There are two types of pensions funds in the UK, the defined benefit plan and the defined contribution plan, both of which have been affected severely by the pandemic. A defined benefit plan, which is the most common, is when an employee receives a payment equivalent to a percentage of the average salary that they received over the previous years of employment with their company. A defined contribution plan is when an employer and employee make monthly contributions towards their pension. Both types of plans are invested into the stock market so individuals can maximise the growth of their savings over a long period of time.
The crisis that hit in 2020 was on the back of a 10 year bull market in the wake of the 2008 financial crash meaning most asset classes were popular and expensive; all 4 quarters in 2019 saw positive growth which was undone in the first quarter (Q1) of 2020. The pandemic brought market instability which has worsened the position of pension schemes. The average pension fund fell by 15% in Q1 of 2020, with savers in both the accumulation (those saving for retirement) and decumulation phase (those who have already retired and are using their savings) of retirement encountering tough economic conditions. The crash we saw in Q1 was described as a “rollercoaster falling at unprecedented speeds” by Alex Koriath, Head of European Pension Practice at Cambridge Associates. In total only 11% of all pension funds avoided posting losses during Q1. Financial markets have somewhat rectified fund performance in Q2 where funds saw a value increase of 13%. Overall, pension funds have now recovered much of the value lost during Q1 but still remain 4.4% lower than at the start of January.
Stimulus incentives instigated by governments and central banks globally have supported the recovery by reducing interest rates. Lower interest rates encourage borrowing, creating inflationary pressure in the long-term meaning assets may be more likely to increase in monetary value.
The pandemic and different age groups
The pandemic has threatened the lives and safety of the ageing population. Results from an Opinions and Lifestyle survey by the ONS display the impact on the older generation:
- Of those aged 60 years and over who said their finances had been affected by COVID-19, the most common reason given was that their household income had reduced (60.5%).
- Of those aged 60 years and over who said their finances had been affected, 28.8% said pension values were being affected by economic instability.
Pensions funds are built on low risk investments, which are made safer as an individual approaches retirement age. Bonds will make up a larger share of the portfolio rather than equities, reducing individual’s exposure to the volatilities of the stock market, as bonds will ultimatey be repaid a certain cash value while equities value derives only from the value of the company. There are many actions individuals might consider in the hope of mitigating their losses from the crash in Q1.
1. Those in defined benefit and contributions plans may want to take smaller income than previously planned or delay accessing their pot altogether.
2. Those who are in a defined contribution plan and are approaching drawdown may want to consider increasing their contributions.
3. Those in a defined benefit plan may want to consider working for a few more years.
The above 3 points all come with consequences, namely adding pressure on those who have lower incomes. Asking to increase contributions when one is not earning much will have extreme negative affects on the quality of one’s life. Asking an individual to increase their pension age may have adverse effects on their health. It is important for the elderly to seek financial advice in order to preserve enough money for retirement. Fortunately, the younger generation will have a lot longer to recover from the stock market shocks of Q1 in 2020. The pandemic could however create a “lost generation” of older people entering retirement in poor health and without the adequate finances to support themselves. Almost half of people in their 50s and 60s believe their financial situations will worsen over the next year due to COVID-19.
Building more robust pension funds
It is important for pension funds to be able to weather uncertainty by pursuing more robust strategies and considering different scenarios which incorporate environmental, social and governance performance. Royal London completed external research on the impact of ESG performance on the outcomes for different asset classes. The results obtained from the research found that companies with strong performance on ESG demonstrated lower volatility in their stock returns. Further, the research also found that good governance appeared to be a particularly important determinant of strong financial performance in the face of economic adversity. While it may be suggested that the lower volatility of ESG funds is due to their association with larger companies which are inherently less volatile, ESG funds are certainly an area to be examined by pension fund managers as economic outlook remains uncertain.
Analytics by: Emily van den Burg