Losing Out

Penney Frohling takes a look at the impact the financial crisis has had on retirement investments

The term ‘wealth destruction’ has become the catchphrase for the global financial crisis, with over seven million references on Google. However, the Oxford English Dictionary’s definition of destruction – the action of, or process of, causing so much damage to something that it no longer exists or cannot be repaired – suggests a more accurate term is required. While it is extremely difficult to quantify, the data suggests that the majority of losses are sitting on paper rather than actually having been realised, and that they reside with large pools of institutional money and extremely wealthy individuals rather than across the population at large.

To what extent then has there been material individual ‘wealth destruction’ as a direct result of the financial crisis? Among which individuals and in what ways? What will have a greater impact in the long term – the steep declines in real estate and equity values, or the knock on effects – unemployment, low GDP growth, the elimination of company benefits?

Different fates

While stock indices lost almost half of their value over the period 2007-2008, declines in individual liquid assets were a fraction of market losses. Index gains/losses are not a suitable proxy for estimating losses by individual investors, which is why many estimates of ‘wealth destruction’ are greatly overstated.

Investors in the countries we analysed fared very differently in the market downturn due to fundamental differences in asset allocation and the structure and maturity of the private pension systems. The strong preference of the Chinese for cash, which accounts for an average 85% of their liquid assets, enabled them actually to increase their wealth during the financial crisis, although this is likely driven by new fund flows from income rather than returns on existing assets. They also actually made money in securities.

Strong buffers

In Germany, where investments in mutual funds and direct equities have declined around 25% since 2005, the well documented preference for cash and more conservative investments also created a very strong buffer to the downturn. The 18% loss in the United States, the highest of any country analysed, is driven by a high proportion of assets invested in equities. The United States and United Kingdom, which both have well established defined contribution (DC) pension sectors, experienced 15-20% drops in pension assets, triggering significant concern about the fate of baby boomers approaching retirement age and their ability to recoup their losses in time.

Baby boomers – aged 45-64 – are typically 30-35% of the population in each of these countries, but hold over 50% of the total assets.

The age 55-64s appear to be in the 10-year period of peak capital accumulation, due to a combination of capital gains on existing investments and an increase in disposable income available for investment. These people have entered their peak earnings years and tend to have lower expenses, with mortgages paid off and children having left home. Because they have the largest pools of assets, it isn’t surprising that the baby boomers also lost the most during the credit crunch. In the United States, 63% of the total $4.1 trillion lost in 2007-2008 belonged to ‘boomers’, with 38%, $1.6 trillion, owned by those 55-64. British ‘boomers’ account for 54% of UK losses, 55-64s 36% of the total. Figures for Australia are lower, with ‘boomers’ taking around 40% of the decline.

The largest net declines in assets – about 15% – were taken by the younger and/or wealthier segments of the market. Compared with Australia and the United States, losses in securities investments were considerably lower. A primary driver of the comparatively soft landing for UK retail investors is that 44% of these investments were in actuarially based, illiquid life assurance products such as investment bonds and with-profits funds, which have a greater proportion of assets invested in corporate and government bonds. Only 12% of assets are held in direct mutual fund investments, in stark contrast to the United States. Although fund flows into cash are nominal compared with Australia, Germany and Italy, investments into cash ISAs, a form of tax deferred savings account, increased 1300% from 2007-2008.

The largest declines in assets, 30% or more, were in defined contribution (DC) pension plans among those aged 55 and over – people at or nearing retirement. Almost 90% of all individuals with a DC pension opt for the default fund, which is 100% in equities until approximately 10 years before retirement, when a proportion of assets are shifted into bonds.

Lack of knowledge/care

There is a broad perception in the life and pensions industry in the UK that the typical investor doesn’t know enough or care enough to take an interest in actively choosing their pension funds or managing their money; there is a significant amount of market data to support this perception. The financial crisis hasn’t helped. Contributions to personal pensions are one of the casualties of the financial crisis, with new business flows down 25-40% depending on the type of pension.

Few British pension investors, except the very wealthy, are offered financial advice when it comes to managing their pension. Along with cheap, simple products, this is a major gap – and opportunity – for the industry.  It remains to be seen if and when anyone takes up this opportunity, as the economics and advice model would require a fundamental departure from the status quo for life and pensions companies, banks, and IFAs. However, there are likely rich rewards for first movers in this space. Any takers?

Penney Frohling is a partner at A.T. Kearney