How compensation can be funded – latest suggestions
by Dr. Ros Altmann
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I have been asked to write a note outlining ways in which the Government could organise a proper compensation scheme for victims of pension wind-ups. This note is in 3 parts:
Firstly, I set out possible ways in which the Government could organise compensation (in line with the recommendations of the Parliamentary Ombudsman).
Secondly, I have included a note written for MPs in November 2003, outlining how, at that time, the Government could have organised compensation for those affected by wind-up, but please bear in mind that we need more money now (I estimated then it would cost £75m a year for 40 years, but it would now probably need more like £100m a year for 50 years, because more schemes have failed since then and some schemes have finished winding up, so compensation will cost more to the taxpayer etc).
Thirdly, I also include a note which I sent to the DWP straight after the announcement of the FAS terms in 2004, asking them to put the annuity purchases on hold, in order to be able to use scheme assets to compensate those who needed help immediately and save money for the taxpayer in the long run. The DWP did not want to do this, they did not really explain why. If they were not serious about wanting to comepnsate, or help those in most urgent need, then continuing with the wind-up and purchasing annuities could have made sense, but it was not a sensible strategy in practical terms. By insisting on proceeding with the annuity purchases, trustees could not pay out scheme assets, but had to keep them to pay Legal and General or Prudential for the bulk annuities they would need on wind-up. Therefore, trustees were unable to pay pensions to those who were terminally ill and who were already past pension age, even though the funds had enough money to do so. For example, ASW Sheerness had sufficient funds to pay pensions to every single member who would qualify for a pension, in full, for at least 12 years after the company failed, but the trustees were not allowed to do so. Every scheme I have seen figures for would have had enough money to pay all pensions for at least 7 years, without needing another penny from other sources and that would give the Government time to organise a rescue.
PART ONE: Suggestions for organising compensation :
There is a large number of ways in which the Government could organise the payment of pensions to members of schemes which are winding up and do not have sufficient assets to fund annuity purchase for all members. The Parliamentary Ombudsman report did not say taxpayers should be expected to fund the whole amount, but it is up to Government to organise the compensation, because Government is largely responsible for the injustice.
Furthermore, the recent ruling in the European Court of Justice showed that the UK Government has broken EU law by not complying with Article 8 of the 1980 Insolvency Directive. This Directive requires Governments to protect pensions of employees fully, if their company goes bust. It is clear that the UK has not done this. Just because the Advocate General found that the UK Government may escape paying compensation due to ‘technicalities’, this does not remove the moral and social obligation to organise a proper compensation scheme for those affected.
Therefore, both in line with the Parliamentary Ombudsman’s recommendations and the requirements of EU law, the UK Government should surely feel obliged to find the money to replace the lost pensions in full. The Government estimates that this would cost around £3billion in net present value terms – in other words, if £3billion could be found, then there would be enough money to pay compensation in full to those affected.
So far, the Government has refused to do this and is merely offering some ‘assistance’ through the hopelessly inadequate Financial Assistance scheme. Even after the recent extension to the scheme, the Government is only committing less than £540million and this cannot replace anything like 100% of lost pensions. Those in the 80% band of the FAS will only receive about 50-60% of their expected pension, those in the 65% band will ultimately receive about 40% and those in the so-called 50% band will get about one quarter to one third of their pension. Also, people will not get any money before they reach age 65 (even if they should have retired much earlier) and they will not be paid properly by the FAS until their scheme has finished winding up – which can take many years. There are already many thousands of members who are past pension age and struggling without the pensions they were expecting, and which Government always assured them were safe and protected by the law. This is a dreadful stain on this country and on the Government’s pensions policy. I am sure all MPs would like to see this issue dealt with properly and I have tried to suggest ways in which this could be achieved.
So how can we move forward to address this issue, with a view to delivering the pensions, rather than just assistance? The following is a list of suggestions which could all be considered, or a combination of some of them.
