The Chicanery of Private Pensions, and what are the substitutes...
In this episode, we are going to discuss the general features of private self-provided pensions and the assorted chicaneries that surround the marketing of them, as well as their natural substitutes - social pensions. We are going to deal with employer-provided pensions separately later. As we go i am going to introduce you to the personal finance concepts of tax convexity, liquidity, risk premia, and open vs closed end funds.
We have all been told, relentlessly, that part of being a financially literate astute adult is making tax-privileged contributions to a private pensions plan to the fullest extent, whether it be an american 401(k) account, or a british ISA, or an australian Superannuation fund account, or wherever, however named... We are told the earlier we start the better and that we are all massively under-invested in our own old age. I beg to differ on all counts, and am here to construct you a substitute that i consider a much better alternative.
It is absolutely true that we should be providing for our old age from the day we start work, and indeed, we are.... Probably to a far greater and more robust extent than you may think, and the more we frolick the better. Hold that frolicksome thought as i introduce you to a global selection of the humble social pension...
In Australia, you do not even need to go to work to be providing for your old age. The state pension in Australia is residence period based. You can decide at age 16 that school bores you, go become a Surfers Paradise street kid, and live on benefits until age 26, then get a bit tired of the local beaches and take your beach bum act global until age 67, any way you can make it happen... You will be fully eligible for an australian state senior pension - about 28 000AUD a year. No questions asked. No work record or contributions account required. Ten years of adult residence and a returned resident at retirement age. That is the deal - and it is the best social pension deal on the planet because it costs you nothing and is not contingent on labor provision, or even residence after 10 years of it. You are free to frolick. Free to qualifying participants is always a hard offer to beat.
Sadly it is not globally portable at retirement age unless you have 35 years of residence in australia, and it is a genuine social pension, which means it is income and asset tested and disappears rather quickly if you have alternate sources of income or a significant asset base beyond your primary home, which is exempt. Australia has a very serious pension deal on the table for global beach bums - if you spend ten years and retire there without much beyond a home and some sensible savings level, it is a gift from society straight to you.
The Americans, hard working bunch that they are, are not believers in social dividends like pensions for long-term residents of the country. They run a contributions system that will take roughly 8% of your pay and another 8% off your employer. It is costing you 15% of your potential labor value every month - for at least 35 years to be fully-franked. It has a typical formula basis, but with a very interesting convexity for lower-income long innings workers. It has particularly valuable asymmetric benefits to a reduced work spouse and to survivors. Social Security payments, with caveats, are fairly broadly globally portable too. They are frolick-franked.
It is potentially about 2-3 times more valuable than the australian state pension, at about 50 000USD a year if you have been a fairly high professional income earner for 35 years of record, but the average is only about 18 000USD. It is a long high income haul to get the pot of gold. .. and i must recuse myself for accusing the americans of not believing in socialism, because they tell me this so often and so loudly, but in fact the american social security system pays a very special social dividend to spouses who have poor working and contribution records.
Spouses with 10 years of marriage record (even then divorced and not remarried) get half of their working spouses entitlement if theirs is less, even if they have never worked a day in their life. Surviving spouses and ex- do even better. They get the full entitlement, not half, and if there are dependants they can get up to 150%.
The americans will only sponsor married beach bums apparently, and your spouse is not going global with you... Dear old other half is chained to the job and two weeks leave a year in america for 35 years to make it happen for you.
The next time an american spits the word socialism out at you if you come from a social democracy like i do, please smile gently, do not bite, and tell that dear person about their social security system for spouses. America is actually a deeply socialist country when it comes to old-age public benefits. I do wonder how many failing early marriages this quick prosaic summary may potentially re-inspire and rescue. I also wonder deeply about the cognitive function of many retired americans i have had spit the word socialism at me within 5 minutes of noticing my accent as they lived off their socialist public benefits.
The British, as is their wont, throw a most meaningful pose, make vast promises, fail to implement, and under-deliver terribly - and late. Plus ca change really. The British social pension will take you 35 years of contribution record, cost you about 12% of your income up to the upper tax bracket and then about 2%. It is costing your employer too, so again about 20-25% of your potential labor value. It is not quite as simple as that because the contributions fund the NHS too - well they are intended too, but anybody who has ever had to use the NHS for anything beyond an antibiotic prescription knows it does not work. In my opinion, many third world countries have better health systems than the uk, but that is a rant for another day.
