When you think of retirement, do you think of summer afternoons in the garden – or do you feel a rising sense of dread?
Chances are, the way you answered probably suggests you are either:
A) A baby-boomer (born in the post-war years, broadly 1946 – 1960)
B) A member of any younger generation
The Department for Work & Pensions (DWP) recently revealed that pensioner income is now only 7% behind the median average income of a salaried worker. In 1994, the gap was five times as large. Leading to what can only be recognised as a pensions crisis upon us.
This might seem like a great thing and, for today’s pensioners, it is. But this level of pensioner income is not sustainable. As the Pension Protection Fund reported, 950 of the UK’s 6,000 defined benefit pension schemes are now “underwater”. That is, they are spending more than they take in from worker contributions. That disparity cannot last forever, and the pensions crisis needs to be resolved.
The Social Security Miracle of the Western World
To explain, we need to look at the generation that is currently benefiting from these high incomes in old age: the generation known as ‘baby boomers’. Final salary schemes began to proliferate in the 1960s, and many boomers took advantage of them. These schemes didn’t limit retirement income to the amount paid in by the member plus investment return, as the modern defined contribution schemes do. Instead they allowed members to build up a ‘benefit’ which, upon retirement, would pay out a guaranteed income for life. There’s a reason this system was referred to as “the social security miracle of the Western world”.
Over the next 50 years, these schemes built up huge liabilities. Many schemes were paying these liabilities using the contributions of current employees, who were still contributing. But these schemes started coming up short when pensioners began living longer than predicted. Essentially, the UK pension sector failed to manage the consequences of demographic change, and can be somewhat accountable for this said ‘pensions crisis’.
Pension deficit vs Pensions crisis
As a result, the entire deficit now facing final salary schemes in the UK is about £1.75 trillion, and the vast majority have now closed to new members and been replaced by defined contribution schemes.
Final salary schemes were excellent – for their early members, and these beneficiaries were lucky to be able to live through a period where these schemes were the norm. They’re also incredibly lucky to benefit from the so-called ‘triple lock’ mechanism, which ensures that the state pension grows each year by the higher of:
1) the growth in average earnings
2) inflation (CPI)
This triple lock means that regardless of recession or low wage growth or low inflation, whilst working people might see their wages drastically fall, pensioner income will continue to rise by at least 2.5% per year.
This is astonishing when we are talking about the most prosperous generation that has ever existed.
The Future of UK Pensions
The triple lock is widely viewed as unsustainable and, at some point, will probably be abolished. Some even suggest that the state pension itself will be abandoned in the future. Therefore, the only way we can ensure that our earnings in later life meet our needs is by securing our financial freedom today. Thus, contributing to pensions earlier, benefiting from compounding returns, and letting the stock markets work their magic over the very long-term.
Today’s retirees may be enjoying their rosy summer afternoons but there’s no reason that the rest of us can’t. The core principle of investing rings true in this case. Start investing as early as you can. If you didn’t start early, start now or this pensions crisis bubble will be surrounding us long into the future.
Risk warning: As with all investing, your capital is at risk. Pension rules apply.
Thanks to our guest blogger Joshua Queen from Nutmeg. Learn more about Nutmeg here.