Financial Adviser feature on future of UK occupational pensions

by Dr. Ros Altmann

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Employers have always been considered a vital part of UK pension provision. However, companies are rapidly pulling out of their traditional final salary pensions role. Workplace pensions are likely to be defined contribution in future. The movement away from final salary schemes is a huge challenge for pensions policy and could deliver exciting new opportunities for financial services companies and IFAs.

The UK model of occupational pensions has developed over past decades and, until recently, we prided ourselves on having one of the best occupational pension systems in the world, with employers promising lifelong support for their workforce and taking on all the risks involved in pension provision.

In fact, successive UK Governments kept cutting state pensions with the expectation that private pensions, invested heavily in equities, would offset these reductions and also generate adequate provision for pensioners. The exceptionally high equity returns in the 1980's and 1990's encouraged the belief that equities could be relied on to always perform well. However, since 2000, falling stock markets, along with falling inflation, lower interest rates and rising life expectancy, have left employers struggling with huge deficits in funds they had not-long-ago thought were in healthy surplus. More realistic accounting rules and increasingly mature schemes, which have to pay out generous pensions to more and more pensioners, are forcing employers to totally reassess their commitment to pensions. This represents a crisis in future pension provision. Suggesting sensible, sustainable solutions, requires unravelling some muddled thinking.

Essentially, pensions have two distinct roles, firstly, providing social welfare and secondly as an investment vehicle.

The original idea of pensions was to provide some social insurance for people who were too old to work, so they could survive. This role would normally be considered a State responsibility, but UK employers have been fulfilling this role too. The end of final salary schemes represents employers pulling out of social welfare.

Over time, pensions have also become an investment vehicle, although this was not the original idea. Pensions help people save while working, in order to have something to live on when they are no longer able to work. Defined contribution employer schemes and personal pensions are designed to help with this aspect of pensions.

The problem with UK pensions policy at the moment is that neither of these two roles is being properly fulfilled. The social welfare role of pensions has been hit by continuous cuts in state pensions and employers retreating from final salary schemes. The investment side of pensions has suffered from disappointing investment returns, falling annuity rates and successive scandals, which have undermined confidence in long-term saving.

In order to improve pensioners' social welfare, Government decided to introduce the pension credit, as a means-tested top-up to state pensions. The majority of pensioners will be entitled to it but this does not end pensioner poverty because a fifth of pensioners do not claim their benefits. More worryingly, though, the means-test penalises private pensions by at least 40% - and for many people by 100% - so it is no longer safe to save in a pension. Pensions are no longer a suitable investment for many people and financial advisers cannot safely advise basic rate taxpayers to put money into a pension. Thus, in trying to provide social insurance via pension credit, government policy is undermining occupational and private pensions savings vehicles.

Pension policy is caught in a vicious circle. If we keep going as we are, the UK is heading for economic decline and huge swathes of the population in poverty.

It seems that employers are being squeezed out of pension provision, which is very worrying. It is not just the cost of providing final salary pensions (which is well over 20% of salary now) but it is also the uncertainty of the cost, which makes final salary pensions so difficult for employers. Finance Directors have taken over responsibility for pensions from human resource departments, leading to a radical review of employer pension provision. In future, employers can only really be expected to help with the investment aspects of pensions, in the form of defined contributions and we should recognise that they need incentives to do this. Workplace pension schemes are often now viewed as a company 'cost' rather than a company 'benefit' and companies are far less certain that they can justify providing pensions.

With lifelong employment a rarity and average job tenure only around five years, employers can no longer be expected to provide social welfare. The State has to pick up this role. What policy needs to do, however, is to encourage employers to help with the investment aspects of pensions instead, in an effective manner through improved defined contribution pension arrangements.

With more flexible employee benefit packages, the spread of means-testing in the state pension system and increasing levels of debt in the population, evidence suggests that most younger people are no longer interested in pensions. In this environment, many employers do not want to offer pensions at all and the longer this situation persists, the lower pension coverage will be. Both employers and individuals need new and better incentives to provide pensions, but radical change of our whole system is needed before such measures can be expected to succeed.

Part of the solution to the pensions crisis seems to me to lie in having a clear distinction between the two functions of pensions, with Government taking on the social welfare responsibility and then encouraging the private sector to provide additional savings on top of this, free from means-tested penalties. Organising such savings via the workplace seems to be a sensible route.

