Pensions

Many Governments around the world have huge pension liabilities. This is not limited to developed countries in the West but also developing countries such as China for example which has a huge ageing population and due to the one child policy of its past means the proportion of workers to retirees is set to increase. Even if economies grow as normal many of these liabilities are unplayable which is common knowledge. The conventional wisdom is there will be a huge drawn out economic crisis due to the drag of such future liabilities. Theories range from lack of workers, lack of money and lack of economic output to support such payouts. While I generally agree that many public and even some private sector final pension schemes will have to cut back I actually think pensions will be the new economic driving force in particular here in the UK where I live. After the recent pensions revolution I will explain why everyone should put money into one and why they will help transform economic growth.

Finally salary schemes, ones that have a fixed income at the end of the employment, are very rare now to any new employees. Instead many of us are now enrolled onto defined contributions schemes whereby you save during your working years and then at retirement draw down on that money. The former legacy pension is a drag on the economy the latter new style pension will help drive economic growth. There are huge advantages with saving into a defined benefit scheme but yet many people still don’t but as time goes on people will come to realise its benefits. Why are final schemes generally a drag on the economy for example many public sector pensions? The money to pay the pensioners come from current taxation in other words they are an expenditure that is not paid for by any form of prior savings. Companies who are still paying down their final benefit schemes can have a surplus for its pension fund however generally they are always in deficit and it costs the company a lot of money and can drag on a companies performance as they try to fill the gap. All of these have a cost in current economic growth. Its a similar story with state pensions, they amount to promises to pay in the future as the Government saves nothing upfront in advance to pay for it in a future date.

Why would a defined contribution, a new type of pension be any different? With my defined pension its based on real savings. I could leave that savings in cash but like many others it generally gets invested in equities, company stocks as over time I want to increase my pot above the rate of inflation so it increases in real terms. The stock market is a wonderful concept. What it essentially does is marry up two sets of interests. We have a bunch of people with spare capital and savings and who don’t know what to do with it. Then we have another set of people, the entrepreneurs and businesses that have all the ideas to meet consumer demands but don’t have the capital to deliver their ideas. The stock market therefore channels real savings into such ventures. These businesses create consumer goods we all use and love, that create wealth for us all in the form of new gadgets and products. As a bonus, as an investor, I get a return on my savings that not only beats inflation but grows in real terms above this over the long term (at least that has been the trend for the past 100 plus years).

The process I have described above creates lots of economic growth. Countries get rich by saving money along with a good dose of entrepreneurial ingenuity, that essentially is the secret recipe to wealth. All wealthy nations or nations that have grown at relatively fast rates have followed this process. Whether its Britain in the 19th Century, Germany and Japan during post World War 2 or China during the 1980’s through to the 2000’s. Without savings the entrepreneur can’t realise his vision or his idea therefore he needs to borrow it from others which is why savings are such a critical ingredient to economic growth. With defined benefit pensions people will save hundreds of thousands each as genuine savings which will get lent out to businesses. In the past this never happened this is why I believe over the next 10–20 years economic growth will actually pick up at some point and get out of the recent stagnant growth of the past 10 years. People are slowly beginning to save and once people realise the benefits of the new UK pension benefits which I will highlight later people will become net savers. It may seem bonkers now where a good majority of people live paycheck to paycheck but I believe more people will look at savings and see others do it.

Some people may disagree in the ability to save hundreds of thousands of pounds and believe that most people will never be able to save that much. Its probably because they have never heard of compound interest. To accumulate sums of money you don’t need to save huge amounts you just need time. The earlier the save the more money you are able to accumulate in your pension. I’m a person who likes numbers and facts to do the talking so I have put together some numbers here. Click the link but to summarise some of the numbers I have assumed a 7% growth rate. There is various literature on why you can assume this if invested in equities, indexes like the S&P 500 the main index in the US has returned 8–9% for any 20–30 year period even during periods of serious bear markets. This return is not equal every year, some years you will get higher returns, some years you will get losses but over the long term this is what the returns even out to. In the sheet titled “Saves in 20's” the person saves £2,500 per year for 10 years during their 20’s. Now with 20% tax relief actually the sum needed is less (I’ll get onto tax relief later). Yet at age 70 the time the person would get state pension they have amassed a pot well over £500K, in effect turning £25K into half a million pounds. Thats the power of compounding. Playing with the percentages can have a dramatic effect on this. If you raise the rate of return to 9% then you will be a millionaire. Think you can’t get 9% return? Well historically thats what the S&P 500 has done. Some indexes return double digit over the long term. The FTSE mid Cap has returned over 14% for the past 60 years, the NUMIS NSCI which is a small cap index is over 15%. Rate of return is vitally important. For any young people out there they should be 100% in equities with some tilt towards aggressive smaller cap indexes.