For your 35 years of being tied to an employer in Old Blighty and hoping to never need health care, much less a decent dentist, you will receive about 10 500GBP. ...If they can find your record and have kept it accurate. Yes, the under-delivery is quite serious. A street cat might be able to live on it - not you. It is globally portable - frolick franked again - but with caveats on the annual inflation indexing. The british really do not like their ex-colonies except when there is a war to be fought, and dying to be done. Again, plus ca change....
The Germans, as you may expect, are an absolute classic case in strong fair and funded social democracy. The social pension, the GRV, will cost you again about 20% of your potential labor value, and has a contributions formula over 35 years. It caps at about 85 000euros income a year and on a fully franked modestly high income record like this would pay about 32 500euros at normal retirement age. It has fairly strong caveats on portability, which i am still investigating. As always, in retirement you will face some additional social taxes on it, rather than just income tax. If you want the benefits of social democracy, the costs are forever.
All of these social pensions are indexed annually for cost of living inflation, on the appropriate domestic formula. Please read that twice fellow frolicker - social pensions are near-perfect inflation hedges. No, read it 5 times. Yes, 5 times. Inflation hedges are very very difficult to construct in private financial assets for the average guy or girl. A decade of strong inflation, by it's nature, will tear your wealth profile apart by eroding the real capital base. It is economic cancer, especially from mid-life and later. ...and that is exactly why social pensions are inflation indexed and provide inflation hedges. You will not be getting that feature in your 401k or super or isa or rierstr fund - believe me.
Now, i have a personal working knowledge of each of those social pension systems because i am a beneficiary of each of them. It is in my interests to have a pretty strong working knowledge of them - and it is in your interest, fellow would-be frolicker, to have a strong working knowledge of the systems you are potentially a beneficiary of. Do i hear scurrying minds wondering whether their past offshore frolics might hold a payout feature?
I bet it has surprised all you would be frolickers that you had so much money saved for your retirement - before anybody even mentioned 401k or super or isa or rierstr products? You are getting stiffed generally for about 20% of your labor value up to a modestly high mid-career professional salary as a general estimate. You have saved 20% of your labor worth, compulsorily, before anybody mentioned private pension accounts. Hold that thought please for later.
Indeed, a private pension account might also be a very viable component in your overall personal finance portfolio, and it might not too... The question is one of suitability, and before we make significant financial commitments we should always appraise suitability. You will find this is enshrined in the investment policy process of any financial fiduciary you deal with who has a formal duty of care, typically your asset manager or pension advisor. Your mileage may vary. Let the buyer beware....
To undertake a suitability analysis we have to understand the key financial and general features of the product we are looking at, it's risk and return characteristics, it's tax treatment, and the way in which it integrates and correlates with the rest of our personal finance portfolio to help us achieve financial goals and reduce financial risk.
Firstly, the primary benefit marketed of private pension accounts is their tax convexity. You will not pay tax or pay a reduced income tax exposure on income you contribute directly to the account. Of course, you will pay tax in the end, when you draw down the money in retirement. National rules vary from part taxation on entry and exit and no taxation on fund growth while in closed fund mode (eg australia) to no tax on entry, full personal tax on exit, and no tax on growth (USA) to the fairly generous british version with large amounts deductible on entry over a 4 year window (240 000), no tax on growth, and a generous 25% tax free lump sum on exit, with flexible annuity or drawdown exit treatments. Personally, i think the british scheme has the best tax convexity. Mileage varies, regulations do change, but the general feature of saving some tax to incentivise you to save is uniform.
The point here is not to get bogged down in national schemes or the risks of regulatory change if you have a large pot, but to simply point out that tax convexity is a complex issue and in general you are going to pay taxes at some point on the time horizon. You may reasonably expect that by saving in a private pension account you will defer some significant taxes, you may avoid some or all taxes on growth, and you may avoid some tax altogether because your marginal tax bracket in retirement may be much lower than it was in your peak earning years, or due to special tax convex exit features in your national scheme. I will spend an episode on comparing schemes later, not today.
We need a reasonable general framework for assessing suitability with a tax convexity product feature, without getting too buried in details. Generally, i consider the value of private pension account tax convexity to arrive in two parts.
