Understand Defined Benefit vs Defined Contribution at last

FatherAbraham

jamesd wrote: »

One key aspect of the Royal London approach is explained by this phrase:

"would buy an annuity at retirement"

It shouldn't be surprising that a person who throws away half of their potential income by buying an annuity would need to invest a lot more money.

The report compares the current situation for many workers (principally private sector) with a former time when employers provided defined-benefit pensions. Since annuities guarantee a specific payout for life, they are directly comparable with defined-benefit pensions.

As such, annuities are a useful yardstick. Investment-based retirement-income generation has a very different nature, and comparisons to defined-benefit pensions are difficult to make.

jamesd wrote: »

Naturally, Royal London sells annuities, so will want to try to maintain an expectation that people would continue to buy them even though sales have fallen by two thirds and the percentage of sales to existing customers has increased from 40% to 60% as those who don't shop around become the dominant buyers.

I, and many other workers, would like to have enough money to buy an annuity providing enough income in retirement, so that I could always sleep easily at night, come that time. It's useful to have reports, such as the Royal London one, which indicate how difficult and unrealistic such a dream may be, because it helps us understand the scale of the compromises, in terms of present income, future income, and guaranteedness of future income which will have to be made.

Warmest regards,
FA

PensionTech

guaranteedness

I like this. I may have to start using this.

"the guaranteedness of these figures is subject to the Trust Deed and Rules"...

hugheskevi

One thing I do not think is given enough consideration is the target level of income individual's plan toward.

The Pension Commission published replacement rates for retirement income at different salary levels (included in this document at page 11).

However, I very rarely see any consideration in the posts on this site about what an individual's pre-retirement income will be, which will require assumptions about individual's earnings growth...not so important for those close to retirement, but very important for those with many years left. Assumptions might be based around average earnings growth, but this is very rarely considered. Instead, benchmarks similar to the Pension Commission suggestions seem to be applied to salary levels of today rather than pre-retirement levels, which is likely to lead to an underestimate.

Then very little consideration is often given to retirement income needs. Research suggests needs are U-shaped, with more needed in the early part of retirement as individuals are fit and active, less in the middle of retirement as health wanes, but not to the point of needing care, and then costs escalating at the end as care needs escalate. Emphasis in planning here seems to be around a sustainable withdrawal rate, rather than matching drawdown to needs. I doubt many have a very good understanding of their likely retirement needs, underpinned with careful analysis of their own spending over a decent timeframe.

I do have sympathy for those not well versed in pensions and retirement planning. DC pensions are great when they have a solid foundation to build on, but as a retirement tool put all the responsibility firmly on the individual, who in most cases is not capable of even understanding the problem the pension is the answer to, let alone shaping the solution. Perhaps that will change over time, as future generations age and have to take more responsibility simply as no other entity will do so.

oldus_gittus

Just imagine all those Zimmer frames whizzing about.

jamesd

FatherAbraham wrote: »

The report compares the current situation for many workers (principally private sector) with a former time when employers provided defined-benefit pensions. Since annuities guarantee a specific payout for life, they are directly comparable with defined-benefit pensions.

I agree that some like such comparisons but...

FatherAbraham wrote: »

As such, annuities are a useful yardstick. Investment-based retirement-income generation has a very different nature, and comparisons to defined-benefit pensions are difficult to make.

there are problems with annuities as a yardstick becuase the comparison is inherently biased by the approach used:

1. Defined benefit, the company bears the investment risk (or sells it and pays an insurance firm to take it). The employee has to address this in teh defined contribution world.
2. Sustained poor performance risk is borne by the employer, pension company or in more severe failures by the PPF or FSCS. An employee has to deal with those risks in the current private sector defined contribution world.

Comparisons like the one made in the piece tend to ignore these cost transfers but a DC employee needs to be planning to deal with them, for things like a 10% say dip in investment income that the PPF may well deliver in similarly adverse circumstances. DC and drawdown approaches often make these explicit, for example using calculators that can have target and minimum income levels.

The employee at least in theory gets some help:

3. The remuneration package can deliver more in raw pay and leave it to the employee to choose to allocate the money to retirement provision or not.