There are three vital components to generating a pension. First you have to save. If you don’t put any money in then you will never get a pension pot built up. Second you need real rates of returns and assets with a long track record such as putting your money to work in equities. Third you need to time. Time is crucial. One of the best times to save for your future is as soon as your born. The best time is actually before you are even born. This is obviously impossible unless you have parents that have the foresight to do this on your behalf. For others your 20’s are a great time to start. On another worksheet “Save 30’s-50s” this person saves nothing during their 20’s however saves throughout their 30’s, 40’s and 50’s again £2,500 each year. Over 30 years they save £75K therefore three times as much as the person in their 20’s in the previous example. This is where time comes into play along with compound returns. Despite saving far more they never actually catch up to the person who saved in their 20’s. In reality the person in their 20’s would continue saving and would have around double the money of the other person who failed to start early. For the price of an extra £25K during your 20’s amounts to £500K when you turn 70. No wonder compound interest is described as the 8th Wonder of the World.

In the examples above the sums involved were quite modest. For anyone thinking they can’t save that then I beg to differ. For example if you buy a couple of coffees every day at £2.50 each and apply 20% tax relief then thats £2,190 there. Take your own sandwiches to work and you can more then save £2,500 per year and even more. Then numbers above don’t take into account pay rises over time, or even a more aggressive growth rate depending on the funds you pick and the charges on your account. Up the growth rate to 9% and you will have nearly £2.5M at 70 by just paying in a total of £100K (actually with 20% tax relief its £80K, even more if you become a 40% tax payer). 2% extra returns may sound trivial but over time with large sums the differences involved are millions.

The great thing about all of this is it encourages people to become savers which in turn drives economic growth. In old age people become self sufficient being able to support themselves. There are a number of other benefits with pensions in the UK.

Tax Relief

As mentioned if you work and pay taxes you get tax relief. In other words if you are a 20% tax payer then your pension payments come out of your pay cheque before taxes therefore giving you instantly 20% free. Even if you don’t earn money the Government will top up payments upto around £3K. If you are lucky enough to be a 40% tax payer then you in effect get 40% free money for your payments. Along with this many employers match your payments to various amounts. For example my employer will match me up to 6% of my salary. If I was to match this then then I put in 6% and get double money. Being a 40% tax payer means I only pay 3–4% but yet in total I’m saving 12%. Its literally free money. 40% tax relief may get pulled at some point in the future so best use it now.

Tax Free Gains

All gains inside a pension are tax free. You only pay taxes once you draw money out of a pension at your income tax level.

25% Lump Sum

Once you decide to take your pension you can take up to 25% of it tax free to do as you please. You get tax relief on the way in and on the way out. More free money. If you are prudent with money then you would be a fool not to take up this feature and take out the full 25%.

You don’t need to buy an Annuity

In the past everyone was forced to buy an annuity whereby you would trade in the value of your money to another company and they would give you a fixed income for the rest of the life. The catch is you gave up that pot of money. Now you can manage it yourself and pass it onto future generations. If you keep the majority of it in good returning assets for example stocks then you can extract 4% safely for life and pass on basically the whole pot to others (the 4% draw down rule is a highly interesting topic that you should explore).

Outside Inheritance Tax

With the recent pensions revolution should you not choose to buy an annuity, then the remaining balance can be inherited by your Children outside of your estate. Whatever you don’t draw down gets passed to your spouse completely tax free also and they can use it just like you would. Its a game changer that allows families in the UK to provide pensions for successive generations.

With all the above benefits it amazes me that people are still not saving. Some common objections are “you can’t spend it when you are dead”. True, you could die tomorrow and you would have missed all the consumption you could have done today with the money. However as a father of three if I was to die tomorrow then I would have done everything I could to leave a financial support for my family which is better than the worry of no money and living paycheck to paycheck. In short I would be glad I had made those short term sacrifices. Another objection is “I won’t be rich until I’m dead”. Many people live into their 70’s, 80’s even their 90’s. With the examples given earlier the savings may provide you for 30 years to live comfortably. Why not do it? Again you could die tomorrow but if you have dependants then you have left them in as good financial condition as you could have. Some would say “I don’t want to invest in volatile assets that could go down” I would say why does it matter when you are not going to touch the money for 30 years. Volatility is your friend. Warren Buffet puts volatility brilliantly, bonds on the other hand, seemingly stable assets, are laden with risk:

Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power — after taxes have been paid on nominal gains — in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date. 

From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk. 

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. 

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control. 

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.” 

For tax-paying investors like you and me, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points. It’s noteworthy that the implicit inflation “tax” was more than triple the explicit income tax that our investor probably thought of as his main burden. “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human. 

High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments — and indeed, rates in the early 1980s did that job nicely. Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label.

Equities are your pensions friend. Embrace volatility, I only invest in volatile assets. I am an investor in Bitcoin, I wouldn’t recommend you put your pension there or invest in it at this current time but returns of $100 to $75 million in 7 years is impressive returns, in fact historic returns. The volatility on it is crazy but you buy and hold and don’t care about short term moves. Goes down 10–20% in a day, ignore it, that’s a good thing. Your pension could fall 50% in year, ignore it, it will come back and more over the long run and will give you significant gains in real terms, this is the trick to investing getting real term returns as Warren Buffet states. Pensions are not some boring discussion with men in suits. They could change you and your families life. As the Chinese saying goes “The best time to plant a tree was 20 years ago. The next best time is now”.