- Using scheme assets and topping up with public money for the balance – at a cost of £100-£150million a year for about 50 years. This was my original proposal back in 2003 and, unfortunately, since then many trustees have bought annuities with the scheme assets. However, in theory, it would be possible to unwind these annuity deals and gather the assets together – perhaps alongside the Pension Protection Fund, or into the Financial Assistance Scheme – and use them to pay pensions on an ongoing basis.
- Taking contracted out benefits back into state national insurance scheme and paying the balance from the Financial Assistance Scheme. All those who reach state pension age are sent a statement with their ‘Guaranteed Minimum Pension’ entitlement and also with the amount of SERPS that they should have received, if they had not been contracted out. It would, therefore, be perfectly possible, for this amount to be paid by the National Insurance pension service, as if the member had not contracted out. National Insurance Fund is in surplus and would certainly be able to afford this. In fact, this would revert to the situation which prevailed before the 1997 changes and would be much easier to cope with.
- Paying lump sums to people with very small entitlements or transfer values to younger members of the schemes, which would mean compensation not having to be paid for many decades into the future.
- Contingency reserve in National Accounts
- Unallocated sums in DWP budget – about £100m a year is unallocated
- Conduct an investigation into actions of domestic and overseas employers whose companies failed to see if there is any possibility of recovering monies
- Ask venture capital industry to contribute funds as venture capitalists are responsible for a number of company failures where venture capitalists restructured companies and let subsidiaries fail along with their pension funds
- Consider asking for contributions from actuarial profession, if it is thought they should have been more alert to warning trustees and members of risks
- Consider perhaps asking for voluntary contributions from banks, life companies, pension companies and other sponsors with an interest in restoring confidence in pensions
- Sources of funds – There are plenty of sources of funds to be able to generate the required £100-£150m a year, but the government will need to organise this. The monies could come from some or all of the following sources and would be more than sufficient to pay pensions. Also, along the lines of the ‘Social Investment Bank’, these monies could even be put into a special ‘Pension Replacement Fund’ designed to replace the lost pensions.
- Unclaimed assets in banks and building societies – estimate £400m
- Unclaimed assets in life policies – £1billion
- Unclaimed assets in pension policies – estimate £3billion
- Unclaimed assets in national savings – estimate £3billion
- Unclaimed dividends and shares – estimate £3billion
- Lottery funding – estimate £300m
PART TWO: Note for Labour MPs, prepared by Dr. Ros Altmann, November 2003
The following is a note prepared for MPs in November 2003, outlining how proper compensation, could have been organised by using scheme assets. At that time, the costs of compensation would have been lower than they will be now. More people have been affected, damages may need to be paid now and also many schemes have already bought annuities. If wind-up is completed, it will not be easy to undo the annuity deals, but for those schemes where wind-up is not yet complete, it could still be possible to undo the annuity deals, because the independent trustees are still in control of all the records.
The Government needs to commit £75million a year for 40 years. This is a modest sum compared to the £10billion a year spent on tax relief and also compared to the cost of giving more tax-free cash to top earners’ pensions after the forthcoming 2006 simplification changes. This overall proposal would allow scheme assets to be used over time, rather than buying annuities and would enable much more pension to be restored to a far larger number of people.
What should happen to the scheme assets? – Pool assets don’t buy annuities
Do not buy annuities, but retain the assets and use them to continue to pay pensions as now.
When the necessary structure has been established, all the assets of all the schemes that are winding up can be pooled into one fund, perhaps called the ‘Pension Replacement Fund’ (PRF) , which can run alongside the proposed Pension Protection Fund. This new PRF would then also receive the £75million a year payments from Government.
How will Government ensure the fund has enough money to pay future pensions?
The Government should commit to pay a sum of£75million a year (index-linked) for the next 40 years into this fund, to ensure that there will be enough assets in future to pay the pensions. We will not be able to predict the exact cost of compensation until people’s claims on the fund are registered. But the PRF should enable replacement of at least 90% of pensions for long-serving members, or within, say, 5 years of normal retirement age, such amounts being paid immediately.