The first part being in deferring taxes on entry and potentially avoiding some of these deferred taxes if you are in a lower tax bracket in retirement (which most are), as a savings incentive. That simple. There is a value proposition here. It is not the killer feature it is marketed as. Saving a 40% tax bill today to lose the liquidity and pay a 30% tax bill in retirement - if you get to a longevity point where you have actually drained your pot - is not a killer feature to me. Yes, it has a value - no it is not the kind of value that would make you cry over too hard if you missed it for a few years occasionally.
The second part of tax convexity value in private pension accounts arrives if the growth in the fund is not taxed in the hands of the fund. This is actually potentially a much more valuable convexity than the tax deferrals and bracket erosions. However, some systems do tax (uk) and there is a general and very unfortunate trend in the western world to fiscal catastrophe after 30 years of baby boomers running ponzinomics in asset markets and on fiscal spending. Your financial frolicker thinks the days of private pension account growth being untaxed look fairly numbered. In any event, you have to grow by as much as inflation every year just to stay still in reals and so this tax convex feature has limited real value in inflationary workout periods. Inflation is truly economic cancer.
I hold two opinionated caveats on this tax convexity feature. Firstly, i think the political risk of regulatory change is high. I think fiscal holes must be filled and these pension account schemes are large invested pots of money that are easy to monitor and tax. I think there is significant political and regulatory risk associated with building or holding a large private pension pot over the next 20 years. Secondly, i think the likelihood of strong financial asset returns after 30 years of very deliberate ponzi schemes since the mid 90s are very very poor - vanishing. My central viewpoint is that we are likely to get taxation on growth, badly performing asset markets for a decade, and moderate inflation for a decade.
Unfortunately, economic context is everything. If you were a baby boomer dumping oodles of cash into a private pension account from the 90s this tax convex feature probably had high value for you on average risk taking patterns. If you are a gen Xer like me, it held some value. If you started work in the 00's it is probably going to come out flat - and you might get taxed on growth as inflation swept through pretty hard and your exit feature convexities that i have not dug into stripped out too. All of economic, financial, and political regulatory risk are heading in the wrong direction hard basically. That is what happens when you run unsustainable policy mixes to support one generation of risk-irrational speculators in the long run. You get a messy workout. We are there - basically,
In any event, taxation should be a secondary consideration to performance, or growth. As in life, we have to make money to pay taxes. However, in general the tax convexity of private pension accounts is their primary financial benefit feature that makes them different from you just investing savings in risky financial assets through a brokerage account directly. Of course, if your marginal tax rate is 10% or 20%, tax convexity now and in the future may be a much less important concern than having the cash you need when you need it in the short term, which brings us to liquidity....
The primary dis-benefit of marketed private pension schemes is illiquidity. They are extremely illiquid products and in many cases you cannot retrieve the money until retirement age with typical caveats such as severe disability and qualifying ages. National schemes vary again. Where you can withdraw there will be tight limits and rules and tax penalty treatments.
As a general guide for suitability assessments private pension accounts are the most illiquid asset you will ever own. They are more illiquid than the car you drive, houses in a housing crash, hedge fund investments that have decided not to return monies, closed end funds etc. They are a seriously illiquid investment vehicle. That should never be overlooked when considering your portfolio of assets from the perspective of providing liquidity when you need it. Your private pension account in not designed to provide liquidity, until you are elderly, with caveats.
If you do not have sufficient alternative sources of liquidity a private pension account might not be very suitable right now in your life. Please read that last sentence 100 times, because you have been told at least 10 000 times that you are a muppet if you do not have one the month you start your first job, and contribute to it regularly from then on. We all understand why we get told that right? Somebody makes a fee from the day you contribute and more fees the more you contribute. It is not rocket science. These guys telling you about tax convexity features are telling you about tax convexity for a reason... You should regard your private pension account as a closed end fund for which the investment incentive provided is tax convex treatment.
The final consideration in general suitability assessment is the kind of risk and reward tradeoffs that can be established, and the fee structure for the product. In general, private pension accounts are limited to risky bets on stocks bonds and money markets. You have all heard of the 60/40 rule and the 4% spending rule. Ignore them both. In my opinion, they are both far too simplistic to have any value at all other than to a social marketer.
What you do need to realise is that money you give to your private pension account is money you will be investing in financial asset risk premia for the course of your working life. It will not be available for alternative asset investment, nor for consumption. If you want capital to start a business you will not find it here, larger deposit to buy a home - same story, artwork, vintage wines, a motorcar collection, private equity, hedge funds - nope. You are allocating money to conventional financial asset class risk. That simple. You want to consider the amount you have exposed to conventioanl asset class risk within the overall parameters of your portfolio and its diversification and exposure to broader risk factors.
