The Wealth of Households and Existential Threats

Among the plethora of statistics put out by governments around the world, numbers on household wealth are relatively rare. The Office for National Statistics (ONS) in the U.K., however, is an exception through its publication of a detailed household wealth survey. Moreover, the survey size is such that we are able to get a sense of the household wealth of the British nation as a whole.

The lessons that can be drawn from this survey are not limited to the U.K. In short, the survey highlights the link between economic growth and individual wealth worldwide.

And here is the result. Aggregate total household wealth in the U.K. was £10.3 trillion (click for larger image, original report can be found here) for the most recent survey period.

Aggregate Total Wealth jpg

Interestingly, the greatest component of household wealth today is pensions rather than property (click for larger image).

Breakdown of Aggregate Wealth jpg

As would be expected, the distribution of wealth is highly uneven and enough to set the pulse racing of every “Occupy” activist. Although, please remember a lot of this skew is a function of age: old people have had more time to accumulate wealth. A newly hired Goldman Sachs financial options trader may spend a couple of years in that bottom decile (if we take into account student debt and assume no drop down wealth from the bank of mum and dad) before their wealth goes exponential.

Distribution of Total Wealth jpg

In numbers, the median wealth figure is £232,000. You need household wealth of less than £13,000 to fall into the bottom 10%, and £967,000 to get into the top 10%. To be in the “Occupy” one percent you need £2,807,000. ONS has put out a fascinating short video presentation on the “Wealth of the Wealthiest”, which is available on YouTube here.

For that wealthy decile, however, all is not quite rosy in the garden: the composition of their wealth is highly skewed. The largest segment is pension wealth (56.6%), followed by property wealth (25.9%), financial wealth (12.7%) and physical wealth (cars, furniture and so on 4.8%).

Breakdown of Total Wealth jpg

What is somewhat bizarre is that between the first household wealth survey before the credit crisis in 2008 and the second survey after the crisis, the value of pensions has gone up a massive £1.2 trillion, or 32%. And given the uneven distribution of pension wealth, this jump is even more pronounced for the middle class and rich.

The logic for this magical creation of wealth is due to the way pension value is calculated. For defined-benefit pensions (those for which the payment is fixed as a percentage of final salary), the value goes up when real interest rates go down. The ONS calculates the value of defined-benefit pension funds using the formula below (the full methodology for the ONS valuation of pensions is here).

Current Value of Defined Benefit Pension copy

It is not necessary to go into every aspect of this formula in order to understand the implications. I will just focus on two parts. At the bottom of the formula is “r”, the real rate of return. Any organization that is contracted to pay a defined benefit pension, wants a high “r”. Why? If they can get a good return on money put aside to pay for future pensions, they need to earmark less money for pensions (and that means more profits).

The ONS reduced the real rate of return “r” (the discount rate) from 2.5% to 1.8% between the pre- and post-crisis period since bonds these days have a much lower interest rate than they did a few years ago. Basically, the statisticians are saying that any firm putting money aside to pay for pensions needs to earmark more now since the return on any pension pot is so much lower now than it used to be.

The second important variable is the annuity factor and the same logic applies. When you retire in the UK, you generally must buy an annuity which pays out a certain amount of money until your death. Someone retiring in good health at the age of 65 today will get an annuity worth £3,600 per annum that goes up in line with inflation if they make a one-off payment of £100,000 pounds (see here). This is a shockingly low rate given that in the U.K. the life expectancy of a female at age 65 is currently 20.6 years and for a male 18.0 years (Table 2 in this ONS publication).

The reason the annuity is so low is because annuity providers cannot find investments of appropriate risk that deliver a return higher than inflation. Nonetheless, for a defined-benefit pension, the annual payment on retirement is guaranteed. Thus the organisation providing this kind of pension must roughly double the pension pot if the annuity rate halves (which it has done in recent years). So for the pension holder, it looks like the value of the pension has gone up even through, and this is key, the pension they get when they retire hasn’t changed.

But it actually gets a lot worse for households. This blog considers two potential existential threats to humanity: climate change and resource depletion. But before either phenomenon would get close to causing a collapse in civilisation it would stymie economic growth first and suppress the real rate of investment return (likewise, Robert Gordon’s end of economic growth thesis would also ratchet down real returns even if it doesn’t pose an existential threat).

And for pension holders, the implications of this are severe. In a previous post, I noted that the Institute and Faculty of Actuaries had looked at resource constraint scenarios and flagged the fact that they impair or even bankrupt defined benefit pension plans.

Defined Benefit jpg

Accordingly, we are entering an Alice-in-Wonderland world where the ONS is sharply boosting its measure of household net worth on the back of faltering growth. But rather than applauding this new-found wealth, households should be very wary of it. In short, the pension providers are being forced to bear an increasingly harsh financial burden when faced with low growth and low investment returns (for climate change, resource constraint or any other reason). There will likely come a point when they can’t honour their pension obligations, and the pension burden will inevitably boomerang back onto households (which at the end of the day means a lower pension).

The bottom line for individuals rich or poor? Where possible, rebalance net wealth away from pensions. Ideally, you need to boost physical or property investments that either provide an inflation-adjusted yield or remove an expense. A large energy-saving capital investment in the home, for example, could provide cost savings decades into the future and help sustain a certain standard of living in retirement. And unlike a pension, such an investment does not have the risk of being subject to an arbitrary downward adjustment by an outside party you have no control over. I will return to this theme in future posts.

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