your company pension is not defined benefit. They are going out of fashion fast. So it looks like there’s not much of a long-term future for Defined Benefit (DB) pensions but how secure are they anyway? We tend to think of DB pensions as having ‘guaranteed’ benefits but this is not true. The cost of these schemes can be a great burden on employers and if they go under your DB pension is in trouble and those benefits are anything but guaranteed. Corporate solvency is something of an issue at the moment so it’s under the spotlight but actually it is a longer-term issue.
Most defined benefit pensions schemes are in deficit
The Pension Protection Fund (PPF) publishes a monthly index of funding position of defined benefit pension schemes called the ‘PPF 7800’. Figures from the April 2009 update are, as expected, pretty grim:
- The total deficit of schemes in deficit in March 2009 is estimated to have worsened to £253.1 billion from £218.0 billion at the end of February 2009. In March 2008, the aggregate deficit of all schemes in deficit stood at £81.5 billion.
- In March 2009, the total surpluses of schemes in surplus fell to £11.1 billion from £13.3 billion at the end of February 2009. In March 2008, the total surplus of all schemes in surplus stood at £58.7 billion.
And that’s not all:
- The number of schemes in deficit in March 2009 stood at 6,637, up from 6,507 schemes in February 2009, and representing 90 per cent of total DB schemes in the sample.
When 90% of DB schemes are in deficit you have to reflect upon the long-term viability of such pensions. There have been great and continuing improvements in longevity; it’s difficult to estimate long-term inflation risks (exacerbated by increased longevity); and pension providers are not in control of wage inflation. There are just too many unknowns to accurately predict and plan for the liabilities. With a fully funded pension such as a Defined Contribution (DC) scheme there are no such issues for the pension provider. Of course you, the eventual pensioner, might run out of funds if you live too long.
It’s not all the fault of a bad pension structure though. It appears as if pension providers have followed inherently risky asset management strategies. During periods of high growth:
“rocketing asset values enabled benefit increases for employees and the introduction of cost-of-living adjustments for some retirees without triggering additional contributions by the sponsor. In fact, from 1995 to 2002, roughly 2/3 of the largest US plan sponsors made no cash contributions to their pensions due to accounting credits.”
The “Crisis” in Defined Benefit Corporate Pension Liabilities: Current Solutions and Future Prospects, Clark and Monk, 2006.
In other words, they took full advantage of the good times with no thought of what would happen when things inevitably turned for the worse. Scandalous but hardly news these days.
Is the Pension Protection Fund viable?
So it’s clear that DB pension schemes are in some trouble but right now the PPF will step in if your DB pension goes bust. Set up in 2005, it recently accepted it’s 100th scheme to be transferred into the PPF. There are currently 31,191 people either receiving PPF compensation or due to receive it when they retire. That doesn’t sound too bad but there are a further 290 schemes with 178,904 members in assessment periods right now. The assessment period takes a while (can be a year or two) and not all schemes will fit the criteria. Also some schemes can afford to secure benefits at, or above, PPF levels, and will be ‘bought out’ by a commercial insurer – and scheme members will generally receive benefits higher than PPF levels of compensation so there’s no need to transfer to the PPF.
The question is, how viable is the PPF given the influx of schemes and the expected higher rates of employer insolvency to come? The latest Annual Report and Accounts for the PPF states “Including provisions for schemes in the assessment period our deficit reduced from £609 million to £517 million”. So even if no more schemes default there is already a deficit of £517 million. Now, clearly not every scheme which is in deficit will go bust but remember there is a current deficit of over £250bn and the PPF currently has total assets of around £5.6bn and total liabilities of around £6bn. There is no contingency for a major pension scheme collapse.
There have been rumours of reducing compensation levels and the report states “The Board favours raising the levy towards the levy ceiling (should we need to in future) before considering use of its statutory powers to reduce benefits.” The report also states that the levy estimate for 2009/10 is £700m.
The PPF is funded through a range of sources: a Pension Protection Levy from eligible pension schemes; recoveries of money and other assets from insolvent employers of schemes they take on; taking on the assets of schemes that transfer to them; and returns on their own investments.
The PPF attempts to encourage final salary pension schemes to reduce their risks since the less risk they pose to the PPF, the less risk-based levy they are likely to pay. The Pension Protection Levy is made up of two elements:
- factors relating to the pension scheme itself such as how many members it has and how many of them are already retired and in receipt of benefits
- risk factors linked to the level of under-funding in the scheme and the risk of insolvency of the sponsoring employer. This accounts for at least 80% of the total charge.
Of course it’s not quite as simple as that. There are also considerations such as how much risk is posed by the investment strategy of an individual pension scheme. These measures are attempts to avoid penalising the safest pensions at the expense of the higher risk ones. It does raise a rather interesting point though – if the highest charges are applied to those at the greatest risk could that not contribute to their downfall? The PPF says not but then surely the increase in the levy is not punitive enough to force the issue. After all, they don’t want to force risky schemes into insolvency with a super high levy. That would not be politically astute.
Back around the time of the inception of the PPF it was claimed:
“the PPF is likely to face many years of low claims interspersed irregularly with periods of very large claims when prolonged weakness in equity markets coincide with widespread corporate insolvencies. We argue that it will not be possible to build up sufficient surpluses in the PPF in the good years to pay for the bad years. It will also be difficult to raise premiums sufficiently after a run of bad years to bring the PPF back to solvency. The Government will not be able to let the PPF default, so it will be underwritten by the Government whether the guarantee is recognised formally or not.”
