In September insurance group Aviva released a worrying report on Europe’s pension gap. In addition to estimating a EUR 1.9 trillion difference between what Europeans have saved and what they will need in order to live comfortably after retirement, the report said Brits are the least financially prepared for old age. The average UK citizen needs to save over £10,000 per year, the report found, meaning that those approaching retirement have a lot of catching up to do and less time to do it in compared to those just starting their careers. This figure is based on the OECD’s recommendation that we need to aim for a 70% income replacement rate—a statistic that is itself a topic of debate (read Morningstar’s John Rekenthaler on ‘The 80% Myth’). With upcoming UK pension reform meaning every working person will be enrolled in a private pension scheme in few years’ time, we spoke to John Lawson, Head of Pension Policy for Standard Life, to get a clearer picture of the impact of planned changes, what the investment industry can do to help, and the potential for asset bubbles.
Aviva’s recent report estimates that the average UK citizen needs to save about £10,000 per year in order to retire comfortably. Obviously, that figure differs from age group to age group, but does it broadly correspond to your view?
I think there are two major variables in here. One of them is replacement rate. I think 70% is probably about fair, and that would be a combination between state pensions and private pensions. Having said that, state pensions for someone on average earnings will probably replace about 40% of their earnings. My view is that we don’t need to save anywhere near £10,000 per year to reach the 70% limit.
For instance, if we take somebody on £24,000 a year, the state pension for them is just over £5,000 per year. And state second pension is probably another £5,000 per year. So they are going to get £10,000 from the state. To get a 70% replacement rate, they need roughly another £6,800 from a private pension. So if you assume you live 25 years after retirement and work for 40 years, the average earner will have to save £4,250 per year.
The other variable is when you retire. Instead of retiring at 65, you could retire at 70. In that case, your state pension will increase by 50% to £15,000, and you would only need to provide £1,800 from your own means. That means you’d need to save only about £45,000 over your lifetime, or just over £1,000 per year without investments.
So I think realistically, looking to the future, people will have to retire at later ages. I think that is one of the major solutions. And that’s not unrealistic. Men are living about two years extra for every decade that goes by; women 1.5 years. We’ve kept state pension age the same for ages, without recognising this increase in life expectancy, which simply means that the state and the private sector has had to pay pensions for much longer compared to 30 years ago.
Beyond potential changes of retirement age, do you still see a problem with investor education and pension awareness at the moment?
I think the average person does not understand what the shortfall is. I also think we have to be realistic and allow people themselves to work out how much they need to save, using fairly simple tools, allowing each individual to play around with the different variables.
Are you then saying that these same investors, who are currently undersaving, should be able to predict their retirement funds?
Yes, there is a massive gap in knowledge between the population and their pensions, and it is something the government and the pensions industry need to do more on. We have the new Consumer Financial Education body, which has been set up, which I think has a huge role to play here. The government could do more as well to introduce learning, for instance right from school age. Money is such an important and useful subject that it needs to be part of the national curriculum from primary school.
It is not really that complicated, to be honest. When you think about funding your pension all you need to work out is how much you are going to need in the future, then you work out how much you’ve already got, either saved personally or how much you are going to get from the state pensions, and then you know what your gap is…and you can start funding your own gap. That process will also tell you whether it is feasible for you to fund that gap. If you earn £24,000 per year and the cost of funding that gap is £10,000 per year, you can immediately see for you, hang on a minute, that’s not feasible, I am going to have to retire later than planned. So it becomes immediately obvious to people. But I think you are right that there is a big leap in the knowledge and that we need to encourage people.
Something that might make people apprehensive is that savings alone aren't necessarily enough for a comfortable retirement. What would be the key strategies and points for first-time investors?
I do think that is probably one of the most complicated things about pensions. I think people understand cash fairly well--they understand cash deposits--and a pension isn’t any different from that. You can have cash within your pension fund if you want cash, so you can view it as a cash deposit that you can’t get your hands on until you are 55 years old.
The complication with pensions is that you can invest in all these other asset classes. Having said that, a lot of people in the UK own shares through privatisations of public companies and through employers’ share option schemes, so people should already have an idea of what an equity is. So we might not being giving people enough credit.
I think the language we use as an industry is also unhelpful. We use all these complex terms, and they are not really complex. Take for example fixed interest securities funds: Essentially all you do is take your savings and lend it to the government or to private companies. So the concept is that you lend money to someone else and they pay you a rate of interest, and that for most people is not a difficult thing to get their heads around.
I think the concepts of cash, equity, or bonds are fairly straightforward. And the final asset class, property, should be pretty straightforward as well. The difference is that people invest in residential property, and pension schemes invest in commercial and industrial property.
