In this week's podcast, we’re going to be covering two hot topics: collective pensions and eurozone interest rates. Every now and then we’ll cover a couple of subjects in one session when things are worthy of note and timely, like these two.
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This session will be split neatly in two, each a kind of mini-session. We’ll look at what you need to know for both subjects. There are no clear action points this week, just information only, but if you have any questions as a result of it, leave them below.
Let’s set the scene for talking about collective pensions by remembering what pensions look like in the UK currently. Generally people are either a member of a defined benefit scheme or a defined contribution scheme.
Defined benefit schemes are provided by employers and the amount of income you get in retirement is known in advance because it is a function of the length of service in the scheme and your final salary, which is defined in a few different ways. So you know that if you work for so many years, you get a known percentage of your income in a retirement.
All the risk of these schemes is with the employer. They provide a guarantee, they’ve got to honour it. And that’s why these schemes are disappearing fast. They worked fine in the high risk, high return days of the 80s and 90s, but in recent years due to lower returns, greater market volatility and with people living longer, the cost of providing those guarantees is prohibitive.
The vast majority of pensions these days then are defined contribution pensions, either with employers or in private pensions like SIPPs and stakeholders. Here, what you get in pension income at the end is entirely down to how much you put in, how the fund performs and what the charges are. A pension investor takes all the risk on themselves.
The idea behind collective pensions
…is that these risks can be shared, and the costs spread. In the same way that diversifying a portfolio across lots of different investments reduces risk, spreading the costs and investment returns across many members of the scheme should make for a more equitable outcome for all.
A key factor of this risk sharing is explained in this extract from an RSA paper on the subject from January 2013.
“What is true for managing investment assets is also true for managing pension liabilities. Imagine two young people about to save for their pension. They intend to retire at 65, and expect to live, on average, until they are 80. But they know it is likely one will live to 70 and the other until they are 90 – they just don’t know who will be the lucky one. What should they do? To be on the safe side, they could start saving until they have enough set aside for a life expectancy of 90, which means they will live for 25 years in retirement. But that will cost them both a great deal.
Alternatively, they could ‘insure’ their lifetime income by buying an annuity when they retire; that is a promise of an income throughout their remaining life. The sensible thing would be for our pension savers to save together. If one lives to 90, they will be provided for by the savings of the other. Both will have a secure income in retirement, but at a very much lower cost.
And if you imagine hundreds of thousands of people all saving together, there are all sorts of risks, and benefits, they can reasonably share. For example, as they reach retirement age, there would be less need to sell out of all risky investments and turn them into cash to buy an annuity. So returns could potentially be higher.”
The figures in the studies vary, but some are saying that the sharing of costs and risks in collective pensions could lead to retirement incomes up to 50% higher than someone saving into an individual plan.
It’s not all rosy though; there are downsides. A key one is the issue of trust: if we are all to save together into one massive scheme, then the members need to trust those running the scheme implicitly. Someone – probably professional trustees – will need to be the ones to say who can retire when and how much they can receive in retirement. These decisions are crucial to the success of the scheme. Take too much out and the whole scheme could fall apart. We need to be able to trust the providers of such schemes, and we all know what a fantastic job our current financial services providers have been doing with our money in the recent past…
A key factor is that whoever is running the scheme must do so entirely for the benefit of the scheme and not for their own personal gain. Charges must be kept low, very low, in order for the thing to work properly. This all means that there is little market incentive for someone to set up a collective scheme. Other than yours truly, there are very few completely altruistic people in the financial services world (tongue-in-cheek).
Another downside is concerns over liability. Many of the schemes, in Holland at least where they have been in place for decades, are sponsored by interest groups like unions, and these bodies are not likely to voluntarily take on pension scheme risk, for the same reasons that employers have been ditching their final salary pension schemes in the last couple of decades here. Apparently the legal framework exists to offer some kind of protection to trustees of such scheme, but that is arguably beyond the scope of this brief coverage.
There are no guarantees of what income you will get in retirement, only an expected level of return and a target income. It is possible for the scheme to adjust your income in retirement if the fund is struggling. Most people like to know what they are going to receive, at least at the point of retirement, and that their income is going to be a known quantity.
And finally, a huge sticking point in may people’s minds will be the lack of control. While the benefits of Collective Defined Contribution (CDC) schemes are apparently proven, it would take something for em to relinquish control of my own savings and investment strategy in favour of letting some trustees have the lot, make all my decisions for me, and then potentially cross-subsidise someone else with what is no longer my money.
So why is this a hot topic right now?
In the Queen’s Speech the other day, Her Majesty’s government announced that legislation would be introduced to allow these kinds of pensions fully to take root in the UK. At the same time, some Dutch ministers are calling for CDC schemes to be scrapped there and that the Dutch should adopt British-style individual pensions.
So nothing is likely to happen in the immediate short term, but collective pensions are quite likely coming to an employer or union near you before too long so it is worth remembering this very brief coverage of the subject, maybe revisiting it and making an informed decision when the time comes.
