EXCALIBUR ACTUARIES
MONTHLY PENSION INVESTMENT REPORT
 (31 December 2008)

Long-term investment for retirement

Excalibur Actuaries regularly analyse the past performance of investment plans as a basis for advising clients on investment strategy both for those in mid-career and for those near or at retirement investing for their income and security during (many years of) retirement. Table 1 shows investment performance and related statistics, covering the past 25 years.

  • The last 20 years of the 20th century were very good for pension investors, averaging 10% returns above inflation and significantly outperforming bonds and annuity prices.
  • The first 3 years of the new century were very bad - an UK equity tracker fund fell by almost 40%, whereas long gilts prices (affecting the cost of buying annuities) increased by 20%. Combined with worsening annuity rates because of increased longevity expectations, people with “money purchase” pensions needing to secure annuities suffered badly.
  • The next 5 years to end 2007  however produced some recovery in the stock market, with gains of 20%, 12%, 21%, 16% and 4% respectively in a tracker fund.
  • However, in 2008 equity values have fallen by over 30%! This is the result of the fallout from the crisis in banking after recognition to their exposure to “toxic” assets of low grade mortgages and the expectation of a severe economic downturn.
  • Annuity costs have increased in recent years with recognition of increased longevity and withg reduction of fixed interest yields. Having reduced further in yield over the final few weeks of the year, Government fixed-interest stocks today yield only about 3 ¾%. Index-linked gilts yields have also been falling rapidly – now they yield only about 1% pa, having been as little as ¾% pa in August – these gilts yielded around 3½ % above inflation very steadily between the 1980s and 1997. The lower return greatly affects prices of inflation-proofed pensions (and the cost to taxpayers of providing these to retired public service staff).

 

Annuities are typically priced assuming investment returns matching long gilts, and allowing for pensioner mortality improving steadily. However, the current annuity market is extremely adverse for those retiring, because: (1) of current low yields on long gilts (see above); (2) insurers are worrying about greatly improved future mortality; (3) the annuity market is “unbalanced” since so many pension schemes are attempting to wind up and buy bulk annuities; and (4) insurers’ financial strength has been hit by falling stock markets and a range of regulatory problems.

Most pension managed funds had been underperforming the equity market for many years, by over 1% a year (25 year average) – see the later section of this report. But managers did better recently, particularly in the three years of falling markets (they typically have cash and bond investments as well as equities) – the median pension managed fund has even bettered the index tracker over the last 10 years which included significant lengths of time with less favourable equity markets.

The changed investment markets today

Investment returns had been very good for many years –even after the recent falls, UK equities returning 9.7% a year (5% above inflation) in the 25 years to 31 December 2008, but only 0.5 % (2% less than inflation) in the last 10 years of that period. But (until the recent market crash) dividend yields have fallen, and interest yields have fallen to around half of historically normal levels as shown below:


Type of yield

average of 25 years

average of 10 years

current

Long gilts

10.0%

5.6%

3.80%

Index-linked gilts

 

2.1%

1.00%

Cash deposits

8.8%

5.3%

4.80%

Equity dividends

3.8%

2.9%

4.50%

The recent falls in equity values has had a shocking affect on the financial situation of many parts of the economy, both corporate and individual. Pension funds have become even more under-funded, pensioners relying on income from their assets have lost buying power and there is a general lack of confidence all round.

The fall in yields has a very large effect on annuity rates, and on actuaries’ calculations of pension contribution rates. What might seem to be a small change by actuaries (from their historically typical assumption of pension investment returns after inflation and charges of about 4%, to perhaps a more reasonable 2-2½% in today’s circumstances), has a dramatic effect on the contribution needed to produce a pension over a 40-year career of two-thirds of pay from age 65 – which rises from 10% of earnings to 20%.

Thus younger people have to face the prospect of needing to save double the amount the previous generation had to save for their pension. Those nearer retirement are even harder-hit – they will need to review perhaps over-optimistic past projections of their likely pension to adjust for the changed investment conditions – and will have to increase contributions unless they have built up substantial pension funds by taking advantage of high past investment returns. Those now reaching retirement are in a very difficult financial position – and are very angry!

Where do we go from here?

The economic position feels as if we are in completely uncharted territory. Historians will point to the inter-war depression, the oil crisis in the early 70s and a relatively short lived recession and negative equity on houses in the early 90s. This meltdown appears to be far more greatly affected by over spending based on excess credit. The catalyst for upheaval has then been a reduction in property values, particularly in the States and the resultant recognition of uncovered mortgages left as “toxic” assets with most banks. Modern financial instruments have allowed this situation to develop without sufficient regulation by the world authorities. Equally, world countries’ economies are far more interlinked than in previous downturns. The unknown outcome is driving market levels down, perhaps by more than the “best estimates” of profitability merit.

From the point of view of dividend returns, an equity dividend yield of 4.5% pa and one that is over ½% pa more than gilts seems a “buy” message. Surely one could expect some dividend growth in the future after the undoubted reductions in the next year or so. However, complete economic seizure would destroy many companies. This is why non-income earning commodities like gold are attractive to some investors.

This writer cannot foresee the outcome so would not like to make strong recommendations. Perhaps the best option is to be as prudent as possible, spread ones bets, and certainly do not over-borrow if possible, even in these low interest times.

 

For further information on this, or on other pension matters, please contact Geoffrey Wilson on 07894-668233, Michael Tong on 02392-463666, or www.excaliburactuaries.co.uk