Financial Adviser feature discussing expected Government pension proposals
by Dr. Ros Altmann
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So, another round of pension reform beckons. Next week’s Queen’s Speech is expected to include the Government’s latest proposals for the UK pension system of the future.
Financial advisers will probably be most interested in the proposals for private pensions, but as reforms to the state pension are essential to the future of private pensions, I will deal with these first.
The Government says it will be making the state pension more generous. However, pension credit will remain and will top up state pensions for at least a third and possibly half of all pensioners even by 2040 (albeit reduced from the 75% that would have been means-tested without the reforms). Therefore, the state system will continue to undermine private pensions. The state pension has many other problems, including its complexity, inadequacy and unfairness and these will be only marginally improved by the reforms. The basic state pension will still be separate from the Second State Pension (S2P) but it will eventually be indexed to earnings. However S2P will become flat rate and will stay tied to prices, so while one part of the state pension becomes more generous, the other part becomes less generous and – most importantly – it will be paid from a later age. This is not really a more generous state pension, just one that is differently configured, giving with one hand, while taking with another.
The continued inadequacy of the state pension means that private pensions will still be an important means of providing a ‘decent’ retirement income. Ministers say the reforms aim to restore confidence in pensions and engender a new retirement savings culture. However, in order to do this, it is surely important to understand why confidence in pensions has collapsed and why our once great pension savings ethic has crumbled. The main reasons are firstly, that pension savings have, for many people, not provided good pensions (high charges, weak investment performance, soaring annuity rates) and secondly, because there have been so many pension scandals that people do not trust pensions any more. The proposed new system of personal accounts may well just perpetuate the problems that have plagued pensions in recent years and undermine confidence further in the long-term, rather than restoring it.
Almost all workers will be automatically enrolled into a nationwide system of ‘personal accounts’. 4% of their salary will be deducted as contributions to these accounts unless they opt out and employers will be forced to put in 3%, with an extra 1% coming from tax relief. These accounts are particularly aimed at getting those who are not currently saving in any kind of pension to start doing so. The ‘target group’ would be moderate earners or people working for employers who do not offer a pension scheme. However, the proposals are fraught with dangers.
Firstly, 8% of salary is not sufficient to provide most people with a decent pension, but as it is a government-recommended level, people will not realise this. Secondly, the 8% is not really 8% anyway, since the first £5,000 or so of annual income is exempt. For example, someone earning £15,000 a year would only have 5.3% of salary paid into their personal account. With such small amounts being saved, the chances of accumulating a worthwhile amount of pension – given the risks associated with investment performance and ultimate annuitisation – seem small, however low the charges are.
Even more importantly, mass means-testing of pensioners renders pensions an unsuitable product for many of those at whom the personal accounts are aimed. Pension credit penalises private pensions by at least 40p in the pound. Lower earners who are likely to stay on low incomes all their working life, will merely have saved to replace the means tested-benefits they would otherwise have been paid by the Government. They will have had lower income while working and then be little better off later. This is hardly likely to restore trust in pension over time.
Those with high debts and those who are very young may be better off not contributing. Locking money away at early stages in one’s career may not be the most sensible thing to do. However, without advice, many people will not realise that a pension is not suitable for them until it is too late. Once the money has been contributed, it cannot be taken back.
The Government suggests that none of this really matters because of the employer contribution. By suggesting that the 4% employee contribution is being matched pound for pound (3% from the employer and 1% from tax relief) Ministers say these personal accounts will be suitable for almost everyone. This is disingenuous. The reality is that a 3% compulsory employer contribution is not very different from an additional 3% employee contribution. The 3% is not ‘free’ money. If the employer contributes 3% into a pension on your behalf, then that is 3% less that he can spend either on your pay, or other areas of the business that could help to secure your job.
A 3% compulsory contribution is more like an increase in tax or national insurance. Some employers will be tempted to persuade workers to opt out of the pension. Indeed, given that many low earners may end up losing some or even all of their personal account pension in a means-tested state pension later, there could be good reasons for employers to alert their staff to the benefits of opting out of the auto-enrolment. So some workers will be persuaded to come out of the accounts, other workers will be auto-enrolled into them but should not actually be contributing at all and still more will find that their investments do not deliver them much pension. None of these will improve confidence in pensions.
One of the biggest dangers of the personal accounts is the negative effect they could have on existing pension provision. Employers may take the opportunity to switch their existing arrangements to the ‘government-approved’ personal accounts scheme. Currently, most employers offering pension schemes are contributing well over 3% of salary, but there is a strong probability that they will try to cut back to the official 3% level, with this ‘minimum’ eventually becoming a ‘maximum’. If those who the personal accounts are aimed at are more likely to opt out and those who currently have a more generous pension arrangement end up being scaled back, overall pension coverage may not improve much, if at all, it might even decline.
What could be done to deal with these problems? The best solution, in my view, would be to radically overhaul the state pension system and pay a flat rate, universal citizens pension, linked to average earnings. Personal account pensions will not be penalised by a means-test, thus restoring their suitability. This would provide a clear message for providers and advisers to offer customers. ‘If you want to survive on the state minimum when you are older, fine, but if you want more, then you have to make some provision for yourself. If you save, you will have more to live on later.’
Alternatively, the Government could decree that all pensions from these personal accounts will be ignored when calculating the means-tested state pension. In addition, if personal accounts attracted only basic rate tax relief and savings in them were capped at a maximum level, the risk of undermining existing pension provision would be significantly reduced, as higher rate taxpayers and higher earners would still need extra pensions apart from the personal accounts.
In the meantime, however, I believe that any short-term attractions of personal accounts are likely to be outweighed by the longer-term dangers of disappointment and possible claims for mis-selling.
Of course, there are also several other important issues to be addressed. Who will regulate these schemes? Who will offer advice? What happens if the investments go wrong? Will employers be at risk if the provider they choose does poorly? What measures will be taken to ensure that good value annuities are available for converting the personal accounts into a pension on retirement? There has been no clarification on any of these points.
The bottom line is that a far more radical pensions overhaul is needed before confidence and trust in pensions can be restored. With continued mass means-testing of pensioners, the pensions industry should carefully consider whether it wants to be involved in these personal accounts at all. After the experience of stakeholder pensions, where huge amounts of money were wasted on a flawed ‘low cost’ model, the industry would be wise to be wary.