The underlying asset classes are quite easy to explain, and something that people should feel comfortable with. Each of these asset classes exhibits a different level of risk, and that is where individual preferences come in. Personally I am quite comfortable with taking quite a lot of equity risk: I am prepared to see the value of my investments fall by 30% overnight in the knowledge that it may also gain by 30%. Some people only want to see the value of their money go up in one direction, even if that direction is only 1% or 2% per year.
Trying to get people to understand the nature of underlying assets and the risks they exhibit is a good next step. Risk is another variable in your savings output, because the higher the risk you are prepared to take, the higher the possible returns, and the lower the money you need to save in theory.
We also need a simple labelling system in the industry. All these tens of thousands of funds should come with a label saying “this is what’s in it,” so the customer can see what is the right mix for him.
Regarding pension reforms coming up in 2012, do you think that they will create the necessary incentive for focussing on investor education?
Absolutely. I think automatic enrolment is a fantastic thing, because then as a nation we will all be in a pension scheme. When everyone has to make a decision, then a lot of questions are going to come up and effectively create a national conversation.
Looking at the same reforms from the asset management perspective, will the increase of assets under management present a challenge?
I think you can get bubbles where the money available exceeds the true value of assets available to buy. You need to have a scarcity of assets for this to happen. Let’s say you have 1,000 units of cash, equity, bonds and property and £10,000 to invest in them. If we suddenly have £20,000 to invest in these same underlying assets then the price of them would double. Does that mean that the price of them is fair, or is it a false market price, because this £20,000 has nowhere else to go?
I think that is a danger, and it is a danger particularly with index trackers because such funds will invest in things like the 100 top shares in the UK come what may. There is a danger of shares being overbought, and there can be a distortion in the investment market for that reason. That is something that default funds, and pensions funds, and the likes of NEST [National Employment Savings Trust] will have to think about carefully. Pouring money into a small number of companies creates a bubble. I think there is already a bubble: You can see when the LSE promotes companies to the top 100 how their share price jumps, and for the companies that are relegated, the share price falls – absolutely the results of trackers.
The other bubble we have in the UK at the moment is in index-linked government debt. Pension schemes--particularly defined benefit pension schemes--have to pay pensions that increase every year in line with inflation, and the only assets you can use to do that are index-linked government bonds, hence the reason why these are overbought.
What I would like to see is greater encouragement of pension money used to fund new assets. By new assets I mean things like infrastructure; we are very bad at using pension fund assets to invest in infrastructure in the UK. Roads, bridges, railways, wind farms and other renewables – that’s infrastructure from which pension funds can get a stable return if it is properly structured. Another one might be affordable housing for essential workers, particularly in the Southeast of England.
So I don’t think that there is a lack of stock of assets. I think that the problem might be that we are trying to force all that money into what’s already there. A huge demand to invest in any one company does not necessarily mean that the company is worth any more than the day before, whereas if you build 1,000 new houses, then you’ve got 1,000 new houses. Investing new money in start-up companies is again a way to create new wealth.
I think there are a lot of opportunities to use pension money more wisely, rather than to force it all into the top 100 companies.
What prevents asset managers from exploring these opportunities currently?
I think they basically look at what is already there, and they don’t see themselves as part of the process of creating new assets, so they rely upon entrepreneurs to create companies and upon governments--particularly in this country--to build infrastructure. That is not true in other parts of the world. In the Far East, in particular, there is a lot of investment in infrastructure by pension funds.
What needs to happen in this country is for the government to recognise that and to try and facilitate. If a fund manager today wants to invest in affordable housing, say in Southeast England, they have to find a property manager, get the local authority to release the land, etc. It becomes too difficult. So I guess they take the easier route. But if the government is serious about encouraging investment in affordable housing, infrastructure, or renewables, it could do a lot to coordinate and even provide the initial capital for development.
Are there incentives to go in that direction from this government?
I think conversations are beginning to happen, yes, but it will take a couple of years. There is a huge stock of current assets under management, in the region of £1.7 trillion, which could be used to develop things that this country needs.
Going forward, is there still a high mountain to climb? Are you optimistic?
I think that there is a long way to go. I think what we need is a plan. If we continue wandering in the dark and hoping that it will happen, then almost certainly it will not happen. I think we need to plan where we are going, and I think the government has got a big role to play in coordinating that plan. I think 2012 is a fantastic opportunity to kick-start that interest in pensions from the population. I would like to see better coordination. I think the government is the natural leader on this--they ought to be--but I am sure we will find a lot of willing participants in the industry to help them put that vision forward.
