How to drive into the sunset of a secure retirement

Published on Friday 25 July 2008 19:54

THE road to your pension can have three drivers and three vehicles.

Just like car drivers, pension drivers face big cost increases and uncertainties. Your employer drives the work-based pension vehicle. You drive any individual pension and other long-term investments. The state drives state pensions and other old-age benefits.

Hopefully these vehicles form a convoy to a comfortable retirement, but for that to happen they all have to be driven in the same direction and not break down along the way.

Today each of these faces big challenges. Not long ago, employers mainly drove the Rolls-Royce of pensions – final salary, or defined benefit, schemes. But since 1997 these have attracted big stealth taxes and are becoming prohibitively expensive to run. Instead, employers are switching in droves to more modest and predictable defined contribution schemes. Unfortunately these will not provide the same comfort – unless you put in a lot more contributions yourself.

An exception to this is the public sector pension vehicle, where the running cost is met by taxpayers. A cost cap has been negotiated between the government and the public sector unions, but it remains to be seen how effective this will prove in practice.

The pensions and investments you drive yourself are particularly sensitive to the state of the underlying investment markets. Cash may appear to be a safe haven in troubled times, but only index-linked gilts are immune to rising inflation and they charge a high premium for that.

The only free lunch is diversification – the spreading of your investments over different types to minimise total risk.

State pensions and other state benefits have their own problems. Very few people would look forward to living on a state pension alone, and they will have to wait a long time for even that – until 68 for those born after 1980.

So what is the government doing to help overcome the obstacles on the road to a comfortable retirement? Its current big idea is auto-enrolment. This means that employees will join a decent work-based pension scheme unless they explicitly opt out.

However, there are several potential accidents ahead. First, auto-enrolment is targeted primarily at lower earners who don't have much, if any, existing private pension. But these are exactly the people most likely to be entitled to means-tested benefits in old age, which means they might not get decent value for their pension contributions. The government is looking at this issue and is due to report back by the end of this year, but it is very reluctant to admit that there is a problem.

Another potential accident is the effect on good existing pension provision. If employers and employees are currently paying more than the combined 8 per cent of adjusted pay that is the minimum for auto-enrolment, there must be a great temptation to regard 8 per cent as the new norm, and reduce payments to this level.

A big issue facing all forms of pension provision is increasing longevity. That people are on average living longer is a great problem to have, but if your retirement is going to be longer you will need more money to pay for it. Nobody is an average, and a conventional annuity is insurance against outliving your pension assets. A new variation on this is to buy investment and longevity guarantees without actually buying a conventional annuity. This is generally called a variable annuity, and may be a better answer for some people.

Unfortunately there is no satnav for the pension road ahead but there are financial advisers.

• Stewart Ritchie OBE, director of pensions development for Aegon, retires next week after 36 years with the company