Pension warp

We keep telling you that quantitative easing (QE) and zero/negative interest rates are distorting the system.

Well, here’s a little more proof if you need it. Perhaps we’re in danger of becoming a broken record on this topic. But bear with me for two minutes. This is about your pension. Given that’s the capital you need to survive the last 30- odd years of your life, two minutes now won’t do any harm.

Actually, perhaps ‘your’ pension isn’t quite accurate. This is about the private pension system and industry as a whole.

It comes from a talk an analyst called Ronald G Layard-Liesching. He is, it seems, a fairly well known financial expert. He co-founded the quantitative finance shop Pareto Partners and currently serves as chairman of Mountain Pacific Group.

His thesis: QE has bent the pension system out of all shape. It’s opened up a chasm between what people have been promised and expect, and what’s actually happening.

(You might say that chasm has been around for as long as the pensions industry itself. That’s a story for another day. But, certainly, QE has accelerated the trend massively.)

A bit of background. The classic mix of assets in a pension – check your own later and see how closely you match up if you like – is 30% bonds and 70% shares.

This mix is assumed to help make you 8% a year

(Again, this may well be a figure that appears as a projection on your own pension statement. I think mine uses 5%, 8% and 10% to give a range of expected returns.)

That may or may not be achievable over the long term. But the interesting point Layard-Liesching makes is that right now bonds can be counted on to deliver 2.2%. That’s low, and in large part that’s because of the staggering amount of money that’s been funnelled into the bond market by central banks since the financial crisis.

It also means that, with bonds making up 30% of a fund, bonds contribute 0.66% of the returns. That means if a fund is going to hit that 8% expected return… the 70% invested in equities have to make up the difference.

It gets worse.

What that really means is that equities have to consistently return 10.5% (10.5% x 70% = 7.35%, with the other 0.66% coming from bonds).

OK, so that all got a bit number-heavy and technical. But there’s an important point to be made:

To return 10.5% a year, equities would have to consistently almost double their long term average performance since 1900.

That’s according to Credit Suisse. For reference, the US long-term share return between 1900 and 2014 was 6.5% pa; in the UK it’s 5.2%, and worldwide it’s 5.3%.

Just think about that for a second

The way things stand, for pension funds to achieve their assumed rate of return of 8%, share markets around the world have to consistently return twice their long-term average. That’s a huge outperformance. Such a big deviation from the long term average is highly unlikely, I would say.

That has two big implications for investors.

• It means that the real rate of return you can ‘expect’ from a private pension fund is probably a lot less than 8%, with all the knock-on effects that has on your final pension pot.
• And, perhaps more worrying, it means pension funds are probably having to take on increasing amounts of risk in the stockmarket, chasing returns that need to come in at twice the long-term average. Taking more risk in and of itself isn’t a bad thing. But when you’re doing it out of desperation, or the people whose money you’re managing don’t realise how much risk they’re taking, that seems like a blueprint for Armageddon.

To come back to my original point – this is just one more in a long line of examples of how you can’t mess around with the financial system by pumping money into one part of it without distorting other parts of it.

I would suggest that if you can’t understand all the consequences of your actions, then you shouldn’t act at all, especially if there’s a knock on for people’s retirement plans. But that’s just me.

Either way, it just serves to underline our point. You can’t live in a world without consequences. Sooner or later, someone pays.

I’d like to know what you think about all this. Does it worry you? Or did you lose your faith in the pensions industry a long time ago? Either way, write to me at [email protected]. I’m all ears.

Category: Central Banks