There’s nothing particularly for you to do about these scheme right now because they are in the future. Just be wary when the time comes and maybe we’ll cover things in more depth in a future session of this podcast…
Eurozone Interest Rates
The other hot topic right now is the raft of measures introduced by the European Central Bank to stimulate the economy in the single currency bloc. The main reason these hit the news for more than a passing moment is the reduction in central bank interest rate to -0.1%
What? How do negative interest rates work?
The purpose of the the central bank is many-fold, but one of its jobs is to be a safe haven for retail banks to deposit their money in the short term. So you would expect Barclays, Lloyds, NatWest etc all to have pretty big accounts at the Bank of England where they will be earning 0.5% interest on their money – the bank base rate.
In Europe, the rate at which banks can deposit money with the Central Bank is now -0.1%. This simply means that instead of paying the banks to deposit their money with the ECB, the ECB is now charging them to do so.
The theory is that if it costs the retail banks money to store their money with the ECB, they will perhaps lend it out to homes and businesses instead. More money flowing out from banks into the hands of people who can use it to buy stuff and to expand their businesses can only be a good thing.
In other announcements, the headline rate of interest was dropped from 0.25% to 0.15% – not really a change worth getting excited about. They also announced an asset purchase program, buying bundles of loans made to small businesses from banks. This will provide capital to the banks so that they can do more of the same – again the idea is to get cash moving to those who can use it to make a different in the real economy.
Finally Mario Draghi, the boss of the ECB announced that the bank will be making cheap loans to retail banks, again to encourage them to lend.
Why is this news?
This all sounds like run of the mill stuff right? We’ve seen lots of announcements like these over the years since the credit crisis.
That’s true, particularly here in the UK. We have taken a different path to our European cousins. Here in the UK we have embraced austerity for 5-6 years and it does seem to be working, despite the long way still to go. In recent-ish times, these austerity measures have been combined with some measures designed to get the banks lending again in a bid to promote growth.
The Eurozone was arguably in a worse state because it is made up of very disparate countries. You have the thriving economic machine that is Germany, in the same currency and with the same central bank as the fiscal basket-case of Greece. These different problems demanded a different response. The ECB hasn’t ever really engaged in Quantitative Easing, for example, the practice of printing money to buy government bonds.
So these measures announced the week before last are unusual, and importantly, untested. Denmark and Sweden have both had negative interest rates with apparently mixed results. In Denmark, all it seemed to do was reduce banks profits, which might sound like a good enough reasons to do it…
Why are they doing this?
Apart from trying to get money into the hands of businesses and households that can use it to boost the economy, the ECB is worried about inflation, or more correctly, deflation. We all know that inflation is the increase of prices over time. If kept within reasonable levels this is healthy. Rising prices should mean rising earnings and people feeling a little bit better of each year.
Deflation is a real concern in the Eurozone. Inflation is currently at just 0.5%, well below the target of 2% and there is concern that deflation may occur. Deflation simply means that prices drop over time. This is a high problem for economies which are built on buying and selling stuff because if I know something is going to be cheaper next month or next year, I will wait until then to buy it. If people aren’t buying, companies are not making profit and paying tax to the government and everybody suffers.
Again, the best way to prevent deflation is to get the economy moving forward and working healthily. Putting (hopefully) more money in people’s pockets with these measures will get more people buying things, companies investing in new jobs and the economy begins to pick up.
Will it work?
Maybe, no-one knows. These measure are pretty much unprecedented. In reality, the negative interest rates will only affect those bank deposits held by retail banks with the central bank. This is supposed to be about 29Bn Euros which sounds like a lot but is small beer really.
The difference made by dropping the rate by 0.1% will likely be negligible too.
The biggest thing is Mr Draghi making his intention clear that the ECB might start a proper program of Quantitative easing, something they have shied away from thus far. This far more drastic measure would doubtless have an impact, just as it has done in the US and home in the UK
What to do
For both these news items, there isn’t anything for you to do. Keep calm and carry on; business as usual. A well-diversified portfolio will ride out short-term market movements in the long run and you shouldn’t be swayed or worried by news like this. But at least now you’ll have the answers to hand when the know-all at the pub starts harping on about the state of the Eurozone. Now you can be the know-all!
Any questions, please do get in touch. The best way by far is to leave the question in the comments section [below] at the show notes: meaningfulmoney.tv/session65
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This week’s reviews
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I do so love a challenge! CF040PV is right, if I'm going to bang on about something – and I do bang on about why I don't like investing in shares – I should be very clear why that is the case. So in two weeks' time I will be covering that subject off in detail: Shares vs Funds, the death match!
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Next Session Announcement
Next time I'm going to be talking about Safe Returns. I'll be chatting to a friend of mine called David Crozier who is an adviser who specialises in advising clients who have had personal injury settlements. In these cases, when people have a finite amount of money and no chance of earning any more, you have to be very careful with how the money is planned for and invested. David will shed some light into his processes and even though most listeners won't be in this situation, there are lessons for all of us. It's great interview which I know you'll find useful.
If you have any questions about this subject, or any other financial query that you want answering here on the show, then the best way to do that is to leave me a voicemail at meaningfulmoney.tv/askpete
That's it for this session of the MM podcast, I hope it was helpful. If I missed anything or if you have any questions, please leave them comments section [below] at meaningfulmoney.tv/session65
I hope you enjoyed this session. Thanks for listening – I'll talk to you next time.