Building your own Final Pitstop : What you would need in a private pension account to replicate a social pension portfolio.

In this episode, we are going to take a very quick look at the actual core value of a portfolio of social pensions.  We will start with direct beneficiary value replicated in a private pension account and distributed via an annuity.  We will then consider taxation effects and finalise with a look at what we would need when spouse/dependant non-primary benefits are included.

For the sake of the argument we will assume that our financial frolicker holds a typical (average) usa, uk, and german pension, vested at age 70 and held to age 85.  This is pretty close to where life expectancy and optimal exercise sit 15 years hence.  This could comprise 10600gbp a year, 22500usd a year, and 15 000eur a year.  

For our first exposition we will assume conversion to an annuity in each case at age 70.  For annuity rates of 2.5% (typical of the gfc extreme low policy rate era) you would need 425 000gbp, 900 000usd, and 600 000eur.  Well, you would have your longevity coupon if you had invested that successfully.  Those are large number folks .  Good luck with that, considering the dot com bust and the gfc - unlikely.  You can talk with your pension broker about tax convexity all day long but big numbers break secondary effects pretty seriously.  For annuity rates of 5%, you need half this.  We are back in the land of reality.  

Quity a few tail edge baby boomers who had moderately risky equity portfolios they topped up in pension accounts will get near this.  Gen X will not.  Gen Z does not have a prayer.  They are paying student debt instead of pension pots.  Boomers really are the gift that just keeps on giving right?  The point is that your ability to replicate the core value of a portfolio of social pensions depends utterly and randomly on annuity rates when you exercise 40 years deep in your investing.  It is nonsense right?  It is not so much a series of returns issue as simply a government of the day floating you or sinking you for the rest of your life with a monetary policy rate decision issue.

Defined benefits and payouts are generally desirable over the stuff that fluctuates with a benchmark rate frolickers provided the benefit level is realistic.  That is why we build a portfolio of them.  Riding the roller coaster of risk to have it all stripped off you because you exercised in 2012 instead of 2006 is pretty brutal - oh and your portfolio got dumped into an atlantic sea trench too.  The wrong way risk on private pension accounts and their exercise value as annuities is truly lethal.  You have been warned wisely again Frolickers.  How is that caricature of your pension broker shaping up these days?

All of those numbers have to be inflated by 15-25% if you deferred your pensions until age 70 - as you should.  They have to be inflated for another 15% for tax effects probably too.  Yes, private pension pots do not really replicate a portfolio of social pensions very viable on an annuity disposal strategy.

A number of my readers will tell me that they do not care about the longevity coupon being replicated and they will take a drawdown option for its flexibility and to avoid unappealing annuity rates.  There is an argument to be made here.  So let us do another back of the envelope replication.  To drawdown for 15 years you are going to need 160 000gbp, 337 500usd, and 225 000 eur.  Look, it is about 1/3 the price of a low annuity regime, and about 3/4 the price of a moderate annuity regime.  It is a real decision in a low annuity rate environment.  Of course you will pay higher taxes, probably 20-25%, so its not as pretty as that.  Conversion to annuity is generally tax shielded better than drawdown options.  It falls apart pretty badly if you live beyond average lifespan by much.  It falls apart totally in your 90s.  Be wary.

Where the replication of a portfolio of social pensions with a private pension account really fails though is when you consider the asymmetric benefits.  When your spouse is getting half thanks to you, or your spouse and child survivors are getting 1.5 times your benefit thanks to you.  These contingent coupons can be achieved with annuities - but the rate effect is disasterous, and you are back into the drawdown optionality really.

Now we come to the point of this little bit of play in rough replication.  The real value in a private pension account is in topping up the core benefits you have acquired in a portfolio of social pensions for you and your family.  Please read that 3 times.  You should not be funding private pension pots in any serious way until your life is established and secure financially and you have 3-4 social pensions ready to pitstop you seriously.  You are just giving hard-earned liquidity to the chicanery of a process that claims 8% asset returns are achievable, when they actually are not over the time frames in question.  You are playing the roulette wheel - and for high stakes.

There is a reason we used to have defined benefit pensions.  You have just witenssed the reason.  The best modern substitute for a defined benefits pension built up over decades of service to one employer is a collection of social pensions.  Make no mistake about it.  However many you can get - go get them.

In the next episode, we are going to investigate the real value in a private pension pot, supplementing your social pension portfolio and providing an earlier pitstop day for you to make sub-optimal employment a distant memory...