The financial services marketplace: structures,
2.7 Saving and investing
2.7.2 Saving Deposit accounts
2.7.2 Saving
It is normal for there to be some form of incentive from the government to engage in this form of saving. The rationale is simple: the greater the extent to which individuals provide for their own retirement needs, the less will be the burden placed on state finances and the taxpayer.
It is customary to conceptualize pensions as being either personal or occupa- tional. Whereas the former is a scheme which is entered into on behalf of the individual, typically by that individual, the latter is a group scheme run on behalf of an employer.
Occupational pension schemes (OPSs) are principally of two types: defined benefit (also known as final salary) and defined contribution (also known as money pur- chase). Defined benefit schemes enable employees to accumulate a pension entitle- ment that is based upon a proportion of their salary in the 12 months leading up to their date of retirement, hence the term ‘final salary’. In the typical scheme, each year of pensionable service will entitle employees to a pension equivalent to one-sixtieth of their final salary. Such a scheme would be termed a ‘sixtieth’ scheme.
Less generous employers may offer an ‘eightieth’ scheme, whereas more generous firms may offer a ‘fortieth’ scheme. There are usually rules that limit the maximum number of pensionable years too; in the case of the UK, this is a pension equivalent to two-thirds of the employees’ final salary. For example, individuals working for a company with a sixtieth scheme would have to work for the firm for 40 years to be in receipt of the maximum pension of two-thirds of their final salary.
A crucial feature of the defined benefits scheme is that the risk for meeting future pension liabilities rests with the employer. The drop in share prices between 2000 and 2003 has resulted in many OPSs experiencing severe funding difficulties.
For this reason, there has been a marked shift away from defined benefit and towards defined contribution schemes. The latter variant has much in common with personal pensions in that contributions from the employee and employer are credited to the employee’s individual pension account. Upon retirement, the employee will receive a pension which is based upon the value of his or her per- sonal fund as at the date of retirement. Thus, the fund will reflect the value of con- tributions made and the performance of the assets into which the contributions have been allocated. Accordingly, the risk is shifted from the employer to the employee.
This benefits the employer by introducing control and certainty, as its pension lia- bilities are discharged fully on the basis of any contributions that it makes on behalf of its staff. In a typical OPS employees contribute in the order of 5 per cent of their wages to the pension scheme, whereas the employer might contribute of the order of 7.5 per cent – the actual amount varies considerably from employer to employer.
An associated form of further pension saving within OPSs are AVCs – Additional Voluntary Contributions. These may be linked to the company’s pension scheme (known as in-house AVCs) or be a stand-alone arrangement contributed to an inde- pendent insurance company (so-called Free-Standing AVCs, or FSAVCs). In-house AVCs usually offer low costs in a limited range of funds, and are relatively inflexible.
The FSAVC usually offers access to a wider range of funds and gives a greater degree of individual control; however, these benefits come at the cost of higher charges.
Personal pensions operate in a similar way to defined contribution OPS schemes.
Individuals select a pension provider and then make contributions to a fund of their choice made available by that provider. At the date of retirement the fund so accumulated is used to purchase an annuity, and this becomes the source of income
in retirement. Thus individuals will not be certain of the value of their ultimate pen- sion until they reach retirement, as it will be a function of investment performance and prevailing annuity rates. This is a simplification of the variants to be found in the field of pensions. No reference has been made to features such as income draw- down and withdrawal of tax-free lump sums. Details vary enormously from coun- try to country, depending upon local tax regimes and prevailing legislation and rules. However, it does capture the essence of the major forms of this vital form of saving.
Savings endowments
A savings endowment is a form of regular saving that in the UK is offered by com- panies authorized to offer life assurance contracts. Indeed, a defining characteristic of the savings endowment is that lump sum is payable to the beneficiary in the event of the death of the customer before the targeted maturity date of the contract.
Most countries have an endowment type of product, although often described under another name. In Germany, in particular, mortgages and life plans are very heavily based upon endowment-type vehicles.
