Across the UK there is a significant variation in the degree of financial security experienced from generation to generation. Post-war children are reaping the benefits of house price inflation and defined benefit pension schemes. Their children, however, are mired in debt and no longer have access to the same generous pension schemes as those of their parents.

Overall, people currently in their twenties and thirties are far less likely to have the luxury of the same level of financial security as that of their elders. As defined benefit (also known as ‘final salary’) schemes are closed or frozen to new entrants, defined contribution schemes are moving in to fill the gap, shifting responsibility firmly from the company to the individual.

But for many among the younger generation, this shifting of responsibility is just a technicality, because the prospect of retirement is so distant as to seem unreal.

Powers of persuasion

When faced with the choice of a new car or home, saving towards retirement can understandably seem less than inspiring. It is easy for people to bury their heads in the sand and assume that the state will ride to the rescue to bail them out when they are old. However, as it becomes increasingly clear that the Government will do less and less for us in terms of retirement provision, it is vital to examine the issues and attitudes that are leading to people ending up with inadequate pensions that cannot possibly finance their twilight years.

The first step is to convince people that they really do need a pension in the first place. Many young people are labouring under the misapprehension that they cannot afford pension contributions and will be able to use their house as their pension.

However, the negative equity trap that affected many homeowners in the 1980s hammered home the point that relying on a single asset as an investment is a dangerous strategy. While many choose to invest via a savings account, the stock market or property, the generous tax relief associated with pensions means that they should logically form the cornerstone of most people’s retirement provision.

Getting the strategy right

Once someone has taken the initial step of joining a pension scheme, they still need to think carefully about a suitable strategy for maximising returns. Many automatically opt for a ‘default fund’ – the standard relatively low-risk option into which pensions contributions are invested unless the investor specifies otherwise. It is a fact of human nature that people are reluctant to risk making a poor investment decision because they feel the pain of losses twice as keenly as the thrill of making a gain.

But loss aversion – or playing it too safe with your investments – can leave people short when they hit retirement age. It is important that younger retirement investors appreciate that the length of time over which they will be saving affords them the opportunity of taking some risk early on.

For those who decide to look beyond the default option, a good-quality multi-asset fund could be a viable replacement, while balanced managed funds are a good halfway house between multi-asset funds and default funds, which are often passively managed.

Another problem is that many people stick with their initial choice for the entire length of their investments, without taking the time to understand the way their pension scheme really works or to revise their level of contributions as their earnings increase.

Stimulating interest

So what measures can scheme providers take to address this inertia among pension contributors, particularly younger people?

The first solution being introduced is the auto-enrolment scheme, whereby employees are automatically signed up to the company’s pension plan and must opt out themselves if they do not want to be part of the scheme.

An auto-increase scheme, meanwhile, involves raising contributions according to a pre-agreed schedule, preventing people from sticking to low default contribution rates when they can actually afford to pay in more.

Lastly, auto-investment involves having a sensible strategy at the outset and paying into an investment fund rather than cash. This keeps the strategy diversified by using multi-asset or target-date funds. These ‘auto options’ can help break down the barriers people put up to avoid making important investment decisions for their future.

Some studies have also suggested that pension savers can become ‘paralysed by indecision’ when faced with an overwhelming choice of funds. Interestingly, this research indicates that when it comes to choosing a fund, less can sometimes be more. As the number of fund choices increases, savers actually tend to become more conservative in their investment strategy, with more of them allocating to cash and bonds. A broader choice of funds also appears to have an adverse effect on the quality of people’s investment choices. For every ten funds on offer, savers’ willingness to take risks is reduced.

Living longer

Yet there is one further factor that makes the need to address the way we tackle pension saving all the more pressing: longevity. No one would argue that better health and improved life expectancy is not good news for the individual. But, paradoxically, the ‘risk’ of longevity is also the greatest threat for a new retiree if their funds run out of steam before they do. However, the prospect of increased life expectancy does not appear to have filtered through to people’s retirement planning; in fact, it is taking most people by surprise.

Current generations of UK pensioners can now look forward to living healthier, more active and longer lives in retirement than their predecessors. Average life expectancy at age 65 is currently a further 19 years for males and a further 22 years for females. Those currently working should be anticipating these life expectancies continuing to rise and be planning for 25 or more years of retirement.

The actual number of pensioners is also expected to increase, with projections indicating that there will be 50 per cent more pensioners in the UK by 2050. By 2051, the 60-64 year olds are expected to be the largest demographic group in the UK. Population statistics for England and Wales at the start of the 20th century show there were roughly 100 people aged 100 and above. This rose to nearly 6,000 a century later. In 2066, this figure is expected to reach a staggering 95,000.

