Pension for Contribution

People are lost if it comes down to their pension. A recent (2012) Friends Life survey found that 68% of Britons do not know the collective value of their pension funds.....

This result is in line with a Dutch 2011 survey, that concludes that 66% has no knowledge of their pension.

Pension illiteracy is clearly a worldwide phenomenon. Pensions are a 'low interest' product. Unfortunately - nowadays - in the double sense of the latter words.

As an actuary, people often ask me at a birthday party : I'm paying a 1000 bucks contribution each year for my pension, but does it pay out in the end? Can you tell me?

Unfortunately most actuaries, including myself, answer this question by telling that this is a difficult question to answer straightforward and that the pension outcome depends on topics like age, mortality, return, inflation, gender, indexation, investment scheme, asset mix, etc., etc.....

Simplifying

To make a breakthrough in this pension communication paradox, let's try to create more pension insight with a simple approach. But remember - as with everything in life - the word 'simple' implies that we can not be complete as well as consistent at the same time. After all, Kurt Gödel's incompleteness theorems clearly show that nothing in life can be both complete and consistent at the same time.

Thanks to God and Gödel, we can stay alive on this planet by simplifying everything in life to a level that our brains can comprise. We'll keep it that way in this blog as well.

How much pension Benefits for how much contribution?

First thing to do, is to give the average low pension interested person on this planet an overall hunch on what a yearly investment of a 1000 bucks(first simplification: S1)until the pension age of 65 year (S2) delivers in terms of a yearly pension as of age 65 in case of an average pension fund.

If we state 'bucks' here, we mean your local general currency. We denote 'bucks' here simply as $, or leave it out. So $ stands for €, ¥ , £ or even $ itself.

Now let's calculate for different pension contribution start ages (S3)what a yearly contribution of $ 1000 (payable in months at the beginning of each month; S4), pays back in terms of a yearly pension (payable in months at the end of each month; S5) on basis of a set of different constant return rates (S6). The calculation is on a net basis (so without costs; S7), a Dutch (2008) mortality table (S8) and without any inflation (S9), any pension indexation (S10), any contribution indexation (S11), or any tax influence (S12).

Here's the simple table we're looking for:

TABLE 1

Yearly Pension at age 65 on basis of 1000 yearly contribution
Pension Indexation=0%, Contribution Indexation=0%, Inflation: 0%
Start	Net Yearly Return Rate
Age	0%	1%	2%	3%	4%	5%	6%	7%	8%
25	2692	3669	5019	6898	9521	13192	18336	25553	35681
30	2345	3113	4134	5503	7342	9812	13133	17601	23612
35	1999	2584	3335	4304	5555	7171	9257	11949	15421
40	1654	2084	2614	3273	4092	5109	6370	7933	9867
45	1311	1610	1964	2388	2896	3502	4225	5085	6107
50	972	1163	1380	1632	1921	2254	2635	3072	3570
55	638	744	860	989	1132	1291	1465	1657	1868
60	312	355	400	448	499	554	612	674	738

In a graphical view on a logarithmic pension benefits scale, it looks something like this:

Example

To illustrate what is happening, a simple example:

When you join your pension fund at age 40 and start saving $ 1000 a year (the first of every month: $ 83.33) until your 65, you'll receive a yearly pension benefit of $ 4092 yearly ( $ 341 at the end of every month) from age 65 of, as long as you live.

From this table, we can already draw some very basic conclusions:

• To build up a substantial pension, it pays out if you start early in life
• The pension outcome is heavily dependent on the yearly return of your pension fund
• Most pension funds operate on basis of a 'general employee and/or employer contribution' instead of individual employee contributions.
  This implies that younger employees pay more than they should have paid on an individual basis and older employees less. In other words, younger employees subsidize older employees. How much more, you can derive from the tables above and by comparing the individual contributions to the general contribution level of the pension fund.

Pension Indexation

As we all want to protect our pension against inflation, let's calculate the outcome of a 'real pension' instead of a 'nominal pension'. As long term yearly inflation rates vary between 2% and 3%, we make the same calculation as above, but now the yearly pension outcome (as from age 65) will be indexed with 3% (fixed) at the end of every year and the yearly contribution paid, will also be yearly indexed with 3%.