With that quick backdrop, here is the pearl in the shiny blue ocean. The simple truth is that most people heed their investment advisors, motivated bunch that they are, or the internet, and invest far too much money in private pension accounts from far too young an age, because of the 'tax savings'. The impact on their liquid access to funds is often catastrophic as life matures and they have children and mortgages, and the impact on their overall concentrated exposure to certain conventional classes of financial asset (stocks and bonds) is also often extreme and catastrophic. Please kick the tyres before you skid a vehicle around a corner in a hailstorm...
If you do not have an emergency savings account sufficient for your job risk of transitional unemployment and other sources of liquidity sufficient to keep you going for 2-5 years whatever they might be (including mum and dad here), then you should not be giving hard cash to closed funds until you are 67. If you are a stockbroker you probably do not need your portfolio as exposed to stock market fortunes as your job is. Get the message?
It's the riskiest kind of financial lunacy to not put liquidity first as a personal investor, and to not consider a broad portfolio that integrates your labor risks and your lifestyle requirements and choices as well. Saving 30% in taxes is great this year - until you need the money or lose your job next year or the year after.... Be wiser.
The Financial Frolicker does not generally believe in early starts to private pension accounts and he consider the relentless action of politicians to make accounts compulsory and the fact that they give you tax breaks in the first place a pretty compelling reason for you to be a bit suspicious in the first event. Politicians of course are very happy to have large nationwide pots of money that they can change the rules on later - but you have to get the money into the pots first folks....
Your FF was prepared to pay a little more tax in his 20s on junior professional income levels, have a little more liquidity, and wait for the liquidity and tax convexity pendulum to swing more in his favor before he even looked at that tradeoff analytically. The point here is to understand your own pendulum and pivot of liquidity and tax convexity and that really depends on your liquid wealth and your income level as you go through adult life, year by year.
He does not believe in huge private pension pots either. A pension pot is not a bank account. It is not yours. It is held, in fiduciary, on your behalf, and rules can and do change in very aggressive and penurious ways. Generation Baby Boomer has been very aggressive about ponzi schemes in financial assets manouvered adroitly with extreme policy settings for 30 years now, and that will come home in the fiscal washing basket someday soon.
This financial frolicker does not like the odds of private pension accounts not facing pretty serious absorption into general fiscal duty. The pots got filled by baby boomers and their kids, the baby boomers will largely get their pots back, and the kids might not, and the grandkids might be stuck with compulsory contributions they would never go further than. That trend is not new, is it, really?
Of course, if this FF is going to tell you to proudly tell your financial advisor that you are financially illiterate and do not want to top up your 401k or your Super fund allowance, when they tell you again about your gap, he better have a better alternative offer. Well he does actually. You just knew it right ... you have been glued to your screen for 10 minutes waiting for the secret sauce?
Well, in the next episode your FF is going to show you how to construct a portfolio of social pensions instead of a portfolio of private pension accounts. If you ever relished the ides of beating Baby Boomers at their own penurious games in Ponzi, and felt miserable in the certain knowledge that you were simply 20 to 40 years later to the ponzi games that they started - and thus the patsie - stay tuned. (By, the way, if you are not a Baby Boomer, you absolutely are the patise at the card game. We all have been for a very long time now. But the ones who will really get hurt are the patsies who thought they would bet like boomers but 20 years later. Ponzi games are what they are. People who arrive late do not get hurt, they get destroyed.)
However, please do me one small favour, dear would-be frolicker. The next time some savvy sociopathic financial sales and advice type tells you that you are not saving towards your old age, please remind him you are saving 20% of your potential labor worth generally, before you came in to talk to him.
Please watch the reaction carefully. It is even better when they are Baby Boomers - they are accustomed to making an actual offer to the financially illiterate masses of their own cohort. It is much tougher when you have no offer to make to the financially literate - and he's younger than your kids. A certain amount of advisor baiting can be a very useful learning experience. You can learn a lot as these savvy types try to show you value where there is none. It is a worthwhile investment of your time to help you refine your critical analysis. Do not bring your cheque book, or your credit card. They are a very motivated bunch.
In the next episode, we are going to reveal the oracle - a truly global diversified portfolio of social pensions. Keep reading!!