Running on empty

Improved mortality rates mean it is ever more likely that those with inadequate pension provision could be forced into poverty at the very time they should be enjoying the fruits of their labour.

The issue of how best to convey the gravity of the longevity problem is one of the biggest challenges facing the UK today. However, the risks created by an ageing population and increased life expectancy are not restricted to the individual but extend much further to governments and corporations. For many pension funds and insurance companies, the prospect of their pension holders living longer than anticipated represents a growing worry. Consultant Watson Wyatt estimates that these longevity improvements have added a quarter to current defined benefit pension liabilities. This underlies the rapid exodus of companies from final salary pension schemes.

With more and more people now living longer into retirement, many will need to work further into early retirement in order to generate the pension income they will need. The changing demographic landscape means that retirement will become a phase rather than an event, with a period of semi-retirement. As a rule of thumb, it would be sensible to prepare for approximately 30 years of retirement. The figures can be alarming: for every five years that saving is delayed, five years of independence in retirement are lost. For every one per cent reduction in contribution rate, your money runs out around two years sooner.

Making your own plans

In the UK, many people have traditionally relied heavily upon the state pension and defined benefit schemes to provide for their retirement. With the focus now shifting from the Government and corporates to the individual, if we want to enjoy our retirement years we need to get to grips with what we have in our pension schemes and how we can accumulate as much as possible. The unavoidable truth is that to have enough in retirement, savers need to maximise their eventual retirement pot by starting to save as early as possible and delaying retirement as long as possible. This is echoed by the Government in its pensions bills, which propose raising the state pension age to 68 by 2050. It will rise gradually, to 66 between 2024 and 2026, to 67 between 2034 and 2036, and to 68 between 2044 and 2046.

Retirement planning, therefore, needs to move beyond simply considering the amount we are accumulating and our contribution rates to thinking about the length of time that our money will last in retirement. In effect, our sixties could be our new forties.

It is also important that savers avoid being too risk averse. While preserving capital is important, it will also be vital to hold equity assets for longer in order to keep generating growth. Given the length of time we are likely to live, the need for inflation-beating real returns now extends into retirement.

Greater saving is also unavoidable. While the total assets in the retirement industry are not growing rapidly, investors are nevertheless facing the need for a pension pot that will need to last longer than before. Investors need to consider complementing their existing retirement savings with other investment funds. Lastly, we need to expect the unexpected. Longevity has taken actuaries and defined benefit valuations by surprise; it will also surprise individuals.

Starting early is the key

The simple recipe for securing adequate pension provision is that the longer the contribution period, the more money can be saved. The earlier a pension is started, the better since the longer the decision to start saving is postponed, the harder it will be to play catch-up with contributions. A good starting point for most people is to work out exactly what their employer’s scheme is offering them and decide how they can maximise it. If, as is increasingly likely, this is a defined contribution (or ‘money purchase’) scheme, then savers must be prepared to accept personal responsibility for knowing exactly what their defined contribution amounts to.

While it is clear that greater responsibility for pension plans will rest with the individual in future, this doesn’t mean that employers are off the hook. A change in the way information about company pensions is given is long overdue – moving from annual statements to targeted communication based on sizes of pension assets, age and distance from retirement age. Stronger encouragement to take up retirement provision and exploring better ‘auto options’ should be at the forefront of employers’ concerns.

After all is said and done, it is high time that we as individuals – and as employers – address these issues, which will affect the whole of society. We all want to live healthy lives for as long as possible, and making sure we have amassed enough money to do this in comfort is going to become a prime concern for us all.

An ageing population
The UK’s population is ageing. Although the population grew by eight per cent in the last 35 years – from 55.9 million in 1971 to 60.6 million in mid-2006 – this change has not occurred evenly across all age groups. The population aged over 65 grew by 31 per cent (from 7.4 to 9.7 million), while the population aged under 16 declined by 19 per cent (from 14.2 to 11.5 million). 16 per cent of people in the UK are currently aged 65 or over.

Another indicator is the dependency of the old and young on the population of working age. In 1971 there were 43.8 children per hundred people of working age; by 2006 this number had fallen to 30.5. This fall reflects both the smaller number of children in 2006 relative to 1971 and the increase in the working-age population, due to the 1960s ‘baby boomers’ who joined the working-age population from the late 1970s.

It is because of this increase in the population of working age that the old-age dependency ratio only increased slightly between 1971 and 2006, reaching 30.0 per hundred working-age people. The ageing index, the ratio of older people to children, rose sharply from 64.0 in 1971 to 97.8 in 2006.

Michael Streatfield is an investment strategist at Investec Asset Management