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Pensions Time Bomb

With increasing pressure on state & occupational pension schemes, clients should consider alternative means of preparing for their retirement.

Over the last century the concept of retirement has changed from being perceived as a luxury to an expected right. During the same period however, life expectancy has significantly increased. According to a research paper 99/111 prepared for the House of Commons, in 1901 baby boys were expected to live for 45 years, and girls for 49. Current UK estimates from the Office for National Statistics for male life expectancy at birth are 78.1 years, and 82.1 for women.

Unfortunately however, as people have come to expect longer lives, our pension systems have not been adjusted accordingly. Whilst increasing life expectancies are good news, it does place increasing emphasis on individuals to fund their own retirement. A recent survey conducted by Allianz asked the question: “Which do you fear the most: outliving your money in retirement or death?” Surprisingly, 61% said they were more scared of outliving their assets than they were of dying.

Modern pension systems can trace their roots back to the late 19th century when Chancellor Otto von Bismarck introduced one of the first nation-wide social security systems in Germany. Since then, pensions have spread and become established globally.

The three pillars of pension provision, below, face unprecedented challenges.

The three pillars of pension provision

State Occupational Personal
Social Security systems provided through government taxes. This can either be on a funded basis (where funds are ring fenced to pay out future benefits) or on a pay as you go basis where benefits are paid for using current tax revenues. Benefits will be subject to a minimum retirement age. Employer-sponsored defined benefit and defined contribution schemes. Typically, employers will make some contributions in the form of ‘deferred salary’. In some countries employer contributions may be mandatory. Additional voluntary contributions may be amassed through the growth of defined contribution schemes. These plans typically provide some tax benefits on contributions. There are important implications for individuals in managing these assets (i.e. investment risk and longevity risk).

A global issue

State pensions use the tax taken from the income of younger working generations to fund older generations. As global birth rates continue to drop, people continue to live for longer and fewer workers are left to support an increasing number of retirees, pressures on global state pension systems will increase.

Inevitably we will see continuing major reforms in most countries over the coming years. For example, in the UK, the state pension age will be raised to 66 from October 2020 and pension experts in the UK are warning that the latest life expectancy calculations could lead the way for the state pension to hit 68 as early as 2027.

Looking further afield, the large emerging economies of India and China are in particularly poor shape. China faces a demographic time bomb more severe than any developed country, caused by its one-child policy. India has a much younger population, so its demographic problems will inevitably be deferred.

In the United Arab Emirates (UAE), only nationals are eligible for state benefits and these do not stretch to expatriate employees. In Hong Kong the normal retirement age is 65. The social security system provides benefits to the elderly, but these are means tested.

Not just individuals

At the same time as state pensions come under increasing pressure to fund retirement provision, occupational schemes face similar pressures. These schemes can be either defined contribution (DC) or defined benefit (DB) arrangements.

With a DC scheme, the risk for providing an adequate pension rests on the accumulated savings built up at retirement. With a DB scheme the investment risk is taken by the employer and the member is guaranteed a retirement income based on pay and length of service.

Over the years there has been a marked shift from DB to DC schemes. Many UK DB schemes are heavily in deficit and companies are coming under increasing pressure to address the current funding gap. It was recently reported that British businesses currently face a corporate pensions deficit of £295bn.

Bridging the gap

It is becoming increasingly obvious that we must all now look beyond state and occupational pension schemes to ensure we have sufficient retirement income in our old age.

One of the ways this can be done is to invest in a regular premium savings policy issued by an offshore provider. These plans are generally available for UK expatriates or foreign nationals, and are designed to generate capital growth over the medium to long term. Because the policies are issued offshore, there is no liability to tax on the income or capital gains of the various funds. Therefore, apart from any withholding tax that may be deducted at source on income arising from certain investments, the underlying fund grows without any further deductions of tax.

Regular savings contracts also encourage the discipline of commitment. Premiums can generally start off small and be increased over time, making the plans not only accessible but also extremely flexible. For example it is sometimes possible to change the frequency of the payments and to take a break from paying premiums should circumstances change. Lump sum top-ups can normally be accepted, perfect for boosting the retirement pot should an individual receive an unexpected windfall.

In an industry that is becoming increasingly competitive, there may also be incentives in return for larger monthly premiums or extended payment periods.

A flexible option?

It is important that any funds selected match the investor’s chosen risk profile. Most offshore regular premium policies allow for a broad choice of asset classes, risk profiles, currency denominations and geographical sectors from a wide selection of fund houses. They may even allow investment in Shariah compliant and socially conscious funds.

Furthermore, where an individual is unsure about where they should be investing or does not have the time to continually monitor investment markets, it is usually possible to invest in a range of managed funds run by professional fund managers.

A real advantage to saving monthly is that an individual does not have to concern themselves with market timing or identifying the best moment to commit. If money is saved on a regular basis, when the share price is down the individual’s policy buys more units. An individual accumulates more within the plan when markets are low and then as a sustained recovery takes place, all of the investment units that have accrued will go up in value. This is called ‘Pound Cost Averaging’.

An important benefit which will relate to UK expatriates only is that upon relocation to the UK, it is possible to benefit from ‘time apportionment relief’. This is a relief which reduces the proportion of the gain subject to income tax by the amount of time spent outside of the UK. So for example is a client had owned the policy for ten years but lived abroad for five of those years, then only half of the gain would be taxable.

In summary

The international financial crisis of 2008 and 2009, from which we continue to see the fall-out today, has highlighted the need for a compensation fund for policyholders. Many offshore jurisdictions now offer the best investor protection schemes in the world, providing all policyholders with compensation of up to 90% of their investment value in the unlikely event that the offshore provider becomes insolvent.

Unfortunately over the past couple of decades, western civilization has not been very adept at saving. While many of today’s workers may have been planning to retire between the ages of 60 and 65, the truth is that they will either have to work for longer or save much harder during their working lives.

More than at any other time in history, there is an urgent need for all of us to accept more responsibility for the provision of our own financial security.

As the well known author on time management, Alan Lakein, once said: “Failing to plan is planning to fail’’. The cost of inaction and procrastination is simply too high to ignore.