Realistic rates of return and fees
The well-rewarded "friends of finance" in government have been pushing for a long time to turn government and company managed collective "defined benefit" pensions into individual "money purchase" pension accounts. One of the reasons advanced for the move away from government pensions is that they look redistributive, as they include insurance against poverty. But that does not apply to company managed pensions, which are upwards redistributive, because many of them are "final salary" ones, where the pension level is not proportional just to contributions, but also to salary level.
I reckon that the reason is that both government and company managed pensions tend to be efficient and have very low overheads, as they are managed by professional teams, leaving little scope for the finance industry to charge high fees, while individual pension accounts are usually managed by individuals, who tend to be less alert to high fees and bad performance, being what the finance industry think of as "dumb money".
The level of fees in particular can have a large impact, because:
They are charged on the whole pension pot, not just on its growth if any, and it compounds. So for example a 1% per year fee on a pot that has 0% real returns would halve it in 41 years.
Return rates are not risk adjusted, but fees are of course risk free. A 1% fee will always apply as 1% whether the return rate is high or low.
Achievable risk-adjusted (and thus long term) real return rates are in the low single digits, typically around the level of GDP growth, or in the 1-3% range for mature economies, and that is not much more than typical fees of 1-2%.
In practice it is very easy for fees to amount to 20-30% of a pension pot, or 40-60% of the returns on it, especially if real returns are low, because it bites hard on the pot rather than its growth. To illustrate I have prepared a simple spreadsheet that has a line for each of 40 years of contribution, from age 25 to age 65, and for each year it has:
A base income, growing at 2% from age 25 to age 45, and then at 1% to age 65, starting from 25,000.
A contribution into the pension pot of 10%, then 15%, then 25% of current income.
A rate of return that each year produces a dividend or capital gain that is cumulated ino the pot.
A rate of fees that each year is applied to the pot, that year's contribution into the pot, and the return cumulated into the pot.
The table (with some rows omitted) for a rate of inflation of 3%, nominal return of 6% and fees of 1% looks like:
. 40 3.0 25,000 30 6.0 -1.0 .years infl% ann. rat return% fees% . . cumul income income contrib contrib pot pot fees fees . age infl% growth% yearly % yearly gross net total total% . . 25 100.0 0 25,000 10 2,500 2,500 2,475 -25 -1.0 . 26 103.0 2 26,250 10 2,625 5,275 5,196 -79 -1.5 . . 45 180.6 2 66,332 10 6,633 153,400 137,120 -16,280 -10.6 . 46 186.0 1 68,986 15 10,348 172,952 154,138 -18,814 -10.9 . . 55 242.7 1 98,188 15 14,728 435,421 373,966 -61,454 -14.1 . 56 250.0 1 102,116 25 25,529 487,075 417,714 -69,361 -14.2 . . 65 326.2 1 145,343 25 36,336 1,176,241 980,392 -195,849 -16.7 . -infl 360,585 300,546 -60,039 . . total avg. total return return return . income contr% contr gross net loss% . . 2,947,244 15 520,039 656,202 460,353 -29.8 . -infl 201,163 141,124 . . yearly yearly yearly . gross net loss% . . 39,208 32,680 -16.7 . -infl 12,019 10,018
Note: the rows with "-infl" report the inflation-adjusted value.
In this case fees amount to nearly 17% of the pension paid out, and 30% of the total return on the contributions made, that is fees of 1% are in effect a tax in pension income of 17% or on dividends/capital gains of 30%.
Note: as to the absolute values of the pension paid when using the final pot to buy an annuity at a ratio of 30: that $32,680/$10,018 (before/after inflation) is 40% the starting salary, and 22 of the final salary, indicating that an average contribution rate of 15% is likely too low, even if rises to 25% in the last 10 years.
For the parameters 3% risk-adjusted real return per year is probably somewhat optimistic, and 1% total fees are probably a bit lower than most people pay, if one includes platform, fund, trading, fees. Changing a bit the values gives interesting other results, the first for a low inflation of 1%, real return of 2%, with fees of 1.5%:
. 40 1.0 25,000 30 3.0 -1.5 .years infl% ann. rat return% fees% . . 65 148.9 1 67,095 25 16,774 462,572 360,682 -101,890 -22.0 . -infl 310,688 242,253 -68,435 . . total avg. total return return return . income contr% contr gross net loss% . . 1,835,948 15 301,020 161,551 59,661 -63.1 . -infl 108,506 40,072 . . yearly yearly yearly . gross net loss% . . 15,419 12,023 -22.0 . -infl 10,356 8,075
and the second for 3% inflation, 5% real returns fueled by a 2% fee:
. 40 3.0 25,000 30 8.0 -2.0 .years infl% ann. rat return% fees% . . 65 326.2 1 145,343 25 36,336 1,176,241 980,392 -195,849 -16.7 . -infl 360,585 300,546 -60,039 . . total avg. total return return return . income contr% contr gross net loss% . . 2,947,244 15 520,039 1,165,261 602,200 -48.3 . -infl 357,219 184,608 . . yearly yearly yearly . gross net loss% . . 56,177 37,408 -33.4 . -infl 17,221 11,468
