The FT at the weekend touched upon an idea about pension funding. It is nothing new and I have longed mused upon it but it is worthy of dusting off again for a flight of fancy, if nothing else.
The idea is that of borrowing to fund your pension in one fell swoop, or substantially so, in any case.
For most people, there will be two big assets that they require in their life: a property in which to live and a pension fund big enough to sustain them in retirement. According to the BBC, the average property in the UK costs £224,000 and, assuming that median full time employee on just under £24,000 requires £10,000 per annum of private pension, the average pension fund would need to be of similar size.
It has become accepted practice over the last forty years or so that working people would borrow to buy their property, could it make sense to do the same with pensions? To answer that, it makes sense to examine the reason for borrowing rather than saving.
The problem with saving to buy a property, given anything like current values, is that it would take a very long time to do so during which you would not have the benefit of the property and you would have to pay another property owner rent to keep a roof over your head. Not that long ago it was common for ordinary families to share a house with a number of other families, often including the landlord. That obviously serves to keep a lid on the rent but very few of today would relish the prospect of one bath a week and no prospect of a Sky subscription.
So, we have come to accept that we either borrow a large sum to buy or we pay a high rent.
The problems with pensions are different. Whether you have a well funded pension makes no difference to you at all until you come to retire. This means that it doesn’t matter if you build it gradually as you do not have to provide a pension for your young family.
The problem for those building up a pension fund is the need to be efficient. If your pension is invested in cash, you will be lucky to receive any real return at all and will, therefore, have to contribute yourself every penny needed. This is why most will opt for at least some exposure to investments which have a chance of delivering a decent real return; that way you can build up a bigger fund with less money.
The problem with these type of assets is that they expose you to investment risk and they may go down as well as up in value and one way of reducing this risk is to have a longer time horizon. If you are viewing shares over thirty years, you may consider the risk of not receiving a decent return to be lower than if you are looking over just five years. So, it pays to be invested for longer to be more efficient and you want the maximum risk exposure to be at the very start, just when people have very little in their pension plan. Near retirement, it may make sense to reduce the risk but this coincides with the greatest fund value. This skew robs many of an efficient pension scheme and increases the risk they face.
If there were a mechanism for people to borrow early on to make large contributions, just when many can afford none at all, perhaps we could ensure that people reached retirement with well funded private pensions. The cost of servicing the debt would probably be comparable to the pension contributions they would have been making anyway and, with a bit of sickness cover in place, they would be better protected against teh risk of illness cutting short their working life and ability to fund a pension, saving the state a fortune in benefits.
