High charges are a consequence of members of Group DC schemes having to leave the scheme on retirement. They lose the bulk discounts that trustees have negotiated for active service members and incur extra costs by having to cash out of the group arrangement and enter into a new individual ARF. A 2016 report of the Pensions Council reckoned that charges on individual insurance-based ARFs were equivalent to a yield reduction of between 1.5% and 2% per annum.
Low investment returns are caused by risk aversion by both retirees and advisers. A working party of the Society of Actuaries in Ireland reported in November 2015 that over 40% of insured ARFs were 100% in cash. Risk aversion and the resultant low returns are understandable in the context of a stock market whose gyrations would frighten all but the bravest – or the foolhardiest. Over the last 32 years, share prices fell more frequently than one month in every three; they fell by more than 8% in a single month on 12 occasions, one of those being a fall of 26.5%. What adviser in their right mind would want to face the wrath of a customer who had experienced a fall of that magnitude shortly after being advised to invest in an equity-based ARF? Better to be safe than sorry.
But in taking the supposedly “safe” option, investors lose out badly in the long-term. Over that same 32-year period, a regular monthly investment in equities would have delivered an average return of 8.5% per annum, despite the occasional blip of a fall in values of 20% or more in less than a month.
It’s easy, but wrong, to say that investors should be educated to accept short-term volatility for the greater good of higher long-term returns. It is part of the human condition to worry more about negative outcomes than to celebrate positive results. To find oneself 20% poorer in the space of a month is far more serious than “an occasional blip”. Losses of that magnitude cannot be dismissed with a wave of the “it’ll be alright in the long term” wand, especially when the clients are vulnerable senior citizens, some of whom are well into their 70s or 80s, or possibly even older. No. We must do better.
We face a conundrum. Short-term safety is the enemy of the long-term good. My proposed solution to the conundrum is to allow new money in and to pay money out to withdrawals based on smoothed investment returns.
The smoothing formula I proposed, which is shown here in graphical form, transforms the pattern of monthly returns.
Dealing with longevity
We have now shown that allowing members to stay in the group scheme post retirement decapitates the Hydra’s head of high charges; that the second Hydra’s head of low returns can be severed by investing 100% in real assets such as property and equities and by smoothing investment returns over time. There only remains the third Hydra’s head of no security of income. Our challenge is to design an axe to cut off this head, finally slaying the serpent.
One of the biggest worries facing a DC pensioner is “How much can I withdraw each year so that I don’t run out of money before I die?” It’s no good telling them that they should plan for an average life expectancy of 26.4 years, or whatever. For someone in drawdown, all that matters is their personal life expectancy, not the average. That could be anywhere between zero and 40 years. There is a risk that they could draw down too much or too little.
The traditional solution to this dilemma is to buy an annuity, but this option carries a heavy cost: the money is invested in low-yielding bonds and most of it is lost on early death. My solution to the dilemma is what I call the “Lifetime Income Fund” (LIF). The LIF works as follows: on retirement (say at age 65) the member divides their retirement pot into 25 identical sub-pots. They cash one of the sub-pots every year for 25 years. Thus, at the end of 25 years, they will have cashed all their sub- pots and will have nothing left. In the meantime, though, they have been contributing 1% of their fund each year to a separate, pooled, LIF account, which is managed by the trustees. The yearly 1% contribution to the LIF is like an additional management charge. On surviving to the end of 25 years, i.e. to age 90, and having taken the last of their pension sub-pots, the Lifetime Income Fund rides to the rescue. It gives the member another sub-pot each year for the rest of their life. Take an example. Suppose Joe retires at age 65 with a pension pot of €250,000. His pot is divided into 25 identical sub-pots, each of €10,000. The first year, he cashes his first €10,000. The second year, he cashes his second €10,000 plus whatever smoothed return has accrued in the year, say €10,400 in total. The third year, he cashes his third sub-pot plus another year’s smoothed return, say €10,700; and so on in each subsequent year. If Joe dies at the end of year two, after cashing his first two sub-pots, the other 23 sub-pots, i.e. €230,00, plus two years’ interest, i.e. 107% of €230,000 in the above example, are paid to his estate. Suppose on the other hand that Joe is still alive at age 90. He has cashed a sub-pot every year, taking his final (i.e. his 25th) sub-pot in his 90th year. By that time, the starting €10,000 per annum in each sub- pot has increased to (say) €30,000 (assuming an average smoothed return of 4% per annum, net of the 1% per annum contribution to the LIF). The following year, when Joe is in his 91st year, the LIF pays him €30,000 plus another year’s interest, and so on each year for the rest of his life. This assures him a sub- pot every year equal to 1/25th of his starting investment, plus interest, for as long as he lives. The biggest “losers” are the people who die shortly before reaching age 90; they have paid 1% each year to the LIF but get nothing in return, only the consolation of knowing that if they had survived for another few years, they too would be beneficiaries under the LIF.
The bottom line is that the combination of investment in real assets, smoothing of investment returns, and the Lifetime Income Fund mean that DC retirees can be assured of an income for life, starting at 4% of their original investment and most likely increasing each year at an average rate greater than the rate of inflation. On death before age 90, any undrawn balance is paid to the estate.
Approximate calculations indicate that someone who lives to 100 could expect under these proposals to get more than 2½ times what they would have got from an annuity. No wonder I have the zeal of a missionary for the idea to be taken up by the pensions industry.
If you would like to explore the proposals in greater detail, they can be found under the “Past Events” section of the Society of Actuaries in Ireland’s website, www.actuaries.ie