Here's the outcome:

TABLE 2

Yearly Pension at age 65 on basis of 1000 yearly contribution
Pension Indexation=3%, Contribution Indexation=3%, Inflation: 0%
Start	Net Yearly Return Rate
Age	0%	1%	2%	3%	4%	5%	6%	7%	8%
25	3687	4914	6566	8814	11889	16112	21933	29978	41124
30	2947	3859	5051	6624	8707	11468	15138	20021	26526
35	2309	2968	3803	4872	6241	7994	10240	13119	16809
40	1760	2218	2781	3479	4344	5413	6735	8368	10382
45	1288	1590	1949	2381	2897	3515	4251	5127	6168
50	882	1066	1277	1523	1807	2134	2512	2944	3440
55	536	633	741	862	998	1149	1316	1502	1706
60	243	281	321	364	411	461	515	573	634

To get grip at the comparison between a real and a nominal pension, we express the real pension (3% Indexed Pensions and Contribution) as a percentage of the nominal pension:

TABLE 3

Yearly Pension at age 65 on basis of 1000 yearly contribution
'3% P&C-Indexed Pensions' as percentage '0% P&C-Indexed Pensions'
Start	Net Yearly Return Rate
Age	0%	1%	2%	3%	4%	5%	6%	7%	8%
25	137%	134%	131%	128%	125%	122%	120%	117%	115%
30	126%	124%	122%	120%	119%	117%	115%	114%	112%
35	116%	115%	114%	113%	112%	111%	111%	110%	109%
40	106%	106%	106%	106%	106%	106%	106%	105%	105%
45	98%	99%	99%	100%	100%	100%	101%	101%	101%
50	91%	92%	93%	93%	94%	95%	95%	96%	96%
55	84%	85%	86%	87%	88%	89%	90%	91%	91%
60	78%	79%	80%	81%	82%	83%	84%	85%	86%

From this last table we can conclude that if you start saving for your pension below the age of 40 your indexed savings weight up to the indexed pension. Above the age of 45 it is the other way around.

The above figures are the kind of figures (magnitude) you'll find on your benefits statements. You can compare in practice whether your benefit statement is in line with the above tables....

The Inflation Monster

In the last given example, pension is 3% inflation protected as from the moment of retirement.

However, if pension is not also yearly fully indexed (in this case: 3%) during the contribution period, there still is a major potential inflation erosion risk left.

In this case it's interesting to examine what the value of a 3% indexed pension in combination with a 3% indexed contribution is worth in terms of actual money, as inflation would continue at a constant 3% level each year. Here's the answer:

TABLE 4

Yearly Pension at age 65 on basis of 1000 yearly contribution
Pension Indexation=3%, Contribution Indexation=3%, Inflation: 3%
Start	Net Yearly Return Rate
Age	0%	1%	2%	3%	4%	5%	6%	7%	8%
25	1130	1507	2013	2702	3645	4939	6724	9190	12607
30	1047	1371	1795	2354	3094	4076	5380	7115	9427
35	951	1223	1567	2007	2571	3293	4219	5405	6925
40	841	1059	1328	1662	2075	2586	3217	3997	4959
45	713	880	1079	1318	1604	1946	2354	2839	3415
50	566	684	820	977	1160	1370	1612	1890	2208
55	399	471	552	642	742	855	979	1117	1269
60	210	242	277	314	355	398	445	494	547

What we notice is a substantial inflation erosion effect as the pension fund participants get younger.

Let's zoom in on an example to see what we can achieve with these tables.

Example

• From table 2 we can conclude that - at a 4% return rate - a 40 year old starting pension fund member, with a $ 1000 dollar yearly 3% indexed contribution will reach a 3% yearly indexed pension of $ 4344 yearly at age 65.
• From table 4 we can subsequently conclude that, based on an inflation rate of 3%, this $ 4344 pension has a 'real' value of $ 2075, if it's expressed in the value money had when the participant was 40 years old (so, at the start).
• From table 4 we can also conclude that in order to 'compensate' inflation erosion for this pension member, the pension fund has to achieve a return of around 7.4%.
  This follows from simple linear interpolation:
  7,4% = 7% + 1% * (4344-3997)/(4959-3997)

I'll leave other examples to your own imagination.

