Pensions: How We Got Here and Where We’re Going

Pensions used to be easy. One would work for the same company for 40 years and collect payments from a defined benefits plan upon retirement.

There was literally 0 thought involved; most were probably completely unaware of the details of their pension plan. They simply had faith that the company would take care of them in retirement.

And they usually did: the humongous corporations that essentially everyone used to work for directed massive amounts of capital to pension funds to invest in the markets. In fact, this was really the only type of investing that every-day people were involved in that occurred for a while. The idea was that these pension funds would be able to generate sufficient returns on this capital to ensure that retired employees could receive some type of fixed payment in retirement.

From collectivism to individualism

This is a great deal for employees and retirees but pretty terrible for companies.

The forecasting required to determine how much to pay retirees, how much capital is required to pay this amount, and what to invest in to generate these returns are incredibly complicated and, worse, extremely sensitive to input variables. If the general level of returns drops, if some assets under-perform expectations, if the company does not invest enough capital, if the demographics of the workforce changes, if anything else happens that affects the pool of capital available to pay loyal ex-employees of Unilever or Barclays or IBM, then these companies would be left with a rather large list of liabilities on their balance sheet with no obvious way to meet them. This is similar to what the biggest corporation of them all – the government – is facing as we speak: generational shifts will place a huge burden on those currently in work to support retirees.

Some smart-arse somewhere realised this at some point and proposed a new system: defined contribution pensions. The shift to these new schemes started to occur in the 1990s, supposedly driven by changes in pension regulation and accounting. Under this new scheme, employees would contribute to a pot, with the government-mandated help of the employer, individually. The individual would be responsible for selecting investments (although, not the pension provider and, hence, the range of available investment vehicles).

This worked well for a while, despite the fact that the general level of personal finance ignorance and apathy meant that people tended to contribute the minimum amount to their pension and tend to stay invested in the default fund. Actually, the jury is still out on the consequences of this change: those whose pensions are mostly composed of defined contribution plans are just starting to retire now. Will they have enough? Did they contribute enough? Did they invest in the right things? These are currently unknowns.

But even if the answers to these questions are yes yes yes, this pension system is still inadequate and in-need of replacement/modification. You see, this system works if one has, say, 5 employers in one’s lifetime. This wasn’t that uncommon a few years back: a 5-10 year stint at a company was the norm.

Now things are changing. And this trend is accelerating.

Harry’s pensions

Harry studied psychology at the university of Nottingham, which he selected for the favourable gender ratio, the rumoured quality of nightlife, and the perceived general level of quality of the course and university (in that order). He had no idea what he wanted to or could do after uni; his academic choices so far had been based on interest, teachers, and his ability to get a good grade.

At university he discovered this thing called “consulting”. It sounded perfect for someone relatively lost who “needed” to “get a good job with a good wage” because, he told people, he wanted to have a “strong financial start” but, really, he wanted to impress his friends, his parents, and members of the opposite sex.

His career flourished, despite the fact that didn’t really enjoy the work: after a year-long internship between his penultimate and final year at university at a niche strategy consulting firm, he joined the 2-year grad scheme at a company commonly known by a 2-to-4-letter acronym upon graduation. He discovered that he had a passion for (was able to tolerate) Enterprise Risk and moved to a different 2-to-4-letter acronym after the scheme had finished. After 3 years he felt as if he wasn’t learning enough (the firm refused to increase his pay) so moved to a smaller company and a more senior position to learn (improve his CV to land a higher-paying position further down the line). At this new firm he thrived (worked overtime to meet the demands of an under-staffed small firm). After two years he had found his true passion (the area that he had become progressively more and more familiar with in a kind of opening-of-Pandora’s-Box-type mechanism by which as soon as you do work in an area, selected randomly, you become more comfortable and more of an expert in that area so it’s easier to find jobs in that area and you end up doing work in that area for the rest of your life) and moved to [insert FTSE 100 company] as a Senior Risk Manager.

Today, this would be considered a relatively normal career with a relatively normal amount of different companies worked at and a relatively normal number of pensions collected…which happens to be 5, all before the age of 30.

Too much admin

This means 5 different (maybe) sets of login details with 5 different providers,  5 different investment portfolios to construct from 5 different sets of investment choices, 5 different analyses to be conducted over fees, options, etc., 5 different systems to become familiar with. All before poor Harry is 30.

Clearly, this system can get out of hand rather quickly; the defined contribution scheme was not designed to deal with this volume of different pensions; it’s very hard to keep track of and organise.

The way I see it, people have 2 options to deal with this situation. One could keep all pensions separate. This has the advantage of your pension pots being diversified across providers. However, this requires a high level of time commitment. Analysing all the different options with each provider, constructing a portfolio, maintaining documentation, etc. all requires time and effort. If you slip up in any one of these areas, it can be costly.

One is also more restricted in the choices one has. It’s common to be provided with a choice of 2 or 3 investment funds, which may not be compatible with your investment strategy. Some providers will be sub-par. Some have very high fees that eat away at your returns. Some have unusable platforms. Some, functionally, have no customer support. This all results in financial, cognitive and temporal costs.

The better option is to perform some type of pension consolidation. We are seeing some companies, PensionBee for example, start to provide this service. But I personally recommend performing this consolidation yourself:

Take out a SIPP with whoever and transfer all outstanding pensions to this SIPP. Invest these thousands of pounds however you wish, using a platform that works, with a provider that has low fees and provides adequate investment options. Then every time you join a new company:

  1. Max your pension contribution. This means contributing the maximum that the employer will match.
  2. Choose the investment option that is most cash-like. This might be the lowest-risk fund, some type of low-interest-rate-fixed-return fund, bonds, or, just, conveniently, cash. Do this because at short time horizons, assets cannot be relied upon to generate any sort of return.
  3. When you leave the company after 1 month/half a year/2 years/5 years, transfer the pension to your SIPP. Invest these thousands of pounds using your investment strategy.

This way you have full (nearly) control over your pension.

What the future looks like

It’s not just the duration of employment with one company that is changing.

The jobs market is becoming more fragmented and modularised. More people are working for themselves, creating side-hustles, engaging in part-time work, working on fixed contracts, etc. Just basically doing more of everything that doesn’t involve working for one employer full-time. For example, the share of total employment that is self-employment increased from 8.05% in 1979 to 14.81% in 2018

These types of work often have no pension attached to them – this places the emphasis even more on managing a pension on an individual basis in a SIPP. We may even reach a stage in which everyone manages their pension in this way, with employers simply contributing directly to each individual SIPP. Or maybe the financial burden will be fully placed on individuals.

Whatever happens, it’s difficult to see the trend from employer to employee reversing.

Individuals must get educated and organised or risk an unhappy retirement.