Investors are told that if they are willing to take more risk and invest in the stock market they will be rewarded over the longer term because of the ‘equity risk premium’. Thanks to a belief in that so-called axiom, millions of people's pension savings have largely been devastated by the credit crunch.
Pension funds have plunged in value as stock markets collapsed, while the pension income available to new retirees has plummeted as the Bank of England prints money to buy gilts and drive interest rates down. Employers are cutting contributions to their workers' pension schemes too as the economic downturn hits their revenues. My report, Planning for Retirement: You’re on your own, which is available for download at www.metlife.co.uk/rp, examines important issues facing people preparing for retirement.
The credit crunch delivered the knockout punch but problems have been building up for years. Analysis from the report shows someone who paid £24,000 contributions over the last 10 years into a defined contribution pension scheme, invested in the stock market, would now have a fund worth £21,000. Defined contribution pension schemes have fallen more than 25% since the start of the credit crunch. Pension planning has traditionally relied on stock market growth to provide good pensions but it has not worked out.
The entire UK pension system has been based on a bet that equities would always do well enough over the long term to deliver good pensions. Generous final salary schemes – as well as forecasts for good personal pensions – all relied on the equity gamble paying off. The expected strong equity returns also enabled successive governments to cut UK state pensions over time.
The idea that equity markets might not deliver over the long term was never seriously entertained by policymakers. Nobody explained to workers that they were effectively gambling their future security on the stock market without any form of insurance to protect themselves against the risks of poor equity returns and rising life expectancy.
A survey by MetLife of people aged 55-64, illustrated the human cost of the credit crunch. More than half (54 per cent) said their pensions would fall short of expectations and a third thought they had wasted their money and wished they had not bothered with pensions. A majority (56 per cent) said they would now continue working into retirement.
The added problem for those just retiring is that low interest rates mean the income streams they can buy with their decimated pension pots is also low. They could invest in drawdown annuities and stay exposed to equities in the hope that a stock market recovery will boost their pension pots in the long term. But this implies more risk.
Another alternative, for those in pre- and post-retirement phases, is to invest in equities but to take out some insurance against the potential downside. Everyone knows their house could be damaged by fire or flood and they may need some insurance against these risks. But pension savers were never told their pension could be decimated by poor stock market returns – even over the long-term. So they didn't know they needed to consider insuring themselves.
But insurance is available. One of the ways to do this is to look at products known as unit-linked guarantees. They may not be cheap, but they do offer some security. Blind faith in the old idea that long-term investors would always do well in the stock market has let millions of people down. The effects of this pensions crisis could be even more long-lasting than the current economic crisis and people need good financial advice. But challenging the traditional City thinking about pension investment is long overdue.
Dr Ros Altman is author of 'Planning for Retirement: You’re on your own – more risks, new solutions?'