Delaying pension saving until later in life is not such a crazy idea, says Teresa Hunter
The said academic was David Blake, of the Pensions Institute at the Cass Business School, who with fellow members Douglas Wright and Yumeng Zhang, has written a series of discussion papers looking at ways to optimise defined contribution pension planning, and the behavioural obstacles preventing us from doing so.
You need to be an actuary and genius to read the reports. But, they conclude, if you’ll allow me the crudest of summaries, that the optimum way to save for a pension is to leave it until later in life, and to then stay fully invested in equities.
The logic is fascinating and flawless. Firstly, they say it can be a mistake to save into a pension when you are young, because you may not be earning much and have other more pressing commitments such as buying a home, repaying student debts or starting a family. Far better to wait until later in life, when salaries are higher. But there is a trade off. If you decide against putting away say 12 per cent, during your entire working life, in your 40s or 50s you must save significantly more, say 50 per cent.
The next secret to an optimum strategy, is to stay fully invested in equities, and not derisk, via lifestyling. They claim this is not as crazy as it sounds, because we should not just concentrate on financial capital, but also take into account what they call our human capital. No, I’d never heard of it either. In a nutshell, our human capital is our future earnings capacity. As these are a guaranteed income stream, they are the equivalent of bonds.
If we are in work and plan to stay that way, our bond-equivalent holdings are already substantial, through this human capital, so it makes sense to keep the rest in equities, given they outperform bonds by 3 per cent over the long term.
The optimum way to save for a pension is to leave it until later in life, and to then stay fully invested in equities
Only towards the end of our careers, when our human capital is eroded by the prospect of retirement, do we need to move into bonds, by annuitising part of our assets. Even then, the authors recommend managing down the bond/equity balance, so that we only fully annuitise by 80, say, when the equity premium finally disappears. Funnily enough, I came to exactly these conclusions years ago, and have followed this strategy ever since, if doing nothing about my pension can be called a strategy.
This makes me as close to a rational investor as you get, according to the authors, who say fear of gyrating stock markets and future job insecurity prevent most investors following this optimal strategy. If their behaviour could be changed, they would be quids in. So who is right?
Am I genius or bonkers? As ever, the perfect theory can break down when it confronts the real world. What about employer contributions?
Many employers will only contribute if staff are also doing so. So it has to be a nonsense for anyone with a company scheme.
The other problem is stock market returns. Blake says he has to use long term trends, but admits the pattern of the last century may not be repeated this. There is some logic though, if you alone are putting the money in. While they don’t consider tax relief and interest rates, tax relief will be higher when you are better-paid. If interest rates and mortgage payments are also high, it makes sense to clear your debts before you start putting cash away.
So how does it feel to be a rational investor? Well, I’d cleared the mortgage on our family house before I was 40. But then there were school fees and university bills to pay. But that was OK, because once the children were finally off the bank balance, I planned to put 100 per cent of my earnings into a pension, in the years running up to retirement.
What happened? Government imposed a £50,000 annual ceiling and we entered an almighty recession. From where I’m sitting right now, being slightly more risk averse might have served me better.
But retirement is still years off, so watch this space.
Teresa Hunter is a freelance journalist