Personal Financial Management

Personal Financial Management Semester 2 2008 – 2009 Gareth Myles g.d.myles@ex.ac.uk Paul Collier p.a.collier@ex.ac.uk

Pension Planning • The lectures so far have mostly focused upon managing wealth during employment • Many people now retire in their mid 50s • A working life of 30 years must then support a retired life of 20-30 years My current reading

Pension Planning • To maintain affluence during a long retirement requires careful planning • Each year of work might need to support a year of retirement • In the absence of interest this provides a simple calculation • And decisive action early in life • Money saved early in life accumulates interest

Early Investment • The benefit of early invested is easily illustrated • £5000 invested when 25 is worth • 5000 (1.05)40 = £35200 at retirement • £5000 invested when 35 is worth • 5000 (1.05)30 = £21610 at retirement • £5000 invested when 45 is worth • 5000 (1.05)20 = £13266 at retirement • £5000 invested when 55 is worth • 5000 (1.05)10 = £8144 at retirement

Early Investment • If these are the only pension contributions • Observe that 73% of the pension fund comes from the first two investments • Early contributions are the most valuable

The Basic State Pension • In most developed countries those who have worked and made contributions to the state (National Insurance in the UK) are entitled to a state pension • No-one should rely upon this to support them (comfortably) in retirement • The UK basic state pension reached a high of 20% of average earnings in 1980

The Basic State Pension • Since then it has been indexed to prices not earnings • As real earnings rise its value relative to earnings falls Pension as a Percentage of Earnings • The state pension will not even provide a subsistence level of income

Pensions Crisis • Countries around the world are suffering from a pensions crisis • UK • Many company schemes are closing • Others are in deficit • Public sectors workers may have to work longer • US • Pension system expected to go into permanent deficit around 2018

Population Issues • Life expectancy is increasing • The birth rate is falling • A smaller proportion of workers has to support a increasing proportion of retired • This makes it impossible to sustain current arrangements Dependency Ratio (over 65 to working) OECD

State Pension Systems • There are two basic forms of state pension system • Fully-funded: the state taxes workers, invests the funds and pays pensions from the investment • Pay-as-you-go: taxes on those in work pay the pensions of the current retired • The UK system is pay-as you-go • As are most systems

Pay-As-You-Go • There is a direct link between dependency ratio/tax payment/pension • The budget constraint is tW = pR • t = tax, W = no. working, p = pension, R = no. retired • Let D = R/W (the dependency ratio) then t = pD • It is expected to be p that falls as D rises • Reliance will be placed on private pensions

Fully-Funded • A tax t is paid when working • This is invested by the pension fund • And returned with interest when retirement is reached • The budget constraint of the pension fund is p = (1 + r)t • This is a form of forced saving • Private saving is replaced by state saving • Only has an effect if private saving is too low

Pension Requirements • Pension planning begins with determining requirements • The central issue is the proposed standard of living in retirement • Will this be simple in a country retreat? • Or active and expensive? • Assume it is decided that £20,000 per year is needed • Simplify by ignoring taxation

Pension Requirements • Also assume • Retirement is at 60 • The expected lifespan remaining is 15 years • The interest rate is 5% • Then the sum required at retirement is

(Calculation) • Assume savings of S in retirement fund and expenditure of E for two years • At the end of year 1 (S – E)(1+r) • If this can finance a second year at E (S – E)(1+r) = E • So S(1 + r)= E + (1 + r)E • Giving

Pension Requirements • The general version of this formula is • Where • S is the sum required • E the expenditure • r the interest rate • T the expected lifespan

Pension Requirements • For E = £30,000, r = 4% and T = 20 it follows S = £424,020 • Note that these numbers • Leave nothing for bequests • Do not guard against a longer lifespan • Provide no insurance against inflation or falling interest rates

Savings Rates • What rate of saving obtains such sums? • Assume £400,000 is required • Saving for 15 years at a 7% return (from 45 to 60) needs a yearly contribution of

Savings Rates • Saving for 25 years at 7% (from 35 to 60) needs a contribution of £5,910 • There is a major advantage to early pension planning

Forms of Pension • There are three categories of pension • 1. State Pension • Probably of very limited future value • 2. Occupational pensions • Provided to those in employment • 3. Private pensions • For those in employment with small firms or who have opted-out • Also uses in addition to occupational • For the self-employed

Occupational Pensions • There are two categories of occupational pension • Final salary schemes (defined benefits) • Pension received is a fraction of salary at retirement • Money purchase schemes (defined contributions) • Pension is determined by value of accumulated fund • The advantage of both these schemes is that employers contribute and employees contributions are tax-deductible

Occupational Pensions • Final salary schemes are the most attractive • Now found mostly in the public sector • Many are closed to new employees in private sector • Risk falls upon the employer (because they must meet the promises of the scheme)

Final Salary Scheme • Pension is equal to • Where n = number of years of service D = 60 or 80 • With D = 80, someone working for 40 years obtains ½ final salary • Plus a lump-sum of 2 to 3 times final salary (which is not taxed) • Pension is usually indexed for inflation • USS

Final Salary Scheme • Take the USS scheme • What is the equivalent private pension fund? • Assume salary of £70,000 • The lump-sum on retirement is £140,000 • Then need an income of £35,000 for 20 years • If at 3% this gives a fund of £536,330 • Together the total is £676,330

Money Purchase Scheme • Contributions to the pension scheme are invested in a fund • On retirement, the fund is used to purchase an annuity • An investment paying a fixed sum until death • The value of this form of scheme is uncertain • Relies on the return on the fund • Depends on annuity rates

Annuities • An annuity is the purchase of a stream of income flows • The basic annuity will promise to pay a constant income until the purchaser dies • The income for any given price depends on • the expected lifespan of the purchaser • market conditions at the time of purchase • Annuity Rates • Annuities may involve the immediate loss of substantial capital

Private Pensions • Allow the choice of investment fund • Can be transported between employers • Have additional flexibility in the final annuitisation • Have to annuitise at least 75% of the fund • But do receive favourable tax treatment • on contributions up to a limit • on the interest earned by fund • Final value is uncertain

Final Observations • Much of the UK population does not have adequate pension provision • This will become a major political issue in future years • There is no costless way for society to resolve the problems • Personal provision is required

Personal Financial Management