Sales of this type of savings scheme have fallen dramatically during the past 10 years in the UK. A major reason for this decline has been the sharp reduction in com- mission-paid direct sales forces, for which this type of product played a core role. At the same time, there was a growing view that the high front-end loaded charging structure made the product poor value for money. This charging structure meant that initial payments into the scheme were used to cover the costs of providing the scheme – including commissions to salespeople. As a consequence, it was common for the break-even point between contributions made and value of fund not to be reached until the policy was at least 7 years old. Prior to this point, savers would have done better had the money simply been saved in a deposit account, although they would have benefited from the lump-sum death payment in the event that they died before the break-even point was reached. Indeed, the product has experienced high rates of early surrender, which usually results in customers receiving less back than they paid in because of the high up-front costs – much of which arose from the commissions that were paid to salespeople.
A variant on the savings endowment is the mortgage endowment, a product which has been widely sold in the UK. This has a structure which is virtually identical to the savings endowment. However, as the name implies, this form of saving per- forms the dual roles of building up a fund, the value of which is intended to be equivalent to the mortgage sum provided by the mortgage lender, and acting as a means of repaying the mortgage in full should the customer die prior to the contrac- tual maturity date of the loan. In common with the savings endowment, sales of mortgage endowments have fallen dramatically during the past 10 years. The rationale of this reduction in sales relates to high charges (again to pay for commis- sion) and a sharp worsening in investment returns, as shown in Case study 2.2.
Collective savings variants
Individuals can save on a regular or periodic basis by making contributions to some form of a collective savings scheme. Examples of this include:
● unit trusts (mutual funds)
● investment trusts
● open-ended investment schemes (OEICS).
In a number of countries there may be preferential tax allowances that govern- ments provide in order to incentivize the savings habit. In the UK, the ISA (Individual Savings Account) is just such an arrangement.
Mortgage endowments are designed to build a fund, typically over a 25-year term, that will match the debt at maturity and thereby ensure the mortgage is fully discharged. For the duration of the term the borrower typically merely pays interest on the loan outstanding to the lender of the mortgage funds. The achievement of the target fund value is based upon assumptions regarding contributions from the customer, fund performance, and associated charges. As might be imagined, fund performance represents the major imponderable. In the UK, the FSA lays down standards for projected future fund growth. For life products, such as savings and mortgage endowments, provider companies may use annual investment growth rates in the range of 5–8 per cent. However, between January 2000 and January 2005 the FTSE 100 (the index of the leading 100 UK companies ranked by market capitalization) fell by approximately 29 per cent. Set against this fall, a mortgage endowment may well have been assumed to achieve fund growth of the order of 35 per cent during the same 5-year period. This leaves a performance gap of some 64 per cent. The effect of this performance gap has been to reduce projected maturity values to an extent that many savers are likely to experience a shortfall in fund value and have insufficient funds to repay their mortgage debt. Many thousands of consumers have been notified by their endowment providers that they face the probability of a deficit in fund value at maturity. The shortfall can be made up by increas- ing the amount saved into the endowment policy, or by the customer finding an alternative source of funds at maturity.
There have been many cases of mortgage endowments having been sold to people in inappropriate circumstances. This had led to what has been termed the ‘endowment mis-selling scandal’. The consumers’ organization Which? has been especially vocal on this matter, and has set up a website that consumers can use to register their concerns and seek guidance regarding how to investi- gate claims for compensation. Well over half a million hits have been registered by the website, an indication of the extent of consumer concern.
Mortgage endowments performed well in the past, especially when they attracted tax concessions, resulting in customers experiencing windfalls when funds actually performed better than their assumed growth rates. However, they are now considered too much of a risk for the typical consumer who is risk-averse and is unwilling to engage in what might be considered a gamble.
Case study 2.2 The performance of mortgage endowments in the UK
These types of savings schemes are largely based upon contributions being made into stock that is traded on the world’s stock markets. As such, savers make their contributions on the basis that share prices can fall as well as rise, and thus the schemes carry a degree of risk. For this reason they are not generally suitable for savers who are either highly risk averse or are saving on a fairly short-term timescale. By contributing on a regular monthly basis, savers can mitigate fluctua- tions in share prices. When share prices fall, a given contribution level buys more units in a fund then when share prices rise. This process is called pound-cost- averaging.