Sequence Risk & Defined Benefit Pensions

 The following snippets are taken from Ian Cowie’s column in yesterday’s Sunday Times.

In the first he reminds us that the sequence in which we experience good or bad investment returns is very important and in the second he gives an example of how generous most Final Salary/Defined Benefit Pensions are, including the Public Sector, when compared to Money Purchase arrangements which are now offered to most Private Sector employees.

Sequence Risk

Leaving the security of a final-salary pension to fund retirement from stock market income is an irreversible decision, which will be right for some and wrong for others. It’s vital that everyone doing so is fully aware of the dangers.

For example, how many have heard of “sequence risk”, or the mathematical fact that the value of your fund will be affected by the order in which gains and losses occur? Here’s a pensions parable in which two investors who each retire with £100,000 both enjoy average annual returns of 7% and draw annual income of £7,000 over the next decade.

Unfortunate Fred suffers losses in the early years and gets his gains later, while Lucky Lucy experiences the same returns the other way round. As a result, despite having exactly the same annual average return, Lucy ends the decade with a fund worth more than £120,000 while Fred has less than £72,000.

The explanation is the way percentages work; if you lose 20% one year, you need to gain 25% to get back to where you started. Or, if markets fall by about 50% — as they have done twice this century — you would need a 100% rebound to recover fully. That’s worth considering while markets trade near record peaks and the next move might be downward.

Defined Benefit Pensions

There are still some 12m active and deferred members of defined-benefit schemes (of which 5.5m are public sector), but the projected cost of providing these pensions has become prohibitive.

These schemes guarantee a pension income as a proportion of the salary earned when the employee retired. All public-sector pensions are defined benefit, although much of the civil service has switched new entrants to “career average” calculations to save money.

The payments are increased in line with inflation every year and schemes typically provide a widow or widower’s pension of two-thirds of the income given to the employee.

What a worker receives in retirement will depend on the scheme. Each is different, but most typically pay between 1/40th and 1/60th of final salary, multiplied by the number of years at the company.

So, if a person worked for 10 years for a company that calculates pension income in 1/50ths and their final salary was £75,000, they would have a pension of £15,000 a year (10 x 1/50th x £75,000).

By contrast, money purchase pensions make no guarantees. A saver builds up a pot that eventually pays whatever pension the market will bear, usually by buying annuities — an income for life. And they would have to save hard to accrue a pension worth £15,000 a year with comparable benefits.

According to the annuity specialist Retirement IQ, a 65-year-old who wants a two-thirds spouse’s pension and payments that keep pace with inflation will receive on average about 2.3% a year from an annuity provider.

To provide £15,000 a year, they would need a fund worth more than £650,000. Imagine trying to accrue that in just 10 years.

If you have any concerns or questions about any finance related matter, please do not hesitate to call me at any time.

With best wishes,

Yours sincerely 


Graham Ponting CFP Chartered MCSI
Managing Partner