Pension finance and economics seminar, 15 November 2004 David McCarthy, Anthony Neuberger.
The counter argument goes that if a large scheme came into the PPF, compensation would not be due to all its members at once as many would not actually be in retirement yet. Further, the PPF claims to have designed an investment strategy to reduce the risk of its investments performing badly at the same time as those of pension schemes. This liability-driven investment strategy is a very sensible precaution and many pension funds are driven more by asset growth than by liability – a mismatch whose effects will be felt keenly now. In planning investment, if one assumes that riskier assets such as equities will generate higher growth then you might think you need less of them to cover a future liability but actually the additional risk really means you ought to have more of them, not less. Despite this good sense, the amount invested by the PPF is trivial in comparison with some of the large DB scheme deficits out there.
Closing defined benefit company pensions can be difficult
There is no definitive answer to the defined benefit pension crisis but many employers would like to close their plan to new entrants and work the liability off over the long-term. However, that means the maturity of such plans accelerates without a stream of younger participants – meaning higher funding costs as participants approach retirement. Accelerating maturity also normally prompts a switch from riskier assets to lower-yielding safe assets meaning there is less chance to make up the shortfall through investment performance. Therefore closing schemes to new entrants can require firms to contribute more in order to return plans to funded levels – possible for some but not for all. Still, however painful this might be many more employers will be taking this step as it is still preferable to having the burden continue for decades to come.
Pension transfer
When employees are considering a pension transfer out of a DB scheme the providers have to calculate the cash equivalent transfer value. In other words, if this was a defined contribution pension, how much money would have to be in the pot to deliver the same level of benefits on retirement? These projections are connected to gilt yields which are currently very low. Therefore the amount of cash needed to reach the target level is currently higher – that’s an issue for the scheme and potentially a benefit for the recipient as it means a larger cash transfer value. Another potential benefit from pension transfer is that stock markets are now much lower so it could be argued that it’s a great time to buy. Equally, it could be argued that the stock market will fall further but what is certain is that prices are much lower than they were before so transferring now would deliver more stock for your money.
If you have a defined benefit pension it might be a good idea to write to the scheme trustees requesting funding details.
There was some research done in 2008 by the Association of British Insurers (ABI) which examined the likelihood of defined benefit pension schemes going bust. The report is called Coping with uncertainty and the importance of the sponsor’s covenant. Based on a hypothetical defined benefit scheme that matches the typical real life scheme, they concluded that an increase in longevity of five years could make it almost twice as likely to fold – although that’s only a change from 3% to about 5%. I’d like to know what effect an increase in longevity of 10 years would have. Or 20. I’d bet good money that it’s just not sustainable. The 2006 Purple Book published by the Pensions Regulator states that each extra year of longevity would add 3 – 4% to pension scheme liabilities.
I’d also like to see how that model looks now in light of the recent catastrophic market conditions. Their models made use of Monte Carlo simulations, where the model is run thousands of times rather than just once, which no doubt allowed a certain frequency for huge market corrections but were their assumptions extreme enough? Additionally, none of us expects such an event to happen right at the point when it hurts us most – just as we are about to retire. While the probability might be low, the impact if the worst happens can be crushing.
Defined benefit schemes are going out of fashion pretty quickly anyway – according to the Pensions Regulator there were around 7,500 schemes in 2007 but the proportion of schemes open continues to decline.
Scheme memberships for the Purple 2008 sample totalled 12.4 million. The largest category of scheme memberships is deferred (42 per cent). Thirty-six per cent are current pensioner memberships, and 22 per cent are members actively employed by the sponsor of their pension scheme.
The Pensions Regulator, Purple 2008
Defined Benefit pension scheme closures by year
Funds invested have recently been hit by the fall in the capital value of investments but also these schemes offer pensions for life to people who are now living much longer than was assumed when the schemes were started. Many schemes are now running a deficit but this is not a good time for companies to make additional contributions – they may be fighting for their own survival.
Corporate insolvencies for the economy as a whole rose in the second and third quarters of 2008 when they were 26 per cent higher than a year earlier. The insolvency rate is likely to rise significantly in 2009 given the economic downturn.
The Pensions Regulator, Purple 2008
The economic climate is proving too tough for defined benefit pension schemes and there can be little doubt that more will fail.
Many employers are encouraging their employees to leave final salary schemes. They no longer want the liability. Many pensions mis-selling scandals came about as a result of unscrupulous advisers encouraging employees to transfer out of their lucrative defined benefit schemes into private pensions where juicy commissions could be earned. Needless to say, this was generally not a wise thing to do. Now the employers themselves are trying to tempt you away with a juicy carrot. They would rather pay out a lump sum now than bear the risk that their final-salary pension plan will not meet its future liabilities. With personal pensions, it is you the individual who bears that risk.
The recent, and presumably ongoing, quantitative easing has forced gilt prices up and yields down. This leads to increased deficits in defined benefit schemes.
A 0.1 per cent (10 basis point) reduction or increase in nominal gilt yields increases or reduces scheme funding by around £15 billion; a 2.5 per cent increase or decrease in the market value of equities will increase or reduce scheme funding by £11 billion.
The Pensions Regulator, Purple 2008
The lump sums offered by employers to leave their defined benefit schemes have gone up recently because returns, as measured by gilt yields, have gone down – meaning employers need to give workers more to produce the same future benefits.
So what happens when a defined benefit pension scheme goes bust? For now, in steps the Pension Protection Fund. I’ll write about that next time.
