FOOL'S EYE VIEW
Pensions: The Scary Numbers

By Stephen Bland (TMFPyad)
May 14, 2001

I have just read that the average wage in this country is about £21,000 per year. That sounds somewhat higher than anecdotal evidence suggests to me, given the armies of people earning much less than that in jobs like catering, cleaning and so on. Anyway, for this purpose let's assume that it is correct. Building on that, let's  also assume that you would like a pension when you retire of a similar sum, and in real terms too. That means whatever the rate of inflation, the pension you want has the same purchasing power as £21,000 pre-tax has today.

As anyone who has looked at personal pension and stakeholder schemes will be aware, these work by the contributor saving up through tax-relieved contributions which are invested in some way, usually in the stock market, to produce a fund at the end of the period. That fund is then used to purchase an annuity which provides an income for the life of the investor, but the capital is surrendered. There are various types of annuity that can be taken and in addition up to 25% of the fund can be withdrawn as a tax-free lump sum, the annuity itself being wholly subject to income tax.

Fairly straightforward, really. There are many criticisms of this system, which usually attack on two fronts. The primary objection is the compulsory rule that 75% of the fund has to be used to buy an annuity, even though the investor may have liked to invest differently. Another criticism is the awful performance that many personal pension schemes have produced in the past, resulting from high charges levied by the insurance companies that run them combined with poorly performing funds in which the money is invested.

This is not my point today, however; these criticisms are well known. You either accept pension plans with tax relief and all the strings, or you go it alone without tax relief and enjoy absolute freedom to invest and retain your capital. Whatever rings your bell. Because of the tax relief, it has to be remembered that other things being equal, particularly assuming the same investments, a pension fund will be some 67% higher for a 40% taxpayer than a fund invested outside a pension plan, perhaps in ISAs or directly. A bit less, in fact, because of the higher charges in pension plans.

Here is the scary bit. A £21,000 pa inflation-linked annuity at current rates would return about 5% of the fund invested for someone about 65. This means that the fund must be around £420,000. Remember, as I said at the start, we are talking here about a real £21,000 and therefore a real £420,000, not merely absolute sums. If inflation averages 4% over the next 25 years, the absolute value of the £420,000 fund required will be about £1,120,000.

(There are two important points to be made here. First, a 25-year time horizon means that our pensioner is starting from scratch at the age of 40 -- many people will start earlier than that (but then many won't). On the other hand, these numbers take no account of charges made by the pension provider or the chance of underperformance of the fund.)

The long term real return of the UK stock market is around 8% pa historically. I know that may not repeat in future but that is all we have to go on. This means that with inflation at the above 4% the absolute (or "nominal") return is 12%. Crunching these figures in my HP calculator tells me that for someone contributing over 25 years, to produce £1,120,000 at 12% pa requires monthly contributions of £658 gross. A pension plan would grant tax relief at source and via the tax return to give basic rate taxpayers a net cost of £513 per month.

I am suggesting that especially where the taxpayer contributes alone, that is without an employer paying in as well, this is almost an impossible target to meet. How many people will be able to find that sum of money every month? Only a small minority I expect.

I see a lot people with pension plans maturing now, primarily the self-employed who had to make all the contributions themselves. Almost without exception the returns are poor and the investors are shocked by how poor they are. There is no way that they can enjoy much of a life on the income produced. There are two main reasons for this. Firstly, they never contributed anywhere near enough, and secondly, the often awful performance by the insurance companies' funds. The latter criticism has been resolved to some extent by the new lower cost stakeholder pension plans, following which a number of companies have said they will cut their charges on personal pensions as well. Self invested personal pensions (SIPPs) are also more popular now, for those larger investors who possess the investment skill to make their own decisions.

But the hard and scary fact remains that to generate a large enough fund on which to receive even the average wage, is always going to be beyond the majority. To stand a chance of getting there you have to start very young and contribute big. And how many nineteen-year-olds are interested in pension plans? And even if they are, and have forty years to do it, to produce the necessary real £21,000 income (given the assumptions above) requires monthly payments of £160 if they are basic rate taxpayers, as is likely to be the case. Again, a near-impossibility for most people that age.

As many readers will know, I am not a great believer in official pension plans. The alternative is to save without tax relief in a non-pension "pension plan" of your own. Using the above example, though, this requires though that you contribute the full £658 per month for 25 years (no tax relief) to achieve your totally unencumbered £1,120,000. Far preferable, if you can afford it. Almost nobody will be able to: far fewer, of course, than even that minority who can afford the tax relieved pension plan version.

More: The Motley Fool's Pension Centre