Interactive Investor – why bother with pensions?
by Dr. Ros Altmann
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The credit crisis has damaged the economy and markets – it has also been a disaster for pensions. Asset value falls have wiped out huge chunks of people’s retirement nest-eggs, while the surge in gilt prices has increased the value of pension scheme liabilities and raised the cost of buying annuities.
Of course, pensions were already in trouble before the latest turmoil. Since 1997, our once-strong retirement savings culture has fallen apart. This is partly due to poor investment returns and a succession of scandals (including so-called ‘pensions mis-selling’, Equitable Life, occupational pension wind-ups) but official Government policy also played a significant part. I am convinced that this administration will go down in history as the one which destroyed our once-envied pension system.
Over the past decade, Government has paid lip-service to wanting to encourage pension savings, while systematically destroying the incentive to save in a pension for most of the population. (It has, however, increased the attraction of pension savings for top-rate taxpayers!) Why did it do this? I believe there was a deliberate desire to maximise short-term economic growth in order to claim political credit for ‘successful’ economic management. The longer-term consequences were ignored, as people were encouraged to spend as much as they could – and then borrow even more to boost spending further. The Government did not want ordinary citizens to save, since that meant today’s growth would be reduced. However, especially as the baby-boom generation was fast approaching retirement, this has left us woefully unprepared for the ageing population.
In reality, Government policy has rendered pension savings ineffective for many. How did policy destroy pension incentives?
Firstly, introducing pension credit into the state pension system in 2003, means pensions are not really a ‘suitable’ investment for most people. Anyone entitled to pension credit (that is nearly half of all pensioners) will lose between 40% and 100% of their private pension in the means-test. Unless they can rely on being wealthy or can be sure they will not fall back on means-testing in later life, those on basic rate tax (nearly 90% of taxpayers!) have a significant probability of finding pensions poor value. ISAs may be suitable, but not pensions.
Secondly, the regulatory system has operated asymmetrically, encouraging borrowing while discouraging saving. The FSA regime facilitated selling mortgages or loans for hundreds of thousands of pounds to people with no hope of paying back, few questions asked, while imposing six-hour full fact finds and risk-disclosures on anyone selling a pension. Is it any wonder, then, that borrowing soared while savings collapsed?
Worryingly, this policy asymmetry continues. To be fair, the authorities have protected bank accounts in full, even in failed overseas banks, but this, too, undermines pensions. Bank accounts are now far safer than pension investments. Failed bank depositors receive 100% of their money back, but the maximum protection for pensions is 90%, which is capped and has little inflation protection.
So, in trying to encouraging over-indebted consumers to borrow and spend more to help revive the economy, policy has reduced the relative security and value of pensions.
But pension savings are at further risk. Sharply easing monetary policy, together with declining sterling, will inevitably stoke inflation. Falling asset values, followed by falling interest income, followed by inflation – a triple whammy for pensions. But more help to debtors whose debts are devalued.
So what should investors do?
Obviously, writing to MPs to complain about the injustice of the crisis measures can do no harm. Other than that, there are no easy answers and much will depend on individual circumstances.
Members of final salary company schemes should be relatively better off. Public sector workers are completely safe, but if a private employer fails, the pensions are transferred to the Pension Protection Fund, which only pays up to 90% of expected pensions, with the amount capped at around £30,000 a year. Therefore, people with much higher entitlements than this might consider transferring to a private arrangement.
Investment performance of most money purchase company schemes has been dreadful. However, for top rate taxpayers, there are still big advantages in pension saving. For every £3 they contribute to a pension, the Exchequer adds another £2 – such advantages may not last. There is also much more flexibility on withdrawals since 2005.
However, for basic rate taxpayers the situation is less clear cut. They may actually be better off foregoing the employer contribution and saving in an ISA until closer to retirement, to be sure they will not suffer means-testing penalties or poor value annuities and can manage without the money contributed.
Those currently close to or contemplating retirement face a real dilemma and will need to decide whether they can actually afford to stop working! Advice, as always, is essential. It may be tempting to take the 25% tax-free lump sum and invest the rest in the hope of benefiting from any recovery. Purchasing annuities will look extremely expensive so shopping around for best deals is vital. Perhaps also check out new companies that offer ‘guarantees’ on future savings income, as well as inflation protection.
Finally, I believe it will be important to try to protect against rising inflation in future. National Savings index-linked certificates offer insurance against inflation, as will index-linked gilts. Gold may be another option. Diversification of portfolios into overseas markets – especially developing economies with better demographic profiles than ours – might also benefit a long-term diversified asset allocation.
Whatever happens, though, I believe we need radical reform of pensions (and retirement). Punishing savers and pensioners will ultimately damage growth prospects. Let us hope that policymakers soon wake up to this reality.