Secrets Of Success: Take control of pension planning to beat gloom

The future of Standard Life, the last remaining mutually-owned life company of any real size, may be up for grabs after the intervention of the regulators, but, in the meantime, the business of managing its clients' billions goes on. As befits an organisation that collects your money today, but only pays out the benefits many years in the future, its investment team has been turning its attention to some of the long-term themes that lie ahead for investors.

The latest issue of its annual publication, Global Horizon, contains a number of interesting ideas and projections, many of which have a bearing also on the issues that most private investors should be thinking about too. Principal among these is pensions, and the vexed issue of how best people can provide for the future in the wake of two powerful trends of the past 20 years: one, the great bull market in equities that ran from 1982 to 2000, and, two, the secular decline in inflation and interest rates that accompanied it. Both trends have conspired to alter radically the assumptions on which any long-term planning must be based. By definition, the huge and unprecedented bull market in equities has made it virtually impossible for investors, whose retirement age remains some years away, to expect similar returns in future.

Even after the bear market that ran from 2000 to spring 2003, it is simply not possible for equity investors to achieve the growth in their portfolios that those who retired in the 1990s were able to achieve. As equities in normal times offer the highest long-run returns among the main asset classes, this undermines one of the most important legs in the conventional pension planning equation. That itself is a tough lesson for investors to absorb, but it is compounded by the fact that the capital sum you need to generate a decent retirement income continues to rise inexorably. This is mainly the result of the secular fall in interest rates, but is also a function of the steady increase in life expectancy, which has exceeded the assumptions on which old plans were based.

The longer you live after retirement, the bigger the sum you need to put aside to purchase the income stream you want. These trends are well known and, of course, lie at the heart of many of the problems that have beset the life companies in recent years, from Equitable Life onwards (though many policyholders, of course, continue to dream of returns akin to those that their immediate predecessors enjoyed).

According to Standard Life, if you add in a factor for the continued real increases in employee earnings (necessary if your pension entitlement is linked to your final salary), the cost of providing each £1 of retirement income has risen by a factor of five since the early 1980s. If you translate this alarming statistic into a required investment return for people in mid-career today, it works out, says Standard Life, to be something of the order of inflation, plus 6 per cent per annum. This kind of return is most likely simply not achievable for most company or individual pension schemes, certainly not if they persist with the traditional balanced or high-equity content mandates that were the norm in the 1980s.

This, in turn, is why companies with large number of pensionable dependents are facing such horrendous pension fund liabilities and why so many are scrapping their final salary schemes in favour of defined contribution schemes that effectively transfer some of the risk of sub-par investment returns to the individual employee. Those who provide their own pensions have to wrestle with this problem alone.

Something, of course, has to give if this vicious circle is to be broken. For investment returns to improve, there will need to be some transition mechanism, which might come in the shape of a return in inflation and/or a rise in the general level of interest rates and bond yields. Further stock market falls are another possibility to allow those who are still providing for their pensions to achieve future returns that are nearer to the long-term average.

More fundamentally, those who are working today are going to have to change their expectations about the timing and nature of their retirement. To provide for a longer than expected retirement, they will either need to work longer or accept much lower retirement incomes. From an investment point of view, another option is to take more risk with the investment policy of their pension funds and/or extend the range of investments they put into them.

The general advice offered by Standard Life to their corporate clients is that they should do both these things. They should diversify more into other asset classes, such as private equity and property, and should also be more active in tinkering with their investment policy. One strategy they suggest is running a series of individual pension funds with different terms, adjusting the asset mix of each one on a year-by-year basis.

That is quite a clever approach which has some obvious merits for a corporate fund, but it does not solve the fundamental central conclusion, which is that simply sticking to the status quo is not - and cannot be - enough to fulfil conventional expectations, given the prevailing assumptions of falling returns, low inflation and interest rates, and growing life expectancy.

Is all hope lost, therefore, for today's generation of middle-aged workers? Despite all the gloom that tends to descend when issues of this sort are raised, there are grounds for optimism for those who are prepared to take control of their pension planning, as an increasing number of people now are. The trick is to give yourself the maximum opportunity to retire at a favourable time, which means something other than waiting for your employer or pension company to come up with an answer for you.

The challenge for the life companies, among other things, is to find new ways of offering savers schemes that allow them the maximum possible flexibility within existing rules. The challenge for the rest of us is to take more control of our own destinies, accept we cannot pre-fix our retirement date or pension fund value, and give ourselves the best chance of generating the necessary return through sensible diversification into undervalued (not overvalued) assets.

jd@intelligent-investor.co.uk