The effect of a constant inflation on a pension is devastating, as the next table shows

TABLE 5

Inflation Erosion Pension indexation=3% as of age 65 Contribution indexation=3% Inflation=3% Start Age Inflation Erosion 25 69% 30 64% 35 59% 40 52% 45 45% 50 36% 55 26% 60 14%

From table 5 it becomes clear that Inflation erosion is indeed substantial. If you have a fully indexed pension from age 65 (who has?) of and you're N years away from your retirement, an inflation of i% will erode your pension with E%. In formula:           Example Set inflation to 3%. If you're 40 years old and about to retire at 65, you've got 25 years (N=25=65-40) ahead of you. If your pension of let's say $ 10,000 a year is not indexed during this period, you can buy with this $ 10,000 no more than you could buy today with $ 4,800.

Your pension is eroded due to inflation with 52% = 1- 1.03^-25. So only 48% is left.....

Finally

I trust these tables and examples contribute a little to your pension insight. Just dive into your pension, it's financially relevant and certainly will pay out!

Remember that all results and examples in this blog are approximations and simplifications on a net base (no costs or taxes are included). In practice pension funds or insurers have tot charge costs for administration, asset management, solvency, guarantees, mortality risk, etc. . This implies that in practice the results could differ strongly with the results as shown in this blog. The examples in this blog are therefore for learning and demonstration purposes only.

The above calculations were made in a few minutes with help of the Excel Pension Calculator that was developed in 2011 and updated in 2012.

With help of this pension planner you can calculate all kind of variations and set different variables, including different mortality tables (or even define your own mortality table).

You can download the pension calculator for free and make your own pension calculations.

More information about pension calculating with this simple pension calculator at:

MORE ABOUT EXCEL PENSION CALCULATOR

Enjoy your pension, beware of inflation....

Links & Sources:

- Download Excel Pension Calculator (virus free)

- The scourge of multiple hidden pension pots (2012)

- Survey:Individual Differences in Pension Knowledge (2011)

- Kurt Gödel's incompleteness theorems

- EU Inflation Monster

Pension Date Outdated

Have you ever thought about your Pension Date?

Isn't it strange? We live in an era with an increasing (healthy) life expectancy. At the same time, there are strong individual old age health differences, resulting in strong individual 'Job Fit' differences.

Yet our 'Pension Date' is kept collectively fixed at an age of 60, 65 or 67.......

Working keeps you alive
The closer you get to your pension age, the more you realize that a full employment break at 65 (or whatever age) is crazy, unwise and even dangerous.

On top of, the life expectancy of the working population has proven (see: Towers Watson) to be significantly (up to two years!) higher than that of the population as a whole. In other words:

The longer you work, the longer you live....

(Non) Financial Pension Planning
More than just financial, Pension Planning is a common responsibility between the employer and the employee, to fit the employee's work (job) and working hours to his changing abilities as (s)he grows older. This way an employee is able to retire gradually. Now (s)he can adapt step-by-step to the changing new social and working environment, while still adding company value.

As the employer's workforce is - just like society - aging step-by-step, it's in the employer's interest to develop an integral HR-Investment Strategy and Action Plan for every to be defined relevant employee age-group.

Work Ability Index
An excellent way to start is to measure if employees are 'Job Fit' with the so called Workability Index.

Introduction to Workability for Employers from MeteorWorkability

 

Work as a burden?
Our present pension system still carries the characteristics of a social environment of the fifties of the last century. In this bible dominated time-frame, work is seen as a kind of burden.:

Genesis 3:19
In the sweat of thy face shalt thou eat bread, till thou return unto the ground;

for out of it wast thou taken: for dust thou art, and unto dust shalt thou return.

Nowadays more and more people are perceiving work as a challenge to develop themselves and others in a healthy way. You are not working to finally 'enjoy' your pension 'doing nothing', but you work because it gives life meaning and your pension plan helps you to financially manage your decreasing work-income and your increasing health costs as you get older and older in hopefully relatively good health.

