Pension Reform in 2005/6

by Dr. Ros Altmann

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Where are we now?

2005 and 2006 will be momentous years for UK pensions. The Pensions Act, designed to increase security and confidence in occupational pensions and the Finance Bill, detailing plans for simplification of pensions taxation, both introduced in autumn 2004, herald huge changes for pensions. Let's explore the impact of the reforms to help deal with the looming pensions crisis.

What will the changes mean for occupational pensions?

The new pensions legislation will not stop the move away from final salary pensions, towards money purchase (defined contribution) schemes. However, the Pensions Act aims to improve security for defined benefit occupational schemes, with the centrepiece of reforms being the introduction, from April 2005, of the Pension Protection Fund (PPF). For the first time, the UK will have a safety net designed to ensure members of defined benefit schemes, whose employer fails, leaving an inadequately funded scheme, will not be left without their pensions. After tens of thousands of members of final salary schemes were left with little or no pension when their schemes wound up, the Government was forced to act. The PPF will be funded entirely from levies paid by employers running defined benefit pension schemes, not by the Government. It aims to provide full pensions for those already retired and around 90% of pensions, (up to around a £25,000 a year cap) for those not yet drawing a pension. In addition, a new regulator will be established to oversee occupational schemes, and help ensure that pensions promises are delivered.

Most defined benefit occupational schemes are in deficit at the moment and their sponsoring employers face increasing costs. Changes to actuarial funding rules (moving to a Scheme Specific Funding Standard) and new accounting rules (FRS17 in the UK and the new European IAS19 accounting standard) are expected to lead to more bond-based investment and less reliance on equity returns, which in turn will require increased contributions. Schemes will also face extra costs from the PPF levies. For 2005, there will be a flat-rate charge per scheme member (some suggest this will be around £30 per person) and for 2006, the levy may also reflect the 'riskiness' of the scheme, with higher charges for schemes that are considered to be at greater risk of falling into the PPF. Exactly how the levies will be calculated has not yet been decided.

The new environment for pensions and the general desire by Finance Directors to have greater certainty of costs, makes retaining a defined benefit scheme more difficult to justify. Employers will be required to consult employees about planned changes to their pension arrangements. There may be some hard bargaining ahead, with members who want to retain defined benefit pensions, perhaps agreeing some compromise to cut costs, perhaps moving to career average or cash balance schemes, instead of final salary. But due to the uncertainty of the long-term costs of any defined benefit arrangement, most new employees are likely to be offered defined contribution pensions in future.

Schemes will no longer have to offer AVC's (Additional Voluntary Contributions), because individuals will be allowed to belong to more than one pension arrangement concurrently, so they can have their own personal pension arrangements, in addition to their company scheme.

Increased responsibilities for pension fund trustees

The responsibilities of pension fund trustees will be vastly increased in the new pensions environment, requiring them to be knowledgeable about pensions law and investment matters. Defined benefit scheme trustees will need to focus much more closely on delivering the promised pensions, rather than maximising investment returns. This could lead to conflicts of interest between trustees and employers when demanding higher contributions to make up a deficit, or less risky investment policies with lower forecast returns.

Defined contribution scheme trustees will need to focus closely on the investment options offered to members and also ensure that the annuity purchase decision is taken with due care. If members do not obtain the right kind of annuity or buy at a poor rate, trustees could face legal challenges in the future.

As the trustees' role becomes more onerous after the Pensions Act, this may start a trend away from trustee-based pensions and more towards contract-based provision. This would mean a rise in group personal pension and stakeholder arrangements, which require individuals to take responsibility for their own pension decisions, rather than relying on trustees or employers.

The new tax regime for contributions

From 6th April 2006 (known as 'A-day') the regime governing pension taxation and contributions will change. The current system of annual contributions limits, dependent on age, salary level, when contributions started and type of scheme, will be swept away, to be replaced by a lifetime limit of £1.5m (rising to £1.8m by 2010) on the total value of pension savings accrued at retirement. Any amounts above this lifetime allowance will be taxed at a penal rate of 55%. The annual contributions limits will rise significantly for most people. Individuals can contribute 100% of their annual income and employers can contribute extra, up to an annual limit of £215,000, with full tax relief. In the year before retirement, tax-favoured contributions can be unlimited, up to the £1.5million ceiling.

Transitional arrangements will be available for those whose pension savings already exceed the lifetime limit to protect their funds from the 55% tax rate. They can choose either 'primary protection' or 'enhanced protection' and are likely to need independent advice on the best options for them.

So, 2005 will be a hugely important year for top earners to take advice on their pension arrangements and decide how best to protect their pension funds, what type of scheme to have and what assets to put into their pension. The requirement to buy an annuity by age 75 is also to be dropped, under certain conditions.

Implications for investment of pension fund assets?

There are likely to be significant changes in the investment approach of most pension schemes. In particular, for defined benefit schemes, there will be a continuing trend towards investment approaches which aim to match the liability payments, rather than just aiming to maximise returns. Trustees will be required to demonstrate that they have considered carefully how their investment allocations are suitable for meeting the pension liabilities.

In the past, pension fund portfolios have relied heavily on expected high equity returns to deliver long term growth, with well over half their assets invested in equities. The typical approach has simply aimed to 'maximise returns and minimise risk'. This sounds sensible, but it is not clear that maximising returns is the best strategy for ensuring members' pensions will be paid. A high return strategy will not necessarily benefit members (since good investment returns are more likely to lead to lower employer contributions than to higher pensions) and high risks could jeopardise the security of the pensions if investment returns are poor. A higher risk asset allocation may well mean that the downside risks are greater than the upside potential.

