David Kingman explores the interaction between poor returns on private pensions and intergenerational unfairness in the housing market
Britain is widely acknowledged to have a “housing crisis”: a situation in which too many young would-be buyers are chasing too few, overpriced properties, brought about by the lack of suitable new housing built in recent decades.
People also often talk about the hydra-headed problem of the “pension crisis”, one important dimension of which is the very low incomes many people in retirement have to live on. However, something that has received too little discussion is the way the two crises may be linked.
Poor returns on private pensions
For workers who don’t have a final-salary pension scheme, which are nearly always more generous, a major source of retirement income is likely to come from a “defined-benefit scheme”; a pot into which they’ve contributed a certain percentage of their salary over their career, which is usually invested on their behalf by a fund manager and then used to purchase an annuity when they retire, giving them a certain income each year for the rest of their life.
Increasingly, these have replaced final-salary schemes in the private sector; these guaranteed the workers a certain percentage of their annual pay at the time they retired for the rest of their life, paid for by the company, but longer life expectancies have made this arrangement too expensive.
Retirement has become more complicated for millions of people as a result, most importantly because the retiree, rather than the company, now bears the risk of living too long and needing more money than they planned, while the income these defined-benefit schemes provide is usually much lower than under the old arrangements, as annuities often don’t provide very much money.
For example, the Financial Times publishes a table of sample annuity rates, which shows that the best annuity a man whose pension fund was worth £100,000 when he wanted to retire at 60 could buy would pay out just £5,689 a year, decreasing in real terms over time as it wouldn’t adjust for inflation.
How many people have a pension pot worth even £100,000? Not an enormous number, partly because employees who move between different jobs often end up with several small funds, none of which is large enough to accrue a high value on its own, and these are then sharply eroded by the high management fees imposed by the financial services industry.
According to This is Money, fees can wipe 40% off the value of a pension fund during its lifetime, and are often only explained to the customer in an obscure fashion which fails to illuminate their true cost. One of the most pernicious examples is called “trail commission”, and involves the financial adviser who originally set up the fund receiving 0.5% of its value every year as the fund goes up in value, even though they may not do any work beyond this point. Trail commission has proved so controversial that the Financial Services Authority have announced it will be banned after 2013, although this is just one of many types of charge customers have to pay – with financial advisors often deliberately advising clients to switch to funds that will give them higher fees.
This transition from final-salary pension schemes to defined-benefit ones has been widely acknowledged as a huge intergenerational issue, because it has created a divide between an older generation receiving the more generous final-salary schemes, and a younger one who will only have the less generous defined-benefit retirement pensions to look forward to. As Lord McFall warned following the publication of his recent report on private pensions, “a golden sunset is giving away to a bleak dawn”.
Yet this issue is also intersecting with the housing crisis, creating big problems for young people who are trying to get on the property ladder.
As David Willetts points out in his book The Pinch, one of the most common reactions from people learning how little their pensions are worth is for them to say “we don’t need to worry. There is a great big pile of money in our house and we can use this to finance our retirement.” This stems from a change in attitudes during the 1990s, which meant people no longer saw their houses just as somewhere to live, but as a “personal goldmine that solves every financial problem.”
People have been getting money out of their houses in a number of ways. One of the most popular has been equity release schemes, used by 123,000 households in the last ten years; these work by homeowners borrowing a portion of their house’s value from the bank or building society to spend now, and the debt can simply be deducted from their estate when they die.
However, the kind of housing investment which has the biggest impact on young people has been the growth in various kinds of buy-to-let enterprise. Entrepreneurial members of the older generation have been deciding en masse that pensions offer such a poor return on their investment that it makes more sense to put the money in property ‒ whose value usually goes up over time – and collect rental income instead.
This became such a popular strategy that for several years in the early 2000s, the number of mortgages being granted to property investors actually exceeded the total given to first-time buyers. The recession has done little to reverse this trend; property prices have remained buoyant, especially in London and the South East, while average property rents achieved an all-time high of £876 per month in June.
Indeed, there is evidence that the squeeze on lending has only made buy-to-let investors more attractive to banks, as they are usually backed-up by a good credit history, can put down large cash deposits and may be able to remortgage their existing property. It’s hard to overestimate how much the ubiquity of buy-to-let investments has reoriented the UK property market, although a good example is provided by the comparison website Moneyfacts.co.uk: there are now 486 different mortgage products available for landlords to chose from, but only 270 for first-time buyers with a 10% deposit.
As so few houses are built in Britain nowadays – the total volume of housing stock currently increases by less than 1% a year – young buyers have been the obvious losers under this arrangement. Priced out by competition from the older generation, they have been left with no choice but to live with their parents or in poor-value rented accommodation ‒ where they don’t obtain the financial asset of owning a house, and evidence suggests that greater instability means crossing the key thresholds of adult life, particularly marriage and childbirth, is postponed, sometimes indefinitely.
This is why average age of a first-time buyer who doesn’t receive financial help from their parents is now 38, leading commentators to label the present generation of young workers “Generation Rent”.
Better private pensions
This suggests that better private pensions would do something to fix Britain’s current housing problem, without necessarily building a lot more housing stock.
Ways this could be done were explored by the McFall report, whose headline recommendation was that pension fees should be capped, while they also argued in favour of greater public awareness of the need for pension savings and creating a comparison service for annuities.
If things don’t change, the present arrangements do at least suit a generation who can cope with low private pensions because they still have their sizeable housing assets to fall back on. How the current younger generation, many of whom may spend their lives stuck on the bottom rung of the housing ladder, will cope with meager private pensions is another problem altogether.