Pension problems need fixing

by Dr. Ros Altmann

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UK pensions are currently in crisis. Both defined benefit and defined contribution pensions are under unprecedented pressure. The Bank of England's policy of Quantitative Easing (QE), has so far bought £375billion of gilts, which underpin all UK pensions. This has added to the pension problems already building in previous years.

The latest official statistics reveal that membership of private sector occupational pensions is at record lows, as confidence and trust in pensions have collapsed. Only a few years ago, our pension system was the envy of other countries, now it is in crisis.

Many workers reaching retirement are finding that their private pensions have not delivered the pension income they expected. Disappointing investment returns, high charges and plummeting annuity rates have left many people unable to afford to retire. In just three years, annuity rates have fallen by over 20%, due to the damaging impact of falling gilt yields. On top of this, EU regulatory changes such as gender-neutral pricing and Solvency II could even depress annuity income further.

And those who did not want to buy an annuity have also been hit. The maximum income that can be withdrawn from a capped drawdown fund has fallen by over 30% in the past three years, due to QE and Treasury rule changes.

It is not only defined contribution pensions that have problems. Defined benefit schemes have been hit too. Falling gilt yields have led to soaring pension deficits, as liabilities have increased far faster than asset values. Even though companies have poured huge sums into their pension funds, the rise in liabilities resulting from falling gilt yields has led deficits to keep on increasing. This is becoming a 'death spiral' for many schemes.

As the Bank of England buys gilts, gilt yields fall and pension deficits increase. Rising deficits mean trustees feel forced to 'de-risk' by trying to match their assets more closely to their liabilities. There are no properly matching assets, but gilts are considered to be the nearest match, so trustees end up trying to buy more gilts. The more they buy gilts, the lower gilt yields fall and, with increasingly limited supply due to Bank of England buying, the more the pension liabilities rise and deficits worsen.

As deficits grow more, companies must put more money into their pension schemes. This weakens their business, may hit expansion and investment plans and weakens performance. This leads to a weaker employer covenant, which requires trustees to reduce risk further. If they buy more bonds, they chase prices up and worsen deficits again. A vicious spiral.

Compounding these problems, banks are increasingly unwilling to lend to companies with pension problems, so their business is weakened further. Some firms are failing due to their pension woes, and increasing company pension contributions reducing tax receipts, as firms plough more money into their pension funds.

Amidst all these pension problems, the Government is about to roll out its new policy of auto-enrolment, which will force employers to provide and contribute to a pension fund for all their workers. 8% of earnings will be going into a pension fund each month - 4% from each worker, 3% from employers plus an additional 1% from tax relief. Workers are able to choose to opt out but it is not yet clear how many will do so.

The pensions landscape could change significantly as a result of this new policy, but without radical state pension reform, it may not be safe to automatically enroll all low earners into a pension scheme. This is because the state pension system penalizes private pension income, leaving pension savings unsuitable for large sections of the workforce. Worryingly, plans for a flat-rate state pension that would remove the mass-means-testing of pensioners have yet to be properly put forward and there have been rumours that the policy may not make it onto the statute books. Without such radical state pension reform, the policy of auto-enrolment could end up as another pension mis-selling scandal. Workers need to be warned of the risks, or pensions need to be made more flexible, so that they are suitable for low earners.

In fact, there could be many advantages to improving pension flexibility. Many people might be happy to start saving, but will be frightened to lock their money into a pension, which cannot be touched for decades. Policy treats pensions as the only worthy way to save for the future, whereas there are other valid savings vehicles that could benefit the economy. Saving in an ISA, repaying student debt or saving for a first home could form part of auto-enrolment, but at the moment anyone saving outside a pension will lose their employer's contribution.

Making pensions more user-friendly could be a major step forward in restoring a retirement savings culture that is so urgently needed. The sooner these issues are addressed, the better all our futures will be.

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