personal financial management

Personal Financial Management

Semester 2 2008 – 2009Gareth Myles g.d.myles@ex.ac.ukPaul 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 planningEach year of work might need to support a

year of retirement In the absence of interest this provides a

simple calculationAnd 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

0

5000

10000

15000

20000

25000

30000

35000

40000

20 30 40 50 60 70

Age when invested

Valu

e a

t re

tire

men

t

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

1980 2000 2050

20 14 7

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

1960 1990 2050

France 18.8 20.8 39.1

Japan 9.5 17.1 44.5

UK 17.9 24.0 38.7

US 15.4 19.1 36.8

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 istW = pR

t = tax, W = no. working, p = pension, R = no. retired

Let D = R/W (the dependency ratio) thent = 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

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

217970£

05.01

05.0120000

14

15

1

1

t

t

S

Pension Requirements

(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

1

10

1

11

r

rrES

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

11

1

1

1

T

T

t

t

r

rES

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

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

14876£

07.1

40000015

1

t

tC

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

Final salary schemes are the most attractiveNow found mostly in the public sectorMany are closed to new employees in

private sectorRisk falls upon the employer (because they

must meet the promises of the scheme)

Occupational Pensions

Final Salary Scheme Pension is equal to

Where n = number of years of serviceD = 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

salary final pension D

n

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

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