As investors, we are myopic, short-termist and obsessed with where the market will go next. Behavioural economics tells us that this has disastrous side effects, in terms of overtrading and bad market timing. But I’d contend that our biggest failing is an inability to recognise the long-term structural forces that have a profound effect on our lives. And the force that we should worry about – much more than where the FTSE 100 is heading tomorrow – is demographic trends, and how they impact pension investing.
If you want a visual representation of this problem, I recommend the new blog by pension consultants Redington, at http://blog.redington.co.uk/. Redington has expressed longevity risk in engaging graphics that everyone can understand, showing how much we need to contribute to our pensions to afford a comfortable retirement.
Longevity risk – unlike others – is a risk that keeps getting worse. Over the past few decades, we’ve seen a massive increase in life expectancy. Nationally, the average time spent in retirement is 17 years – but that hides huge variations. In Kensington and Chelsea, it is already 23 years, while in less affluent parts of Scotland it is still 15 years. However, I would expect the NHS to work hard to narrow these differentials and suggest that people in their 40s should factor in a further 23-year life expectancy for retired males as a minimum – with 26 years a realistic possibility.
Consulting firms like Redington have lots of pension fund clients who spend a lot of time worrying about longevity risk. But, in their experience, very few ordinary investors even understand the risk – which is why they’ve started the graphics orientated blog.
If US 401K retirement plans are a guide, investors still save far too little for their retirement. An academic report (Munnell and Sunden, 2006) concluded that these plans were coming up short because of low participation rates, inadequate contributions, poor investment decisions and withdrawals. Few participants contribute the legal maximum: the ‘modal’ contribution rate is just 6 per cent employee deferral plus a 3 per cent employee match. A recent Wall Street Journal article concluded that “the median household headed by a person aged 60 to 62 with a 401K has less than one-quarter of what is needed... to maintain its standard of living in retirement”.
So I asked Redington’s ‘creative’ economist Gurjit Dehl to run the numbers for me on longevity trends, and the results were hugely illuminating – as well as being deeply worrying. Dehl based his analysis on an annuity income post 65 of £25,000 per annum (which is fairly generous, I accept) and then assumed a 3 per cent inflation rate (which might seem a little adventurous to some) and a discount rate of 4 per cent per annum.
If we assume that life expectancy stays at 17 years, our £25,000 annual retirement income target would require a lump sum investment of £98,585 or £2,000 per annum over the full working life of an adult. That would achieve an eventual lump sum of £386,400 at age 65. But, as longevity increases, that required lump sum increases. If retirement is to last 23 years, the lump sum we need rises to £507,035 which would require annual pension contributions to increase 235 per cent to £4,699 per annum, or a lump sum of £138,628.
If we’re especially optimistic, and we assume a 26-year life expectancy for a man post age 65, the contributions increase to £5,946 per annum – an increase of 297 per cent – or a lump sum of £157,126 – which is a 159 per cent increase in the one-off payment.
How realistic is this? Increasing pension contributions by 200 per cent is a laughable ambition for the majority of investors, many of whom struggle to make their existing, inadequate, level of pension investments – even if they are especially motivated and, like me, manage their own self-invested personal pensions.
If, as individuals, we’re not saving enough using existing longevity assumptions, we have a problem. But given sustained increases in longevity, we have a crisis that makes the recent stock market volatility look like a walk in the park. Isn’t about time we challenged the idea that relying on individuals to plan for the very long term is a dangerous exercise in wish fulfilment – and accept the need for a concerted collective action now?
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