• 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 annuities, pensioners suffered badly.
• The next 4 years to 2006 have however produced some recovery in the stock market, with gains of 20%, 12%, 21% and 16% respectively in a tracker fund. 
• Annuity costs stabilised in 2003, but increased with further falls in long-term interest rates in 2004 and 2005. Government fixed-interest stocks today yield little more than 4.4% a year. Index-linked gilts yields have been falling even more rapidly – now they yield barely 1.2% a year (and fell to below 1% during February) – these gilts yielded around 3½ % above inflation very steadily between the 1980s and 1997, which 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 have been underperforming the equity market for many years, by over 1½% a year (25 year average) – see the later section of this report, and see Table 2. But managers did better in the three years of falling markets (they typically have cash and bond investments as well as equities) – the median pension managed fund beat an index tracker by 3½% a year for those 3 years - but fell behind again by 2½% a year in the rising market since then.

The changed investment markets today

Investment returns, even after recent falls, have been very good for many years –UK equities returning over 13% a year (8% above inflation) in the 25 years to 31 December 2006, and 7% (4% above inflation) in the last 10 years of that period. But dividend yields have fallen, and interest yields have fallen to around half of historically normal levels (shown below:

This 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!

Investment during retirement ( Annuities and Pension Fund Withdrawal Plans)  

People retiring normally buy annuities (after taking a retirement lump sum – although with falling investment yields, members of final-salary schemes need to think very carefully before commuting part of their guaranteed pension for a lump sum, even tax-free!) – but there are options for those with larger funds. Their pension funds can stay invested in Pension Fund Withdrawal (PFW) plans, investing in a mix of equities and bonds aimed to outperform the long gilts yields underlying annuity prices. This has significant investment and longevity risk – requiring regular advice to understand and manage that risk.

Historically, equity PFWs would have outperformed annuities (even after charges). Over the last 80 years, the Barclays Capital Equity-Gilt study shows 7½% a year growth above inflation on equities compared to 2½% a year on long gilts. The adverse markets since 2000 have however hit PFWs very hard - over the last 25 years, our Annuity Relative Price Index (ARPI – see Table 1) shows the median pension managed fund failing to match long gilts (equity trackers, however, have outperformed gilts by 1% a year). Over the last 10 years, the picture is much worse – pension funds have underperformed by over 3% a year.

Our chart “Relative Performance To Annuities” shows the movement of an equity tracker fund (blue) and the median pension fund (red) relative to long gilts monthly since December 1995. In simplified terms, when this chart is LOW, it may be a good time not to buy an annuity (in other words, for those retiring then to take out an annuity deferment plan), and when the chart is HIGH, it may be a good time to buy an annuity.

This strategy involves substantial investment risk – as well illustrated by the Chart! When equity markets are low, there can be hopes, but no certainty, of recovery. We suggest that investors should be cautious about taking out PFWs, and only do so after:

·                    understanding/accepting the risks of equity investment compared to annuity purchase, and investigating annuity options including non-traditional, investment-linked, ones;

·                    obtaining regular advice monitoring investment performance and annuity prices;

·                    considering whether the Excalibur chart is or is not above the long term trend;

·                    establishing an investment strategy with a reasonable expectation of beating long gilts, including normally an equity content - making sure that charges are sensibly low;

·                    and expecting to maintain the PFW for several years.

Some investors will have other reasons for taking out a PFW (for example a health problem or inheritance tax-planning concerns), which can be taken into account with the considerations above. Planning should also look at total investments including non-pension-fund assets.

Reasonable expectations of future long-term investment returns

It is possible to analyse current investment markets to produce a framework of reasonable expectations of future long term investment returns. We start from the current yield on long term gilts of 4.42% a year, and on index-linked gilts (ILGS) of 1.23% above inflation. Mathematically, this shows an expectation of average future inflation of 3.15% a year.

Over the last 80 years, equity dividends have grown by 1½% a year above inflation. Dividends to pension funds fell sharply on the government removal of ACT in 1997 – and have only recently (May 2005) recovered to the 1997 level - but even so dividends today are well above levels 20 years ago. We suggest that it is reasonable to expect long term growth of 1% a year above inflation and charges. Current dividend yields are 2.86%, which suggests a future long-term return on an equity fund of:

2.86+ 1.00 + 3.15  = 7.01% a year

Note that money investment returns in any period are also affected by changes in market yields (returns in the 1980s and 1990s were very high because yields fell so rapidly), but this has little effect on the relative performance of equities and gilts, which is the main subject of this section of our report.

This exceeds the return on gilts at current prices by 2½ %. This may be a sufficient margin to justify equity-based long-term investment for pension funds. [However, for those who do not understand and accept equity investment risks, for those nearing retirement and intending to buy an annuity, and for those in drawdown expecting to buy an annuity in just a few years, total investments should probably have a large gilts,  bond, and cash deposit element.] It is also sufficient to make a case for investors considering buying an annuity to review investment-linked options such as with-profits annuities, where a significant part of the underlying fund is invested in equities rather than gilts - but expert advice is needed!

Performance of individual pension fund managers (January 2006)

Table 2 analyses the performance of the 25 largest balanced managed pension funds (typically used in personal pensions) with a 10-year performance record. The table ranks the managers by their average fund return over the 5 years to 1 January 2006, which ranged from +6.6% a year down to -0.2% a year, and also shows performances in the two previous 5 year periods. We comment:

·                    the tracker fund underperformed managed funds in the 3 years of falling equity markets (2000, 2001 & 2002 - due mainly to managed funds having cash and bond investments), but has still beaten the average (and beaten 27 of the 29 individual) managed fund over the 10 year period by over 1% a year. The table also shows that the tracker fund has outperformed the average UK equity managed fund;

·                    the number of funds is falling as the insurance sector “consolidates” by mergers and reorganisations at a time of financial weakness;

·                    comparisons are greatly hindered by the fast pace of mergers and takeovers in the insurance and financial sector, where investors have no real idea whether a merged company will be more likely to follow the performance of the stronger or the weaker of the two predecessor companies;

·                    manager performance is not predictable or consistent – the table shows that of the 10 managers who were at or above the median in the most recent 5 years, only 5 were also at or above the median in the preceding 5 years, and of those 5, only 1 was also above the median in the preceding 5 years. Another way of looking at this is that only 5 of the 14 above-median managers in 1996-2001 maintained this in the next 5 years.

The selection of a fund manager is therefore very difficult!