FOOL'S EYE VIEW
The Ideal Pension - A Fool's Paradise?

By Stephen Bland (TMFPyad)
July 9, 2001

What is an ideal pension? I guess the answer is one that provides an income sufficient to enable the individual to live in the manner which they desire, from a financial point of view. And this will depend upon whether you prefer to live in a cardboard box or a palace.

First, though, let's knock on the head this idea much beloved of many advisers that you need less income in retirement. Does it really make sense that the day before you retire you are happy earning x, and the day after you are just as happy with 2/3x or less? Unlikely, unless perhaps the income you were earning immediately prior to retirement was way too much for you -- and how many people can honestly state that they earn too much?

I never understood this concept that you need less money in retirement. If anything you might need more to live out all those expensive unfulfilled dreams you promised yourself, like travel the world, learn to fly a plane or whatever. And if you suffer from poor health and don't have private health insurance, then you will need the money to go private and pay for it yourself if you want to beat NHS queues and get more dignified treatment.

There perhaps was a time when all you did after retirement was potter around in the garden until you had the decency to quietly drop dead after a short period. That's all gone now and retired people are often amongst the most active in society, and so they should be. They have the time, and if they are lucky they have the health, to go out and live it up. All they need is the money. The question is whether a pension plan is likely to provide it for them.

The short answer is no. Hence the Fool's paradise part of the title. The old style defined benefit plans provided by many employers used to guarantee 2/3 of final salary for those staff employed for a long enough period.  I don't know why 2/3 but at least it was there. Many employers are now switching to defined contribution personal pension style schemes which guarantee you nothing, let alone 2/3 of final salary. The reason, of course, is that these are cheaper.

Worse, many employed people have no pension scheme at all, particularly those working for small businesses, and the same goes for many self-employed people. Of those that do have some kind of scheme, the majority are completely inadequate, will not go anywhere near meeting even the 2/3 target and will provide only a miserable pittance when the time comes.

So we have to conclude that in general a large number of people, possibly the majority, have either no pension arrangements at all, or a wholly inadequate scheme. There is a good reason for this, at least amongst those that have to arrange their own contributions and do not have the benefit of an employer making payments as well. It is this. They cannot afford to make sufficient payments, even if they were made aware of how much they would need to contribute to have a good pension.

To get a decent pension that might get somewhere approaching your final salary or profits requires that you start as soon as you commence work, say early twenties for a graduate, and pay in at least 10% of your income until you are 60 if that is when you wish to draw. Even then, because there are obvious risks involved in the performance achieved by the fund, there is no guarantee of how much you will get. If you don't start until you are over thirty, you cannot possibly achieve through normal pension schemes a sufficiently large fund to provide a pension anywhere near your final salary or profits without making payments that are a massive percentage of your income, maybe 15-20%.

People usually live up to their incomes. They will tend to increase their living standards as they prosper. Most will not be able to contribute the huge sums required to fund adequately a pension plan if they have to do this from their own resources. Plus few tend to think of pensions when they are twenty or so anyway. Understandably, it all seems incredibly distant and irrelevant.

What about the Government? Well, seventy quid a week or so is the current basic state pension and for that you will have to wait until you are 65. Can't go round the world too many times or fly many planes on that.

In practice a number of people will have other resources to provide an income when they retire. The usual additional sources are inherited money and selling their property to buy a cheaper one. So this group is not totally dependent upon any pension schemes, a fact for which they should be truly grateful.

For those that are not so fortunate, the future is pretty grim I'd say, particularly for the group that have to self-fund their schemes. Only a very small minority of the latter are contributing anywhere near enough, for long enough, to get a comfortable retirement income. The rest cannot afford it or don't care.

A further problem with many schemes is the poor return. I see personally the results of many insurance company schemes now maturing for self-employed people. The misery they create for those investors who believed that they would have a decent income and have only a travesty of that for which they had hoped is very sad when you observe it at close hand.

Investors in personal pensions, especially the self-funded, must understand that they are taking two huge gambles, first on the insurance company's fund performance and second on volatile annuity rates. In the past these combined gambles have frequently failed to pay off sufficiently well.

What is the answer? Sad to say there is no easy answer for most people except start early and put in as much as you can afford, minimum 10% if you are young and much more if you are older. How many will do so or can afford to? When looking at the options for funds, avoid the managed fund. Stick with either an equity income fund or an index fund.

Even better, for those with the right personality and a little more adventure, avoid pension plans altogether and consider trying to build up a high yield blue chip equity portfolio using ISAs to the limit and then investing directly. Our High Yield Portfolio board has a lot of ideas on this strategy. No tax relief, but likely far better performance than any pension fund plus you keep the capital to produce the income the way you want it when the time comes.

More: The Motley Fool's Pension Centre