What happens before this Pension Replacement Fund (PRF) is properly set up?
Independent trustees who are winding up the funds would continue to run these assets as now, until administration of the Pension Replacement Fund is in place. All pensions already in payment would, therefore, continue to be paid as now, but without buying annuities.
Any members who come up to retirement age will then start to receive their entitlements from their existing scheme (to be calculated by the independent trustees) which will then be taken over by the Pension Replacement Fund once it is established.
Independent trustees will continue to administer the winding up schemes as before, except they will not need to purchase annuities. Once the Pension Replacement Fund Board is ready to take over, there will be a transfer of assets and scheme records to this new Fund
How would the independent trustees transfer the assets and records to the PRF?
Independent trustees would write to all scheme members and inform them that the assets and administration will be transferred to this new Fund. At the same time they can also notify members of the amounts of their claim being submitted to the Pension Replacement Fund on their behalf. All the records can then be transferred over to the Board of the Pension Replacement Fund, together with the names, addresses and entitlements of all scheme members.
The independent trustees would then have finished their involvement and all future responsibility would pass to the Board of the Pension Replacement Fund.
How do the members receive their pensions from the PRF?
Those already receiving pensions will carry on receiving them as before. Those who have not yet reached retirement age, would be contacted by the PRF perhaps 6 months before retirement date, as is currently done for state pensions. Once the Board of the PFR has verified the entitlements, based on the details provided by the independent trustees, the PRF will then start paying their pensions from the retirement date.
What happens to members whose schemes have already bought out their annuities?
This situation will be more difficult, but such members are clearly entitled to the same help as others, since they have suffered the same loss of pension rights. Some members may have taken transfer values and the amount of their losses will be harder to calculate. The Board of the PRF will need to take actuarial advice to assess the amounts of lost pension to be restored to these members, which I would expect to be paid in the form of top-up pensions on an ongoing basis.
PART THREE: The case for stopping annuitisation: Note prepared for DWP following announcement of Financial Assistance Scheme terms
Trustees of schemes in wind up should be instructed to stop purchase of annuities immediately. There is a strong case for asking trustees not to purchase annuities for schemes in wind-up. The purchase of annuities will mean that there will be less assets left to fund ongoing pensions over time. The PPF is based on the idea that it is more efficient to run the schemes on an ongoing basis, rather than purchase annuities and it seems difficult to understand why this principle should be different for current wind-ups, which will be eligible for assistance from the Government’s ‘Assistance Fund’. Since we do not yet know which schemes will be eligible, surely all schemes should stop buying annuities, until the situation becomes clearer.
The reasons to stop buying annuities include:
- Annuities entail increased costs, due to insurance company profit margins:
It is more costly to buy annuities, than to run the schemes on, because insurance companies make a profit on annuity business (otherwise they would not offer them!) and this profit margin entails a reduction in scheme assets.
- Bulk annuity market is not functioning in the consumer’s (trustees’) interest – only two providers in the market for bulk annuities:
Only Legal and General and the Prudential offer bulk annuities for winding up schemes and from time to time, there may only be one, as the insurance companies do not always have the reserve backing available to offer bulk annuity business. This is not a well-functioning market, and the trustees do not have any buying power to shop around for good quotes, because there are not enough providers to shop around with!
- Annuity purchase exacerbates the unfairness of the priority order:
The result of buying annuities is that the scheme assets will be even more unfairly divided up than is required by the windup priority order. Those already retired will be taking a larger share of the assets, due to the costs of annuity purchase, and this leaves less assets for the non-retireds, meaning they will eventually get smaller pensions.
- Costs of Government assistance are likely to be lower if annuities have not been purchased:
If Government is to offer an assistance scheme, it will be cheaper to run on an ongoing basis, just paying out pensions over time. Once annuities have been bought, the costs of any top up assistance rise and the taxpayer will potentially need to pay more than would be the case if the annuities were not purchased.
