A defining moment in a young person’s life is their first job. I remember getting my first job after finishing university. The thing I was most looking forward to was getting paid and having some money to spend. But getting paid was only half the story. Along with the regular salary came other benefits, some useful (such as health insurance) and some baffling – the pension contribution. I was asked if I wanted to contribute 10% of my monthly salary into a pension pot that I couldn’t touch until I was 65. This was crazy – why would I want to start worrying about myself at 65 when I was still in my 20s? The expectation was that the pension was normal and everyone ‘should’ have one. But in today’s world are pensions still the best way to fund retirements?
The pension has been a standard part of getting old for over a century. First set up in the latter part of the 19th century in Germany, the pension spread across the world in the 20th century. It has now come to define government efforts to ensure that the elderly are able to live comfortably in retirement. But, as the establishment of modern medicine meant that people live longer (and needed more money over a long life), societal changes now demand a rethink of how retirement should be funded.
The truth is that many pension programs are functionally bankrupt. In the past, pensions have been structured as ‘defined benefit’ plans. This means that pension holders are entitled to a specific payout when they are eligible to receive the pension. Generally, this means a percentage of a salary at retirement or a fixed amount every month. When there are enough younger people to pay into the pension pot, this model works. However, as there are fewer young people to support retired people who are living longer and longer, the outflow from the fund surpasses the inflows and there is a problem. This is why we have seen major problems in US states such as Illinois and countries like Brazil that have pension schemes that are too generous for our current economic reality.
The alternative model of pension to a ‘defined benefit’ plan is the ‘defined contribution’. In a defined contribution plan, the payment upon retirement are dependant on how much the holder paid into the pension pot and how the funds have appreciated from investments over time. This model is more sustainable because each person’s pension pot is segregated. On the other hand, it is highly inflexible. Young people are paying into an account where they can’t touch the money for over thirty years, and have limited options in what they can invest the pension money in while they wait.
For young people today, the pension is an archaic concept that is not suitable for everyone. Rather than rely on the pension to fund a retirement, young people today could think of other ways that investments will generate an income. A good example of this is real estate. A real estate investment can generate significant rental income every year. If someone young buys a house with a small deposit and a mortgage, in 30 years the mortgage will be paid off and the rental income can be enjoyed. Other options to generate passive income include investing in dividend yielding stocks or buying an annuity. For all these reasons, a pension should no longer be the default retirement option for a young person. There is a whole stable of other routes to retirement. These should all be considered carefully when developing a long term financial strategy.