Pensions are a mess – how did we get here? – Ros Altmann

    Ros is a leading authority on both private and state pensions,annuities and
    retirement policy. Numerous major awards have recognised her work to
    demystify finance and make pensions work better for people.

  • Ros Altmann

    Ros Altmann

    Pensions are a mess – how did we get here?

    Pensions are a mess – how did we get here?

    Overview of pensions in the UK

    by Dr. Ros Altmann

    (All material on this page is subject to copyright and must not be reproduced without the author’s permission.)

    It seems the pension contract in the UK has become unaffordable. Just over ten years ago, the UK pension system was considered a model for others to follow. Our very low state pension was supplemented by good employer or personal pensions and most workers seemed to be heading for a reasonable retirement. Equity markets were booming, interest and annuity rates were high and actuaries and investment advisers believed good pensions were easily affordable.

    How things have changed! Over the past decade, our pension system has disintegrated. Workers’ retirement plans are not turning out as expected and many face the prospect of an impoverished old age if they do not keep working. Private sector employers are abandoning generous final salary schemes, switching employees into much less generous defined contribution plans, with uncertain investment returns, high charges and increasingly expensive annuities.

    To understand how pensions ended up in the current mess we need to look back at the history of the state pension which was first introduced in the UK in January 1909.
    It was only payable to individuals age 70 and over who had an annual income below £21 (equivalent to £1,600 today).

    Life expectancy then was less than 70, so that receipt of the old age pension was the exception, rather than the rule. In 1945 the Beveridge Report paved the way for a new National Insurance system which was to pay a Basic State Pension (BSP) to men over 65 and women from age 60.

    There are over 12 million pensioners in the UK, costing around £50bn a year in basic state pensions alone. Average life expectancy for 65 year old males today is 17.8 years and for women, 20.4 years. By 2033, there are expected to be 16m over 65s, including over 80,000 centenarians (compared to 11,000 over 100s today).

    Even with the planned increases in the State Pension Age , the projected rise in life expectancy of two or three years each decade will lead to increased costs for State Pensions.

    To avoid a soaring bill for old age pensions, UK pension policy has consistently attempted to offload the cost and risks onto the private sector – employers and individuals. Governments have continuously reduced state pensions, relying on generous employer final salary pension schemes and private pension funds – invested in equities – to deliver increasing private pensions.

    Until the late 1990s, unusually high equity returns and relatively high interest rates seemed to validate this model, but this appears to have been an illusion. As asset prices and interest rates fell, it became clear that the costs and risks of private pensions are much higher than previously believed. In fact, they cannot be relied upon to deliver adequate pensions, especially as life expectancy keeps increasing.

    The problems have been compounded by the unique UK system of encouraging people to ‘contract out’ of the state pension system, effectively swapping their state pension rights for private pension promises.

    These ‘contracted out’ pensions are really privatised social welfare benefits. Unfortunately, many of those who contracted out of the state system have found they are receiving far less from their private pension than they would have received from the state.

    Transferring pension risk away from the state does not make that risk disappear. If the private sector does not deliver good pensions, or cannot afford the costs, the risk ultimately falls back onto the state.

    This encapsulates much of the UK pensions problem. Neither state, nor private pensions are working effectively.

    As lifelong employment disappears, average job tenure declines, financial pressures on companies intensify and corporate ownership changes more frequently, companies cannot justify continuously trying to ‘run up the down escalator’ in an attempt to provide long-term welfare benefits that are provided by the state in most other countries. Pension scheme deficits have soared as longevity has increased and investment returns have fallen short of forecast levels, so employers are retreating rapidly from offering generous final salary pensions.

    When moving to defined contribution (DC) schemes, or relying on private personal pensions, employers and individuals are generally not contributing enough to provide the level of pensions that were expected from final salary schemes.

    The reduced expectations for future private pension income have thrown the inadequacy of our state pension system into stark relief.

    Since 1980, the State Pension has been uprated in line with prices, rather than earnings and has, therefore, fallen significantly behind average earnings, thus becoming wholly inadequate for preventing poverty.

    Many pensioners (especially women) do not even receive a full BSP, leaving millions at risk of poverty. This led the Government to introduce a means-tested pension credit, designed to target spending on the poorest, rather than raising State Pensions for everyone.

    However, anyone claiming pension credit (nearly 50% of pensioners are eligible) loses at least 40% of their private pension income and many lose all of it, leaving a substantial proportion of pensioners penalised for private pension savings.

    Furthermore, there are still well over 1million pensioners in poverty, due to imperfect take-up. As mass-means-testing discouraged private saving from supplementing the inadequate State Pension, so the whole pension system has become unstable.

    Even though the Government has introduced numerous measures to address the pensions crisis, it keeps getting worse. Several high profile pension scandals have severely undermined public trust and, unlike savers in failed banks – whose money has been 100% safeguarded – our regulatory system has not protected pensions in full. Until 2005, there was no proper protection for occupational pensions at all.

    Around 130,000 workers who put their life savings into their employer’s final salary scheme found they were not completely safe or protected by the law.

    I spent many years fighting for these pensions to be restored and watched people die in misery without their money. The whole sorry saga added to public mistrust of pensions, as did the Equitable Life debacle and before that, the Maxwell scandal.

    The Equitable Life victims have only recently been told that the government is willing to pay £1.5bn in compensation – but this is 10 years after the event and far less than the amount suggested by the Parliamentary Ombudsman, Ann Abraham.

    Thankfully we now have a Pension Protection Fund, which replaces 80-90% of final salary scheme benefits if an employer fails, but there is a cap on payments and inflation-linking, so workers can still lose out substantially.

