On pensions, part 2: understanding the concepts

There are only seven concepts needed to understand pensions. First, the two types of pension. Then a word on funds. Then the four mathematical concepts to see them in context. (Remember the basic rule: this stuff ain’t hard. The financial industry just wants you to think it’s hard.)

There are two basic types of pension: defined-benefit and defined-contribution.

Concept 1. Defined-benefit includes those gold-plated final-salary and the slightly-less-golden career average schemes in the public sector. Pay in throughout your career (usually not very much; your employer coughs up too) and you’ll receive a proportion of your salary at retirement. Forever. Not subject to how long you live, not subject to the ups and downs of the markets. Since such deals often rise with inflation too, they’re a great deal.

So great that they’re bankrupting every country that offers them.

Because defined-benefit is inherently unsustainable. Imagine a senior manager retiring at the public-sector average of 58. His employer may have to stump up two-thirds of the salary he earned in her last year … bumped up with inflation… every year for the rest of his life. With today’s lifespans, that might mean paying his pension for more years than he worked. That’s defined-benefit, and it’s killing both our public finances and the finances of private companies offering such schemes.

(So why does the public sector continue to offer them? Simple politics. Promising a pay rise costs money now; promising a pension costs money after the next election. Both are effective in buying public sector workers’ votes and sending the bill to future generations. And in countries like the UK, which has a large public sector, there are many millions of votes to be won that way.)

Concept 2. Defined-contribution. This the only reasonable way to run a pension fund without storing up trouble. You have an individual retirement account, it grows or shrinks with whatever you invested in it, and what you get out relates to what you put in. (A simple savings account is a defined-contribution plan.)

Defined-contribution plans tend to pay out far less than defined-benefit, largely because you’re taking all the risk instead of outsourcing it to your employer.

While it might be great to have someone else taking all your investment risk, it’s happening less and less for private employees; defined-contribution is now all anyone outside the public sector can expect. Taste the difference: a senior civil servant on a defined-benefit retiring today, on £85k at the age of 60, will receive a pension exceeding £5k/mth. That sum will be adjusted upwards for inflation, risk free, for the rest of his life. To get the same through a defined-contribution plan,  you’d need to have north of £2 million in your pot.

Defined-contribution isn’t generous. But it’s sustainable.

(There is one lump of sugar: with defined-contribution, you get to be in control. If you’ve got a taste for risk, you can dial your preferences into your fund and enjoy wild growth if your investments have a good year. I don’t need to mention the corollary, of course.)

However, most defined-benefit plans from employers make it hard for you to exert a great deal of control over them, which is why this blog is mostly about defined-contribution. It’s about what you can do to maximise your pension.

Concept 3: the investment fund. Whether you’re defined-benefit or defined contribution, you pension is part of a fund, a sheaf of investments (shares, bonds, cash) chosen to increase in value over time so the pensioners can be paid. Big companies and public sector organisations might have only one fund for all employees; individual self-investors might buy slivers of many funds bought on the markets. (There are thousands to choose from.)

The only thing worth remembering is that funds are aggregated. One fund may bundle together many investments (such as shares) and sell the bundle as units. (Imagine a basket of vegetables: that’s the fund. Your pension pot contains a bite of carrot, a slice of cucumber, a peck of peas, and so on.)

A £100 unit may contain slivers of a telecoms giant, an oil startup, and government bonds, weighted by the fund manager to produce maximum return. Funds on the markets are very liquid; if your pension pot isn’t in nice multiples of £100, you’ll simply own relevant fractions of a unit too.

Now for the maths: compound interest, pound-cost averaging, weightings, and Projected Value. Relax; it’s all simple.

Concept 4: Compound interest is what you learned in school. Put in £100 at 10% interest, get £110. Leave it there, and next year you’ve got £121. Investment funds carry other goodies like dividends and coupons, and if you reinvest these back into your pension plan (you should) the compounding just works harder. Compound interest is simple.

Concept 5: Pound-cost averaging is the reason you should invest a set amount in your pension each month, before any other expenses go out. It’s a way of smoothing out the stockmarket. Let’s say you’re in Fund X whose component companies did well this month. Their share price is high, so you’ll get fewer shares, but they’re doing well, so you don’t mind. The next month, when the company hits the skids, your regular payment buys a lot more of their shares, so you own more shares and reap the benefits when the company starts growing again.  Pound-cost averaging is simple.

Concept 6: Weighting. Your pension plan is probably in more than one fund; how they’re mixed or “weighted” is a key concept to understand. Fund Y is making 20% and your fund contains its units; why has your pension fund lost money? Because Fund Y comprises just 10% of your portfolio and the rest of it is toxic waste. Weighting is how you balance your pension pot with your appetite for risk. Adventurous young males in good health choose funds in emerging markets and new technology; sozzled greybeards stick to bonds and index trackers. Weightings are less simple but more fun.

Finally, concept 7: Projected Value, or PV. This is how you plan for the future: given average returns of X percent a year (long-term stockmarket returns are surprisingly stable) with n years of contributing N pounds rising at Y percent a year…  accounting for inflation, charges, and risk by Z percent… and you’ve got your pension pot, from which you can work out what you can afford to draw as your monthly pension. Projected value is simple and fun.

That’s all you need. Next: setting things up.

One thought on “On pensions, part 2: understanding the concepts

  1. Pingback: On pensions, part 1: getting the mindset « chrisworth.com

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