Why Defined Benefit Pensions Were Doomed to Fail, and What’s Next
By Emma Davidson
We all know the story. Your uncle or father, or you, spent a lifetime working hard and believing their pension would be enough to sustain them in their golden years, but the alarming reality that this would not be the case left them in a bit of a bind.
To understand what went wrong and why defined benefit pension schemes were doomed to fail, and how we can avoid that going forward, we need to review the past one-hundred years to explain why our approach to wealth management needs to change. Each generation’s outlook on life had an impact on government and financial policies, so let’s go back exactly one hundred years to see how we got from there to here.
1900 – 1920: The Greatest Generation
It’s 1915. A large part of the world had been at war for more than a year and the primary occupations in the Western world were farming, steel factories, coal mines or the military. The country with the highest life expectancy was Denmark at a rather low 58 and France was a disheartening 36 years. South African’s life expectancy was only 34.
While pensions have been around in some form since medieval times for the relatively wealthy, it was not until 1908 that pensions became a state affair in the UK. People were eligible for a pension when they reached 70, which was convenient, as life expectancy in the UK was just 48.
Children born at this time would become known as The Greatest Generation. Their mind-set was, “you do it because it is the right thing to do.” It was a generation motivated by a sense of duty and one without any sense of entitlement. Nelson Mandela was born in this era (1918).
1920 – 1940: The Silent Generation
The Silent Generation, born from the 1920s through to the 1940s, would become the healthiest, the wealthiest and the longest living generation of all time. A brilliant example of this generation is Queen Elizabeth II who is now the longest serving British Monarch.
We witness the upward movement in the human hierarchy of needs moving beyond the desire for mere survival. Social policies started to gain traction across the Western World. In the UK the National Insurance Act of 1946 introduced a universal state pension and it was around this time that pension ages were also reduced to 65 for a man and 60 for a woman.
Now, based on the life expectancy in 1915, reducing retirement ages doesn’t seem like a bad idea, but of course people were becoming a lot healthier and live a lot longer. A disconnect was forming.
1945 – 1965: The ‘Baby Boomer’ Generation
Between 1915 and 1955 world health and medicine enjoyed incredible progress. In Switzerland life expectancy was 70 and France had nearly doubled, from 36 to 68. The Second World War was becoming a memory and, along with the post-war economic boom, we have a new generation who were the product of the post-war Baby Boom.
Generally speaking, they were idealistic and uncynical. They marched against war, and for gender and racial equality. They loved rock ‘n’ roll and visited a country to lie on a beach, not to fight in a war.
Many of them are now retired and enjoying generous, final salary Defined Benefit pensions, something that up and coming generations cannot look forward to. Defined Benefits refers to pensions in the form of a guaranteed income, usually based on someone’s final salary.
Let’s remember, when these pension schemes were formed, nobody thought people would live past 65, nor had they factored in how each additional year of life was multiplied because of the sheer size of that generation and the fact that the next generation – the one paying those pensions – was much smaller. A crisis was looming.
Between 1950 and 2000, these paradigm shifts slowly started to become glaringly obvious, in spite of human nature’s tendency to white wash impending doom, and some pretty creative accounting in an attempt to shield us from the obvious truth. It worked for about three decades before we were rudely awakened by bond yields plummeting and it finding out that equity markets don’t always go up.
In the UK, the total shortfall of Defined Benefit Pensions stands at over 360 billion pounds as of February this year while in the US (predominantly the private sector) it is three trillion dollars. So what have governments around the world and newer corporates done to amend this, going forward? In two words: Defined Contribution.
In a nutshell, at retirement, you take out what you saved, i.e. what you put in. While Defined Benefits effectively means my pension is someone else’s responsibility, Defined Contribution pension means it’s nobody’s responsibility but mine.
Generation X, Y and Z
Generation X are those born between about 1965 and 1980 and they are epitomised by the comedy series Friends whose characters are classic Generation X. This generation has brought in the idea of ‘working to live’ rather than ‘living to work’. They believe respect is earned; they are comfortable with authority, but unimpressed by titles.
Generation Y – or Millennials – are those born between the advent of the Walkman and the founding of Google. They accept others of diverse backgrounds easily and openly and they take a global perspective due to easy access to digital information. They are also very comfortable sharing their entire life online.
The Z Generation are those born after 2000 and are set to continue on this trajectory.
The most important characteristic of X, Y and Z generations is that they understand there is no such thing as a free lunch. This means that the idea of a Defined Benefits system makes no sense to them. This is just as well, because it’s no longer an option.
They also value transparency. These generations have lived through the 87 crash, the Dotcom bubble and the GFC. Because of this, they will not fall for the kind of creative accounting and “that is how it is so fall in line” that allowed the pensions crisis to develop. They do their research first so they can tell if what they’re being told makes sense and if the person they’re speaking to genuinely knows more than they do or adds value.
So What Now?
I believe we are now in a world where the responsibility is on us to provide for our retirement.
I believe that the forward thinking investors will no longer “defer to the experts” to manage their money but they will want clear and unambiguous return profiles with clear pre-defined outcomes.
In response to this, more financial advisors are directing clients to Structured Notes. A Structured Note doesn’t depend on promises to be met by future generations. A structured note is a pre-defined and pre-agreed set of outcomes that will be delivered in the future.
Effectively it is a deposit account with a set amount of market exposure options allowing as much risk or as little risk as you want, depending on the return you need. More risk equals more return. It’s a legally binding contract from the issuing bank. Your pension is invested offshore in a tax efficient Trust. The Trust then buys a trading wrapper, commonly referred to as a PPB. The PPB then purchases the structured note that best suits your risk/return profiles.
Based on the past 100 years, and the way that each generation has left its mark on policy, I’m not looking into a crystal ball or pretending I’m smarter than the next guy, but I believe Structured Notes – with the clarity, control and defined outcomes associated with it – are and will increasingly become the investment of choice for generations to come.
About Emma Davidson
Emma Davidson is a driving force within the world of financial services and investments. She is an entrepreneur who has built a hugely innovative and successful boutique business called Affinity Capital. Based in London, the Affinity team has more than 26 years’ combined experience in trading structured investments across the trading floors of some of the world’s major investment banks. They have personally run, structured and priced billions of pounds worth of structured investments for an elite and exclusive list of clients.
In addition to running her business, Emma is an author, an innovator and a thought leader in the niche world of structured derivative investments. The principles of integrity, honesty and collaboration are at the heart of everything Emma does. She believes true success comes from enabling her partners and seeing others benefit from her experience and knowledge. With the pick of partnerships available to her, it is no wonder she chose to work with Carrick.
Together with the Carrick Directors, Emma now exclusively runs the Carrick Note Programme for the whole of Africa.
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