- Annuity purchase usually includes members who are not traced, wasting valuable resources:
When trustees buy annuities for a scheme in wind up, they usually purchase pensions for members they have not been able to trace, in case these members subsequently come to light and want to claim their entitlements. This means that the schemes are buying annuities for people who may not even exist, and therefore some of assets will be wasted (and the insurance company will pocket the extra money). This money would be better deployed on giving more to other members. If an assistance scheme is run on an ongoing basis, pensions will only be paid to members who lodge claims and no assets will need to be set aside for people who may not exist!
- Purchase of index linked and deferred annuities is particularly expensive:
The purchase of index-linked annuities is particularly poor value at the moment, because of the lack of backing assets. Purchasing such annuities is sapping far too much from pension schemes, leaving far too little to divide among other members. If the trust fund is run on an ongoing basis, the profit margin for the insurance companies would be available instead to the scheme members.
Questions and Answers:
- Surely buying annuities now will at least offer a ‘guaranteed’ outcome for one group of members.
The cost of this ‘guarantee’ is not justified. There could be some guarantee for some members, but the purchase of annuities will mean that this guarantee of income for pensioners is bought at the expense of those members who are not yet retired. If the scheme buys annuities for all members, then even more of the assets will be lost to insurance company profit margins and risk margins. Both level and index-linked annuities are poor value – especially deferred annuities – and this means that too much of the assets will be used to secure an income for the group which gets the fullest entitlement (pensioners), to the detriment of other members. If the trustees are supposed to look after all members’ interests and given that we know an assistance scheme is a possibility, it would make sense to wait before buying the annuities, to see who will be helped and how. It will be cheaper in the long run if pensions are paid out over time, it will be more cost-efficient for the taxpayer if assistance is needed on an ongoing basis, rather than an amount of money to pay out the replacement ‘assistance’ pensions from day one.
- Annuity rates may worsen, so schemes should buy now.
Interest rates are rising, longevity forecasts have already been revised upwards and annuity rates could improve or worsen – it is not a one-way bet. Insurance companies will be pricing in expected future demographics and will have been widening their risk margins in the last couple of years. Since there are only two providers – and sometimes only one provider – it is impossible to argue that this market is functioning to offer good value to the consumer. It may be, but equally, it may not be and trustees cannot be sure that they will be better off buying now. Of course, the insurance companies will tell them that rates will worsen, to encourage purchase, but this may turn out to be wrong.
- At least buying out level pensions will secure something.
The problem is that buying out level pensions will still mean that more of the assets are used for this one group than might be necessary if the funds are run on an ongoing basis. Until we know more about how the assistance fund will work, which schemes and members will be entitled and so on, the trustees are at risk of favouring one group unfairly over another. Also, it would perhaps be better for the Government itself to write the annuities and pass on any profit margin to the taxpayer, rather than to the Prudential or Legal and General shareholders.
- Annuities offer good value and a guaranteed income.
If annuities are such good value, why is the PPF not planning to buy them? First of all, there are only two providers for bulk annuities, secondly index linked and deferred annuities have become extremely expensive, thirdly the providers will be building in a profit margin, fourthly the trustees will be buying annuities for some people they have not traced and who may never come to light, so this money will simply sit with the insurance companies and be wasted, when it could be used to pay higher pensions to deferred and active members.
- What about the GMP?
This is one area where a real help from the DWP would be to agree to take over all the GMP and contracted out rights responsibility from existing trustees. Putting all members back into the state scheme automatically would save enormous amounts of time and money for trustees and release significant extra assets to be used for members’ pensions. Buying annuities for the GMP is a very complicated and expensive exercise and hugely wasteful in pension fund resources. The small amounts, different indexation requirements and complexity of this exercise suggest to me that purchasing annuities to match this liability is a dreadful waste of money. Annuities purchased for this purpose are very hard to justify.