Are traditional pensions still optimal in the 21st century? [closed]

Question

I have long had an issue with traditional pensions, I searched around and found some people at least seem to share some similar thoughts.

In short, my concerns are:

• Too restrictive (you can't use the money until an government set age, if you take it early, there are heavy tax implications)
• Not versatile enough (few pensions allow you to choose a fund, and even those that do, normally only let you pick one - you can't diversify over multiple funds)
• Not actually as tax efficient as people say (you don't pay tax on the investment, but you pay income tax when you draw-down)
• Are often difficult to manage (transferring pensions and keeping track of them as you move jobs can be cumbersome)
• Have their own set of risks (we've all heard of the horror stories where directors disappear with millions of dollars of pension money just before a company gets liquidated)
• Often invest in funds with high management fees.

However, pensions do have one major benefit: Employer matched contributions.

For me, the above benefit isn't enough, so I am investing in my own funds over a cheap platform. I am able to choose my own risk this way, paying into mostly higher risk equity funds for now (I'm 32), with some investments in bonds & gilts. As I age, I will inverse this, raising the bonds contributions and lowering the risk overall. I have also chosen funds with low management fees.

I'm investing 500 a month and plan to increase this contribution each year by 3% to match inflation. If I do this for the next 30 years, and obtain a conservative effective annual rate of 7.23% from my investments over that period, I'll have a portfolio value of around 838,000 by the time I'm 62.

Based on all the above, I'm inclined to suggest to others to simply do the same.

Maybe I'm missing something but my question boils down to:

Are traditional pensions the best way to plan for retirement in today's cheap, self-investing internet era?

Answer 1

There are a few issues with your assumptions, which significantly downplay the benefits broad investment vehicle you are calling 'pensions'. I will tackle 3 of them:

Tax advantages: this is jurisdiction dependent*, but you are assuming the initial investment is 'not taxed', and that the future withdrawal is. Let's keep that assumption, and assume a 30% rate of tax.

If I invest $1000 today, and get a $300 tax savings, and also invest that $300, and earn your suggested 7.3% for 30 years [1.073 ^ 30 gives us a multiplier of 8.3], then I would have 8,300 in a yet-to-be-taxed pension account, and 2,483 in an already-taxed account. Withdrawing my 8,300 at the same 30% rate of tax [I am ignoring that most withdrawals will happen at a tax bracket lower than when you made contributions, as most people earn more during their employment years], nets me 5,810 after-tax from the pension, and 2,483 from the non-pension. Remember that of that 2,483, all but $300 is earnings, so I need to pay some tax there too - let's assume the same 30%, which leaves us with 300+2,183*.7 = 1,828 [I am ignoring lots of possible tax complications because we don't know the jurisdiction, but this is the gist of things], which is $7,638 total after-tax amount to spend in retirement if we invest with the pension.

If I invest $1000 today, it nets me $8,300 at retirement, of which 7,300 is earnings, which we need to tax at 30%, meaning we are left with 1000+7300*.7 = 6,110. In this hypothetical example, the fact that our tax savings are compounded for 30 years makes them more valuable than avoiding tax down the road. You may wonder why my answer differs from what you seem to have calculated - remember that your earnings above your initial $1000 will be taxed one way or another; I have generously assumed that your earnings in a non-pension account will only be taxed when you withdraw, when actually taxes will probably be owing on interest, dividends, and capital gains along the way, which will further limit the compounding you get in a non-deferred account. [to quantify this extra cost, we can reduce your 7.3% earnings rate by 30%, to 5.1%, which after 30 years nets you a multiplier of 4.45x, meaning your ending after-tax amount could be as little as $4,450 in a non-pension account, assuming 100% of your earnings each year are taxed in that same year]

Side note on tax advantages - they may be available to you in other ways; for example in Canada RRSP's are entirely self-directed investment vehicles that have the same tax benefits as pensions, with more flexibility in some cases. This comes at the drawback of loss of employer setting up the plan + employer match if applicable.

Company match: This one is quite straightforward - If you get a 1:1 company match, then for every dollar you invest, your company gives you a dollar. That means you double your investment, right from the start, and get to accrue earnings on that doubling immediately. You simply can't beat an immediate 100% return without gambling on some zany get rich quick scheme.

Investment mix: If you have a defined-contribution pension plan, you are likely in control of your investment. You may have a limited number of options to invest in, but should easily be able to adjust your debt / equity investment mix in all but the most lacklustre plans. If you desire to go more advanced than what your plan can offer, that's where you should consider 'topping up' above your plan, and investing on your own.

In short, specifics of your plan and the tax surrounding it will impact its benefit, but if you get a tax savings and a company match, the result is basically unbeatable.

*I see you've added the UK tag now; I don't have the knowledge to convert the generics of my answer to the specifics of the UK system, but the general thrust of benefiting by compounding your initial tax savings should still hold true.

Answer 2

Grade 'Eh' Bacon has already given a strong answer, which applies well to UK pensions.

But to address your specific problems:-

Too restrictive (you can't use the money until an government set age, if you take it early, there are heavy tax implications)

You can retire and take a personal pension at 55. That's early enough for most people. The government doesn't want people treating their pension as a savings account, and spending all their pension long before they retire.

Not versatile enough (few pensions allow you to choose a fund, and even those that do, normally only let you pick one - you can't diversify over multiple funds)

That's down to the employer. Mine allows me to mix-and-match a number of different funds.

Not actually as tax efficient as people say (you don't pay tax on the investment, but you pay income tax when you draw-down)

True, buit almost any other investment requires you to invest the money after you have been taxed on it. Many people will have lower incomes after they retire, and so will have a lower tax rate. For example, you could avoid paying tax at 40% on the money you invest in a pension, and only pay 20% tax when you take it out.

Are often difficult to manage (transferring pensions and keeping track of them as you move jobs can be cumbersome)

You don't have to transfer the money if you don't want to. It may be easier to sweep a number of small funds togther when you retire. There is a pensions tracing service to find old funds, even if the company has changed names.

Have their own set of risks (we've all heard of the horror stories where directors disappear with millions of dollars of pension money just before a company gets liquidated)

That shouldn't happen any more, as all schemes must have a board of trustees looking after them. If it's a defined contribution scheme, and most are these days, then the money is in an independent pension fund, out of the control of the employer.

Often invest in funds with high management fees.

Again, my employer lets me choose. All my money is in a cheap tracker fund. And they have already sorted the migration from higher risk shares to lower risk bonds for me. I don't have to do anything.

Don't underestimate the value of an employer match to your pension. Finding an investment with a 100% growth in the first year is pretty much impossible. Even a crummy fund with an employer match will beat a good fund with no match.

Answer 3

At least in the US, plans of this sort usually include at least one low-fee index fund that invests in a wide range of large companies, a fund that invests in a range of bonds, and a money market fund. Many people want some collection of those to make up a substantial portion of their portfolio. One can invest in a pension fund with money that you want in these core investments, then invest outside the pension fund for the things you want to be more specialized.