The piece assumed that the employee did the minimum auto-enrolment amount permitted short of opting out. So from the outset we have a case where the employee is deemed not to care about retirement income but instead is prioritising current spending. That's rather different from the theory of DB where it's supposed to attract employees because they care about retirement. Comparisons of unmotivated do the minimum with those who are motivated and do a lot more have uses but they don't really make for very comparable cases.

FatherAbraham wrote: »

I, and many other workers, would like to have enough money to buy an annuity providing enough income in retirement, so that I could always sleep easily at night, come that time. It's useful to have reports, such as the Royal London one, which indicate how difficult and unrealistic such a dream may be, because it helps us understand the scale of the compromises, in terms of present income, future income, and guaranteedness of future income which will have to be made.

I agree that it's nice and given unlimited money and transfer of the costs of providing tail risk protection to me maybe I'd buy an annuity at the outset. But I can't get the money from an employer, the PPF or the FSCS and those who fund them so I'm left with what I can do. Yet I do know that my employer is in theory paying me more than if there was a DB scheme (and in practice is via a transition process) so I get to choose my priorities.

saver861

hugheskevi wrote: »

O
I do have sympathy for those not well versed in pensions and retirement planning.

I think that is where the young have an advantage. They will be much better prepared for retirement than the current generation of retirees.

The smart ones won't need to work until 77. Even those not so smart will not need to work until that age!

Too many headlines looking at what they 'are not getting' rather than what they can get and can do.

But, if you want readers, you create the catching headlines ... that will never change.

jamesd

hugheskevi wrote: »

Then very little consideration is often given to retirement income needs. Research suggests needs are U-shaped, with more needed in the early part of retirement as individuals are fit and active, less in the middle of retirement as health wanes, but not to the point of needing care, and then costs escalating at the end as care needs escalate. Emphasis in planning here seems to be around a sustainable withdrawal rate, rather than matching drawdown to needs.

Well, more around sorting out a range of target incomes and determining that those are likely to be sustainable. It is possible to model variable spending, though.

Here's an example with the cFIRSsim tool and assumptions roughly modelled on my own objectives, you might want to follow along:

Basics
retirement year: 2016
retirement end year: 2054
Portfolio
Portfolio value: 365000
Spending plan
Spending plan: Guyton-Klinger
Initial yearly spending: 18000
Spending floor (inflation adjusted): Defined value 12000
Social security (state pension)
Annual: 8000
Start year: 2031
Other income
One Amount: 1000 Start year: 2038 end year 2054
Extra spending
one: 54000 false for recurring, start year 2028
two: 2000 recurring true start year 2052 end year 2054

And run simulation.

That model is 1000 lower spending need from age 75, 2000 higher from age 90, an interest only mortgage to pay off and 8000 state pension. Target income 18k, minimum 12k aside from those age 75 and 90 adjustments.

Not quite full success on those details but that's decent enough because modifications can be made that have been shown to increase success rate:

1. Guyton's sequence of return risk taming, using cyclical PE vs historic average and adjusting equity/bond holdings depending on where things are in the cycle.
2. A year of investment spending in cash to avoid selling during down times.
3. Add some small caps (added 0.5% to 4% rule safe withdrawal rate).

kidmugsy

PensionTech wrote: »

I like this. I may have to start using this.

"the guaranteedness of these figures is subject to the Trust Deed and Rules"...

Surely the technical term is guaranteednessidity?

kidmugsy

jamesd wrote: »

Guyton's sequence of return risk taming, using cyclical PE vs historic average and adjusting equity/bond holdings depending on where things are in the cycle.

If that's the alternative, the man in the pub will do what he's done for a couple of generations - he'll assume that the taxpayer will stump up.

bigfreddiel

Orwell wrote: »

However if the employer is the State, then the hard-pressed taxpayers will lose their hope of any pension in the battle to keep the public sector in the style to which they have become accustomed.

E.g Goodbye to proper pension tax relief shortly.

My advice, join the public sector.

I did and never regretted it and I was in my late forties before I joined the civil service.

Cheers fj