Today, doctors voted to strike over changes that are being made to their pension plans. Having been surprised to see clearly intelligent people talk complete gibberish about pensions, it's obvious that a simple guide to pensions is needed. So here it is.
Pensions are like a bucket.
The idea is to fill the bucket with water (representing money) while you're working. And then you empty the bucket when you retire. Easy, isn't it?
Well, it would be, but this situation requires a lot of judgements:
Filling the bucket
You have to decide:
- How much water to add to the bucket each year;
- How many years you'll add water to the bucket; and
- (ok, this doesn't quite fit) The level of investment growth over the period up to retirement.
Emptying the bucket
You have to decide:
- How much water you'll take out the bucket each year;
- How many years you'll take water out of the bucket; and
- (ok, this doesn't quite fit either) Interest rates in retirement (because pension pots are turned into safe income streams).
There's a hole in my bucket
Inflation is a cancer that will eat into your pension both up to and during retirement. So you have to decide:
- How big is the hole in the bottom of your bucket (representing inflation).
So how does all this work?
The relationship between these items is fairly self-explanatory. Putting in more water every year, putting in water for more years and obtaining high levels of investment growth will lead to a lot of water in the bucket. Desiring a high pension for a lot of years while interest rates are low will require a bucket with lots of water in it. An emptyish bucket requires either a low pension or a shorter period of retirement.
The logic underpinning the bucket is inescapable.
But this doesn't apply to me because I've got a defined benefit pension plan
Yes, the bucket does apply to you. Even if you have a defined benefit pension plan. It's just that different variables are held constant compared to your unfortunate brethren on defined contribution plans.
Those on defined contribution plans typically have "number of years in" fixed. They then have "asset returns", "inflation", "number of years out" and "interest rates" as independent variables. If those variables conspire against them, as they have in recent years, then if they don't want "water out" to suffer, they must increase "water in". As most employers don't increase their level of contribution, employees must increase their pension savings unilaterally, or accept a lower pension in retirement.
Those on defined benefit plans typically have "number of years in", "inflation" and "water out" fixed. They have "asset returns", "number of years out" and "interest rates" as independent variables. If those variables conspire against them, as they have in recent years, then "water in" must be increased substantially to compensate. The difference to defined contribution plans is that the responsibility to increase contribution levels usually rests with the employer, not the employee.
OK, so defined benefit plans don't actually have a bucket with each employee's name on it. They have one big bucket, into which current employees and employers pay and from which pensioners are paid. But it's a helpful discipline to think of there being separate buckets. Those supporting the doctors strike like to argue that the current scheme is "in surplus" because there is more being paid into the scheme than is being paid out. Thinking about it in bucket terms shows this argument to be a load of nonsense. The excess of contributions over pensions in payment tells us nothing about the long term viability of the scheme, which can be determined only by considering the other variables in the equation.
So, are the doctors right to strike?
I don't intend to answer that question here. But a proper answer to the question requires you to consider just how much it costs to provide a doctor with the promised level of pension, given assumptions over mortality and inflation. Is the current employee contribution to this cost fair, or should the employee be asked to contribute more for a longer period of time to make it fairer?
Any answer that doesn't consider this angle simply doesn't answer the question at all.