So what changes do we need? Introducing a £110 a week citizen's pension, indexed to earnings, would deal with social welfare, without undermining the investment role of pensions. The basic state pension and state second pension would be merged and everyone would be entitled to this basic minimum. This would then leave the private sector free to offer savings and investment products to all, with a clear message that financial advisers could give to clients. Government provides enough to live on, but only just. Anyone wanting a better lifestyle later will need more. If your employer can help, so much the better.

Abandoning S2P and the complexities of contracting out could save £11billion a year of contracting out rebates, easily financing the £7 billion a year cost of a citizen's pension. This would end state earnings-related pension provision, but is this a problem? Firstly, S2P will become flat-rate in future anyway, and secondly, why should society ensure that higher-earners also receive higher pensions? Surely it is up to individuals how much they save and a well-functioning financial services sector should be able to provide attractive pension products.

Once the State takes care of basic social welfare, it would not longer be essential to force people to contribute to pensions or to require them to annuitise their savings. There would be freedom of choice, but it is in the social interest to encourage people to save if they can.

Since it can no longer be automatically assumed that employers have a duty to provide pensions, they are likely to need meaningful incentives to offer pensions to their workforce. Workplace provision is much more cost-effective than individual pension arrangements, so employer schemes are important and employers would have an important role in facilitating pension saving. Individuals, too, need better incentives. Just relying on tax relief - which gives least help to those who need most - is unfair and inefficient. Matching incentive payments, say an extra £2 for every £3 everyone contributed, would be fairer and more effective. Extra rewards for employers who ensure generous pension contributions for their staff could also be helpful.

So, in future, employers can provide access to pensions and perhaps be encouraged to contribute on behalf of their employees, because the workplace is a useful way of pooling resources and harnessing economies of scale. Financial advisers can help employers to do this.

To sum up then, solving the pensions crisis requires urgent radical changes. The Government should provide a universal Citizen's Pension to take care of social welfare, sweeping away the complexities of S2P, contracting out and pension credit. In addition, the State must provide fairer and more powerful incentives to encourage employers and individuals to fulfil the savings element of pension provision. Financial advisers and financial services companies have a key role to play. Their challenge is to help companies and individuals understand what can be done to achieve successful investment returns for the future in a defined contribution pension arrangement. Organising the investment side via the workplace is the best way to achieve economies of scale and advisers should be preparing to help employers and individuals manage the change from defined benefit to defined contribution pensions.

By assuming these high returns would last into the future, employers thought they could provide generous final salary pensions at very low cost! Indeed, employer pension schemes - many of which were established in the 1970's - did so well in the bull markets, that actuaries suggested these schemes were in surplus and that employers could reduce their contributions and enhance members' benefits. In the industrial restructuring of the 1980's and 1990's, it proved very convenient to fund redundancy costs via a pension scheme in surplus, by offering generous early retirement packages. In fact, the Inland Revenue was tempted by these surpluses too and to tax surpluses above a 105% statutory level. Policymakers took the opportunity to pile extra burdens onto employers' schemes, requiring them to provide spouse cover, inflation-linking and revaluation of leavers' pensions.

When employers started providing pensions, lifelong employment was much more the norm. Loyal workers served their employer straight from school and stayed with the company until they were too old to work. Employers felt a paternalistic duty to look after these employees once they had left the firm. It gradually became the mark of a 'caring' employer to provide a 'decent' pension for their workers. Worker representatives pushed for better coverage, more generous provision and human resources departments insisted that they needed to offer good pensions in order to attract the best employees. The final salary pension was seen as the 'gold standard' of company benefits, in which the employer promised to pay a pension, based on the member's final salary, for as long as the worker lived after retirement. While schemes were young, no-one worried much about the long-term costs of this. However, most final salary schemes now have to pay out huge amounts in pensions each year, so they do not have the luxury of waiting and hoping that equity returns will be high enough in the long term to meet their liabilities. Employers are struggling with huge deficits, as the costs of continuing to offer final salary pensions are far higher than they ever dreamed of when they started these voluntary schemes.

Policymakers would still need to encourage the investment element of pensions, to give as many people as possible more than the state minimum, but compelling employers or individuals to save is not the answer. Many employers and individuals are in debt and forcing them to contribute, would damage economic welfare. In any case, extra pension contributions would have to come from somewhere, and would reduce wages, investment, employment or profits. However, 'soft compulsion', including contributing part of each year's pay rise into a pension, or automatic enrolment into company schemes, while still allowing people to opt-out, would still allow for individual choice.

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