Scottish Widows has just released the results of this year’s pension survey. The survey aims to find out how much people are tucking away for old age. And this year it makes for grim reading.
The figures show that ‘adequate’ pension contributions have fallen – down 8% over the last few years and a whopping 5% this year alone.
Now bearing in mind we’re all told that we’re supposed to be saving more, not less, this looks ominous. And put together with the fact that the survey also reveals expectations of what people will get from their pensions are rising, then clearly something’s amiss.
Today I want to give some of my observations as to what’s going on. I have to be careful: I’m not giving advice on how you should save for your pension, but I do think there are good reasons why investors are paring back their contributions.
Investors have become wary of the stock market
Financial markets are all about perception, and economics is all about incentives. If we look at the two together, then I think we’ll see why contributions are slipping.
Perception is everything in the markets. If investors think the market may fall, then they don’t put money in. In fact, fear is likely to drive a primitive selling instinct.
Let’s take a look at the FTSE 100 over the last 25 years or so. I’ll show you what I mean.
FTSE 100: 1985 to date
Source: Yahoo Finance
I’ve split the chart into five-year periods so we can make sense of it. As you can see, for anyone in the markets back in 1985 (and I’d just started), things were 'Great, Great, Great' – three five year blocks that, on the whole, served investors very well indeed.
The perception was that the markets go up, up and away – peaking just as the millennium approached.
And so began the next era of not-so-great results. Today, investors are much more familiar with the recent couple of five-year blocks that I’ve dubbed ‘Oops’ periods.
Perceptions have turned. A one-off dotcom bust can be excused, but a sub-prime rout, followed by what looks like a banking crisis (now brewing in Europe) just looks careless.
Risks are up and perceived returns down. And there’s nothing like uncertainty to drive away investors.
Fewer parents now preach “Put your money in stocks – and save up a good pension”. I suspect many parents now say: “Put your money in bricks and mortar.”
Perceptions may have changed. And that’s one explanation for declining contributions. But it’s not as worrying as the hard economics of it all – remember, the incentives?
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Incentives are disappearing
Until recently investors just handed over their cash and waited for the returns to come in. But now that they’re not seeing those returns, they are starting to look a lot closer at the whole business. And one vice in particular is standing out: fees.
Suddenly investors are appalled at how much money is being skimmed off by the fund management industry. And they are right to be: the ‘odd percent’ fees here or there really rack up over the years.
But there’s something even more pernicious eating away at the incentive to save, and that is the return on government bonds.
The way a private pension (money purchase) works is a bit like this: you pay your money in and the funds are invested in the markets. When the time comes to cash in (drawdown), you buy an insurance policy that pays you an income until you die (an annuity).
But anyone with their eye on the ball realises that these annuities pay naff all. I mean, to get an index linked £3,000 a year, (ie where the income goes up with inflation) a 65 year-old will need to put in about £100,000. I’ll let you work out yourself how much that means you’ll need to retire!
Many people are probably thinking: “Crikey, I can do better than that outside the pensions system”.
And the reason annuity rates are so low is down to the mega-low returns on government bonds. Until that changes, investors will be put off by pensions.
Now, the other great incentive for pensions has always been the tax break.
But then again for most people, these breaks are fading. Let me show you why it can be right to delay paying into a pension.
If you’re not in the higher rate tax band (£34,371) - and most people aren’t - you’ll only get 20% relief on what you pay in. That’s certainly not as enticing as an immediate 40% or more for the higher-rate payers.
And once tucked away the likelihood is you won’t be reacquainted with this cash for a long, long time. And even when you are, you’ll get taxed as you drawdown your income anyway. Who knows, by that time you may even get taxed more as the money comes out than you got in relief on the way in.
So facing the need to pay off debt, raise a house deposit, or maybe even start a family, the disincentive to lock away cash is clear - even from a tax perspective.
Given the way the tax system works, every year more and more workers are caught in the higher-rate tax band. And arguably that’s when you should start pumping cash into a pension.
Before hitting the 40% rate, it may make sense to pay down debt and put any left-overs into an Isa. When you reach the higher rate, you switch the Isa into a pension and claim tax relief on it.
Buy-to-letters may get tripped up
Incentives for saving into a pension are eroding (especially for the young). Meanwhile, the perception of what financial markets can deliver is evaporating.
Frankly, it’s little wonder that young and old are turning their backs on pensions and the finance industry. Incidentally, the survey says that pension commitments are disappearing across the board – young and old, rich or poor.
Today, investors have more faith in bricks & mortar. Now, property has its own issues, namely leverage (high mortgages). And though I can see where savers are coming from, I suspect that many have over-committed. Putting say £50k into a buy-to-let may be fine... but it’s the £200k loan that may prove problematic at some point.
Though I’m a big fan of tangible asset investing, I have to say the fact that so many investors are moving away from financial investments is starting to bring out the contrarian investor in me. That doesn’t mean I’m piling all-in on stocks. But I do see a point in the next few years where stocks will look extremely cheap, and housing expensive.
What do you think? Leave a comment below.
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