    Of course, the disintegration of our once-thriving retirement savings culture, is partly due to disappointing market returns, high costs and rising life expectancy, but much of the blame lies with politicians who failed to respond to the challenges of our ageing population as circumstances changed.

    If the BSP had been uprated in line with earnings since 1980, it would now be worth well over £140 a week – the very sum the government has recently proposed as a flat-rate State Pension future state pension.

    Having advised Government for several years from 2000, I have seen short-sighted, misguided policy thinking undermine our pension system. Did the Government truly want to encourage pension savings? Or did Gordon Brown just want people to keep spending and borrowing as much as possible, to maximize short-term economic growth? Perhaps that is why the Financial Services Authority has operated asymmetrically, making it far easier to borrow, than to save.

    Recent comments by Charles Bean, deputy governor of the Bank of England, that individuals should spend, rather than save, to boost the UK economy, certainly reinforce this concern.

    In fact, despite all the government’s initiatives, the pensions crisis has kept worsening. ‘Low cost’ stakeholder pensions were a failure. ‘Decision trees’ could not cope with the complexity of our system and so-called ‘A’-day pension tax ‘simplification’ has been unravelled.

    Even the Pension Commission’s recommendations were a political compromise – just tinkering with the current system, rather than proper radical reform.

    Pensions are the ultimate long-term investment and trust is essential. Money is locked away for decades and cannot be taken out, even in an emergency, before your 50s. Pensions policy, therefore, needs to operate over many decades, which clearly does not suit political time horizons.

    In reality, most politicians and policymakers do not seem to understand pensions. But why should they? They will receive extremely generous, taxpayer-funded pensions, without having to deal with the mind-numbingly complex and unreliable system they have designed for the rest of the population.

    It seems the halcyon age for pensions was in the 1980s and 90s when equity returns were largely buoyant and final salary schemes even had surpluses – something which is almost unheard of today.

    Many companies used their final salary pension schemes to fund generous early retirement/redundancy packages, encouraging people to believe they could retire at 60 or earlier, on a full company pension, despite rising life expectancy. This created dangerously unrealistic expectations.

    But there is no going back to those halcyon days. Employers are ditching final salary schemes because of their soaring risk and cost due to volatile stock market returns, increasing regulation and growing life expectancy.

    Increasingly, workers are being forced to shoulder the responsibility for funding their pensions via defined contribution (DC) schemes as their employers shift to less onerous pension arrangements for their workers.

    In addition, the credit crunch has severely damaged private pensions, thereby significantly worsening the pensions crisis. Furthermore, demographic trends in the coming years, as the baby boomer generation starts to retire, mean there will be fewer workers to support a burgeoning pensioner population. This will lead inexorably to a ‘pensioners’ crisis, unless we make radical changes to pensions and retirement.

    We need a whole new retirement model, with people working and contributing to their private pensions for longer. The ‘cliff edge’ model, of suddenly ceasing work entirely at retirement, must change to one of ‘partial retirement,’ whereby workers gradually downshift into full retirement.

    The whole pension system, both state and private, needs radical reform, but in order to recognize the needed reforms, it is important to unravel some muddled thinking.

    The word ‘pension’ actually means two different things, which have the same name.
    The original idea of pensions was social insurance, preventing poverty for people who were too old to work.

    This should normally be a State role, although 20th century employers stepped in to provide such social welfare, via final salary pension schemes.

    The word ‘pension’ also refers to something very different – namely long-term savings. This is normally a private responsibility, but again employers stepped in to help by providing pension schemes and death-in-service benefits.

    Unfortunately, as longevity soared, investment returns plunged and regulatory burdens added cost and complexity, employers have pulled out of final salary pension provision, moving to new DC arrangements. However, employer contributions to DC schemes average around 6 per cent compared to over 15 per cent for final salary (DB) schemes. Small wonder, then, that the average personal pension fund at retirement is just £30,000, which will buy a 65 year male today an annual, level income of £1,959 (£163.25 a month) according to annuity specialists, Burrows & Cummin.

    To conclude, over-reliance on employers and equity markets to provide good pensions has failed. The state tried to supplement pensioner income on the cheap by means-testing nearly half of all pensioners for pension credit, which rendered saving for a private pension an unsuitable investment for many low paid workers and left many in poverty anyway.

    The introduction from 2012 of automatic enrolment for all workers into a company pension scheme or the planned National Employment Savings Trust (Nest), cannot work safely with the current state pension system, as workers could end up saving just to replace means-tested benefits.

    The coalition government has proposed radical reform of the state pension system, whereby it would merge the BSP with the additional state pension to provide a single weekly payment of around £140 a week for anyone with a full National Insurance record.

    This, together with the proposal to raise state pension age to 66 for both sexes (but not as quickly as by 2020!) and encouraging more private savings, are the first steps in a much needed radical rethink of pensions policy.

    However, it is also essential to reform the concept of retirement itself. Pensions alone cannot solve the pensioners’ crisis. The more we can encourage and facilitate (not force) people to work beyond age 65, the better for all of us.

    The government has scrapped the default retirement age of 65 – a reform which should have been introduced years ago, as it is essential for those who want to work longer to be encouraged to do so. Allowing employers to sack people just for being 65 is a huge waste of resources.

    This period of semi retirement, the ‘bonus years,’ when people will be given the opportunity to work part-time, (just as has been achieved for working mothers) and gradually reduce working hours, will boost both their own income and the economy.

    The coalition government’s proposed pension reforms represent a good start to improving the current pensions mess, but expectations must change if we are to achieve a sustainable retirement system.

    This must entail a decent state pension, more encouragement of saving and longer working lives. The sooner politicians wake up to these challenges the better for all of us.

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