Karl Lagerfeld, the Perfect Example
A strong example of such a new 'life policy' has recently been given by Karl Lagerfeld in an interview with Edie Campbell for Vogue. Karl is almost 80 years (!) old and besides one of the world's successful businessmen, fashion designers, artists and photographers, still vital and going strong in life.

View the next summary and enjoy Karl, regarding his view on retirement....




Change our Pension System
To cope with the aging workforce and to profit from 'elderly workers', employers have to:

• fit their employees' work (job) and working hours to their changing abilities as they grow older.
• This implies that employees have to be able to retire gradually.

A NEW PENSION SYSTEM
A new flexible pension system is needed to facilitate gradually retirement of employees:

1. Skip THE Pension Date
Therefore 'THE Pension Date' in our pension regulations has to be fully skipped as soon as possible and  be replaced by an individual, flexible and gradually applied partial pension.

2. Change Pension Payment Structure

• As from the (example) age of 50, every year the employee and employer agree on what income corresponds with the contracted activities of the employee and what the employee supplementary needs as pension income. 
• Each year, this required 'pension' income is deducted from his pension account. 
• The pension account of the employee yearly grows with the realized investment return of the pension fund and an age-dependent proportional part of the accounts of pensioners that died.
• A yearly pension communication benefit statement informs the employee about the expected development of his yearly pension in the future, in line with the agreement between the employee and the individual employer.

FINALLY...: IF NOT

If companies don't change their HR-Strategy and correlating Pension System, they and their employees will be confronted with unsustainable financial pension outcomes in the future, with as a result:
- Pension Cuts,
- Social Turmoil and
- Declining Profits.

It's the responsibility of every actuary to advice employers to take action in renewing their pension system to the demands of our modern and aging society.

If not.... actuaries will not be seen as advisors or helpers, but as the executioners of pension cuts.

Actuaries, it's up to YOU!

Perhaps some actuarial coaching may help us......

Sources/Related Links: 
- Mortality Experience (TW;PDF;2010)
- Does Your Job Fit Your Age?
- ABC-News: Aging: Work Longer, Live Longer
- Example Waikato: Strategies to retain staff in employment as they age
- VOGUE 2012: Karl Lagerfeld: Retirement Is Death
- Make your own free Cartoons at Pixton

ESM, Rate Rating Procedures

As of  October 8, 2012 the European Stability Mechanism (ESM) is a fact.

ESM is a European multilateral lending bank that lends money to euro Area Member Countries in order to facilitate them to restructure their debt and financial position.

Please note that the ESM lending is funded by debt only! 

ESM Rating

On October 12, 2012 Fitch Ratings has assigned the ESM a triple-A (AAA) Long-term Issuer Default Rating  and a Short-Term IDR of 'F1+'. The Outlook is Stable.

All Hosanna one would say. Well almost....

At the end of the FitchRatings document two small remarks state the following:

1. The rating is robust to downgrades of 'AAA' shareholders into the 'AA' rating category.
2. However, as Fitch has previously commented, in the event that Greece were to exit from the eurozone, the ratings of all sovereign and sovereign-rated entities in the eurozone, including the ESM, would be placed on Rating Watch Negative as Fitch re-assessed the broader political commitment to the euro and the potential contagion and financial implications of a Greek exit.

Implicitly the first remark implies that if individual AAA countries are downgraded below AA, the Fitch rating is no longer robust. As the probability that such a downgrade might happen, is substantial, it is strange that this 'downgrade risk' is not explicitly valued in the rating procedure.

The second remark implies that a significant risk (1Y default Risk Greece>30%; see also: Default Risk at Risk) as the exit of Greece, has also not been valued in the rating procedure. Not to mention that a possible default risk or exit of Spain has not even come into the mind of the FitchRating scientists. 

Conclusion
From a risk management and valuation perspective, leaving out both risks in an official rating procedure is ridiculous and looks more like a kind of 'lip service' instead of a serious rating procedure. Above all, it places rating procedures in a bad spotlight.
It's about time to rate the ratings agencies an their rating procedures. Who's willing (or dares) to do so?

Perhaps it's also time to fill in the Risk Manager vacancy in the ESM Organization Chart...... ;-)

Sources/Related Links

- ESMs FitchRatings document 2012 
- Presentation ESM
- ESM Organisation Chart

Aftermath European Crises Explained