Adrian's Corner - Don't mention the pot size

19 October 2015

Adrian Boulding - Retirement Strategy Director at Dunstan Thomas

I was fortunate recently to attend a lecture by Professor Robert C Merton, the nobel prizewinning economist and resident scientist at Dimensional Fund Advisers in the US.

He is critical of the way that many DC schemes communicate with members and was at pains to point out the damage we do by telling members the size of their DC pot and recent year's fund performance.

In a very academic way, he distils pensions savings down to its basic rationale, the goal of providing a replacement income after our time in work comes to an end.

I have to agree he has a point here, and one we've been forgetting recently with all the excitement over George Osborne's pension freedoms and the ability to cash it all in on reaching the magic age of 55.

We could learn something from the DB world here. For as many DB trustees have found, under certain economic circumstances your assets might have been going up but your funding position was getting worse because the value of the income streams the DB scheme has promised are going up even faster. The correlation between pot size and what pension that pot will provide is far from straightforward.

The message is that by focussing on the pot size, we are sending out irrelevant and potentially mis-leading information to the consumer. Unless we turn their focus to the real desired outcome – a replacement income in retirement – we cannot hope that they will make sensible decisions.

Members will need to make decisions when they are no longer on target, which generally means they are part way through saving and it’s becoming apparent that the projected outcome is likely to fall some way short of what’s desired. For many years I have followed the Turner Commission mantra of three broad choices, which were presented back to the then Government by Adair Turner as “save more / work longer / pay higher taxes”. Of course the Pensions Commission was looking at the whole population, and for an individual the third option of higher taxes is not really a choice, unless they can pay extra national insurance to top up an incomplete State Pension.

Professor Merton introduced a third option more suitable for individuals – “take more risk”. In many ways this is highly appealing, as it doesn’t involve the reduction of immediate consumption that “save more” requires or the deferment of the leisure time that comes with retirement that “work longer” involves. Simply move your investment to higher risk funds and your expected outcome is back on target.

This underlines the difficulty of deterministic projections. As the Professor pointed out, if you want to use higher risk investments, then as part of the plan then you have to be aware of the potential downside and have an accepted course of action for when the potential risk is realised.

All of this would have been good advice if pensions were just meant to provide a pension. But the hugely popular reforms introduced by George Osborne have complicated that somewhat. Nevertheless the same output focus can still be adopted. The target is likely to be a lump sum at retirement, a few more lump sums along the way to provide for holidays etc and a further lump sum at the end to provide an inheritance. Plus of course a regular monthly income with hopefully a degree of inflation protection to maintain living standards.

In reality the cost of the monthly income is likely to overshadow the others, as most people are in a deficit position with inadequate savings and from a Maslow needs perspective that regular income is pretty essential whilst those lump sums are just icing on the cake.

So I came away convinced by Professor Merton’s arguments. We should focus on the income stream required in retirement. And as there’s a huge difference between wealth and permanent income, we might be wiser not to mention the pot size to pension fund customers.