Consistent returns are the key to better pensions
One of the biggest questions facing individuals is how to fund an adequate retirement. We have turned to the past to find some practical answers, testing a variety of contribution, investment and pension payment policies against more than 300 years of UK equity and bond history. We concluded that trying to raise contribution levels beyond certain limits is unlikely to be viable. A more fruitful way of ensuring better results would be to minimise swings in investment performance.
The UK offers possibly the longest run of financial data available anywhere. We looked at equity, bond, interest rate and inflation data going back to 1694, overlaying them with alternate pension saving and paying (“accumulation”) and (“decumulation”) strategies. We assumed a pension drawdown period of 30 years and salary increases of 1% a year. Our “target” pension payment was 65% of final salary.
On that basis, what level of savings would be required to fund a reasonable level of income in retirement? Starting with a contribution rate of 8% of salary, in line with the post-2018 target of the UK’s NEST state-sponsored scheme, and a portfolio 100% invested in UK equities, our accumulated balance after 40 years of saving would have left a median “pot” equivalent to 7.5 times final salary.
How much of these savings would be left at the end of the drawdown period as a multiple of that final salary? If we set a level of drawdown such that the “median pensioner” had no money left after 30 years, only a fairly meagre income amounting to 42% of final salary was possible. Moreover, the range of outcomes was enormous, including several years of substantial deficit. More conservative investment portfolios, such as 60% equities, 40% bonds or 100% bonds, narrowed the range of outcomes slightly, but pushed the median result well into the red.
Clearly an 8% accumulation is far too low to support pension outcomes that are likely to be acceptable for most people. If instead we ask what is a realistic contribution rate to support 65% of final salary for 30 years, assuming a 100% equity investment, the required rate would go up to about 12.4% of salary. But the dispersion of likely outcomes would remain very large. Using more conservative portfolios only raised the required contribution rate, while leaving the range of outcomes unacceptably wide.
The nub of the issue here is that the outcomes from either an aggressive growth strategy or a more balanced strategy are simply far too volatile. Consider instead what we could achieve with a constant real return rate of 4.8%, the same average return as from the 60/40 balanced fund. The median end result of the decumulation period rose to 16 times final salary and there was only one observation when the drawdown requirements were not met – and even then the funds only ran out after 29 years.
The obvious conclusion is that the biggest driver of sustainability of pension outcomes is the stability of real returns. Of course, contribution rates are also important. But given that there are practical limits to the amount that people are willing and able to save, we would argue that they are likely to prove less important than returns. The emphasis therefore needs to switch to both the level of returns and the order they come in. Absolute return and other hedge fund type strategies may prove useful here, as could some sort of volatility control overlay. We would not wish to minimise the difficulties of attempting to reach more certain targets but, if it can be shown they are achievable, the benefit should be well worth paying for.