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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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 198020002050 20147

8. 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

9. 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 196019902050 France18.820.839.1 Japan9.517.144.5 UK17.924.038.7 US15.419.136.8 Dependency Ratio (over 65 to working) OECD

10. 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

11. 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

12. 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

13. 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

14. 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 Pension Requirements

15. (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

16. 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

17. 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 Pension Requirements

18. 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

19. 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

20. 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

21. 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

22. 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) Occupational Pensions

23. 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

24. 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 Final Salary Scheme

25. 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

26. 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

27. 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

28. 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