Investing in retirement
The $15 trillion question
Many retired people don’t have proper pensions any more. The financial-services industry may end up cashing in
Jul 12th 2014
WHAT to do with your money when you retire? It is a question that worries many workers in their late 50s and early 60s as they prepare to forsake the daily commute. And it is a question that fascinates the financial-services industry, which would love to get its hands on people’s retirement pots.
The question is all the more urgent because pensions as people used to know them are disappearing in the private sector. The traditional defined-benefit (DB) pension was paid by a company on the basis of an employee’s length of service and final salary.
Companies are retreating from such promises because of the cost; investment returns have been poor and people are living longer. Instead, staff are being offered defined-contribution (DC) plans, in which both employers and employees put money into a pot.
A pot is not a pension. It can be turned into one by buying an annuity, an income that will last until death. But outside Britain, few exercise this option. And the British government is in the process of abolishing the requirement to turn a DC pot into an annuity. Folk will be free to use their money as they see fit when they retire.
The sums are huge. According to TowersWatson, an actuarial consultant, 58% of all American pension assets are in DC schemes. In Australia, the proportion is 84%. In 13 countries studied, DC assets comprise 47% of the total, or around $15 trillion.
Some people may celebrate retirement by blowing their money on a world cruise or a sports car and then rely on the state to care for them. But the vast majority will be more responsible and will try to convert their pots into an income. This will involve a bunch of difficult questions, the answers to most of which are not knowable in advance, and on which they will struggle to get independent advice (many intermediaries get paid more for selling higher-charging products).
How long will people live? How much will they need to set aside to cover the cost of nursing care? What will be the rate of inflation? What is the outlook for investment returns?
The finance industry has a whole range of products for retirement, all of which involve a certain degree of trade-offs. For example, most retired people would like some certainty about their future income. But that certainty comes at a cost; financial-services companies can provide it only by investing in assets with lowish risks and correspondingly low returns. Britons complain about poor annuity rates, but those rates seem disappointing because bond yields are close to historic lows.
A lot of retirement products accordingly invest in riskier assets, so as to offer a higher return. But that can be dangerous when stockmarkets tank. One of the most popular American schemes—which earlier this year had around $650 billion of assets—is the target-date fund (see chart): workers choose a fund with a date close to their expected last year of employment. Such funds follow a “glide path”, taking less risk as the retirement date approaches. But this method offered little comfort in 2008, when Lehman Brothers collapsed: the average target-date fund by fell 23%, according to Morningstar, a research firm.
Nevertheless, target-date funds may be better than the alternatives. A study by Vanguard, a fund manager, has found that within five years of stopping work most Americans transfer their assets from their employers’ DC plans into individual retirement accounts (IRAs). These are often recommended by brokers who are paid well for selling them. But the clients end up paying more for advice and investing in funds with higher fees than if they had stayed put. Mercer, a benefits consultant, says that fees on large corporate DC plans are 20-50% lower than those on IRA accounts.
For those who choose to manage their own money in retirement, what are their options? The nearest equivalent to target-date funds fall into two categories; balanced (or managed) funds and “absolute return” funds. Both attempt to offer a steady return by investing in a wide range of assets, or by the use of derivatives to reduce risk. Neither is specifically aimed at the retired but both have an obvious appeal to older people.
But even here, balancing risk and return has been difficult; since early 2007, just as the financial crisis was beginning, the average British absolute return fund has barely kept pace with inflation, according to FE Analytics, another research firm. The snag is that people pick funds on the basis of past returns, only to find that their choices have a risky mix of assets and fall sharply at the least convenient moment.
Another problem is the level of income (or drawdown) to take from the pot. With an annuity, the income is certain. But other funds offer no such guarantees and may offer only a modest income which investors have to top up with regular withdrawals. Investors who withdraw money too quickly (or are too pessimistic about their lifespan) risk running out of money in their 80s. The issue is made more complex by regulations and tax laws which affect the pace at which withdrawals can be made.
Variable annuities are an American product that aim to give both returns and certainty: when the pot is being filled up, the schemes invest in risky assets, but on retirement, the investor can opt for a set income. But these products have been criticised for inflexibility and high fees. FINRA, an American securities-industry regulator, says that investors “should be aware of their restrictive features, understand that substantial taxes and charges may apply if [they] withdraw [their] money early, and guard against fear-inducing sales tactics.”
Britons used to buy products that had similar features: “with profits” policies, which invested in a diversified pool of assets and paid bonuses each year. Like the biblical Joseph, the policies kept back profits in the fat years in order to maintain bonuses in thin ones. But high fees and disappointing returns have dented their popularity. Although the design of with-profits funds looks ideal for retirement, few choose them any more.
A radical alternative, used in the Netherlands and recently promoted by the British government, is the “collective DC” scheme. Under DB plans, all the investment risk fell on the employer; in normal DC plans, it falls on the employee. Collective DC schemes allow risks to be shared: instead of an individual pot, members receive a regular income from the common pool, although that can be cut if investment returns are poor.
It seems unlikely that collective DC schemes will catch on in Britain or America, where the freedom to control their own retirement pot is so appealing to workers. But the danger is that this freedom translates into a licence to print money for the financial industry. What people need is truly disinterested advice, so they can pick inexpensive, diversified products to keep them in their old age.