So the investment aims of defined benefit schemes in future are likely to focus more on minimising downside risk, which may well mean a much reduced reliance on equity investments and a more broadly diversified portfolio, investing in bonds, index-linked gilts and probably also alternative assets, derivatives and swaps.

Pension fund investment benchmarks will become more scheme-specific. The Minimum Funding Requirement (MFR) will be replaced next year with a new 'Scheme-Specific Funding Standard', which should lead to more emphasis on liability-led investing. Derivative strategies can help achieve a closer match between assets and liability profiles and focussing on absolute returns, rather than returns relative to an index, will become more common. Diversification into hedge funds, funds of hedge funds, and derivatives are likely to become more mainstream, with trustees aiming to benefit from risk premia in asset classes other than just equities. Using hedge funds, for example, or commodities, whose returns are lowly correlated with the returns of traditional assets, can greatly enhance the efficiency of a pension fund portfolio, reducing the risk and enhancing potential returns.

Investment of personal pension fund assets

The investment options for personal pensions will be opened up enormously after 'A-day'. At the moment, there are many different types of pension scheme, each with different investment restrictions. In future there will be very few restrictions on which assets can be put into a pension. For example, residential, commercial and overseasproperty, art, stamp collections, classic cars, hedge funds and derivatives are expected to be allowed. People will be able to borrow 50% of the fund value and take out a mortgage to pay for a property in their pension, with full tax relief. In fact, the post-April 2006 proposals are a huge potential tax giveaway to top rate taxpayers. Those who can afford to should probably consider putting as much as they can into a pension, in case the Treasury decides to reduce this generosity. Certainly, they should seek independent advice from an adviser who is up to speed with the implications of the new regime.

The new pension environment

These tax changes could fundamentally change the whole environment for pensions. It will no longer be necessary to think about pension contributions every year, for fear of losing an annual allowance. Pensions could become a 5 - 10 year exercise, perhaps later in life, contributing large sums with full tax relief and perhaps saving in a different form earlier on, without having to lock the money away for decades. Another effect of these tax changes may be that top executives will no longer be contributing to pensions (because they will already have their £1.5million pension amounts and can't do any more) which might mean they lose interest in providing pensions for their workforce. Given the reduction in confidence in pensions generally, this is a worrying prospect.

Reforms still urgently required

1. Reform State pensions

There will be significant reforms for occupational and personal pensions, but one area which Government has failed to tackle, is radical reform of the state pension system. This is urgently required. At the moment, the state pension system is undermining private provision. The UK pension model over the past few decades has relied on continually reducing state pensions and shifting the burden of pension provision onto the private sector, companies and then individuals. However, the reductions in state pension have gone too far and the burdens placed on companies and individuals have become too great. Company provision is falling, most schemes are in deficit and closing and state pensions are so low that most people cannot live on them. The result is that the majority of pensioners now need to apply for means tested benefits (the pension credit) in order to escape poverty. This, however, penalises private pension savings. Those who are entitled to pension credit will lose at least 40% of their pension and in many cases all of it, when they claim the benefit. This is a huge disincentive to pensions and has resulted in a situation where forecasts suggest that over 75% of pensioners will be entitled to pension credit in future. Therefore, pensions are no longer suitable for many people and financial advisers cannot safely recommend a pension to anyone who is not on higher rate tax, who does not have an employer contribution, or who cannot be sure that they will be in the top 25% of the income distribution on retirement.

A growing consensus is emerging that we need to move away from mass means-testing of older people. A widely-supported reform for a citizen's pension, could mean the State paying a higher pension, of around £110 per week, to all those over age 65, as of right. This would be based on residency, rather than National Insurance contributions. It would address some of the major problems of the current state pension system. Firstly, people would understand what State pension they will actually receive. At the moment, most have no idea how much their state pension will be. Secondly, it would ensure that all those who need extra income, actually get it. Currently, around a third of those entitled to pension credit do not claim it, so they stay in poverty. Thirdly, it would mean that private savings would no longer be penalised by the state pension system. The financial services industry could safely sell pensions. The £110 per week, may be enough to live on, just, but anyone who wants more will need to save for themselves or carry on working. This is a clear message, compared with the mixed messages being sent out by the state system now. Fourthly, it would address the problems of poverty among older women. Women's pensions are around half those for men, partly because they have an incomplete National Insurance contribution record, due to spending time out of the labour force. A citizen's pension would recognise that women who are not working are still performing a socially valuable function.

2. Better incentives for pensions

The other element missing from Government pension reforms is provision of new incentives. There are no new measures to encourage either employers or individuals to contribute to pensions. Given the loss of confidence, scandals, scare stories and confusion that have surrounded pensions in the past few years, many people, particularly the young, are simply not interested in contributing. They would rather spend the money now. If we really want to encourage people to start contributing to pensions, new incentives are needed. At the moment, the only incentive offered is tax relief, but this is not an effective incentive mechanism for most people. Tax relief gives the highest incentive to those who need it least. The 90% of taxpayers not on higher rate tax, receive lower incentives. Higher rate tax relief provides an extra £2 for every £3 contributed to a pension, but those on basic rate tax only receive an extra 85p for every £3 they contribute. This is regressive, inefficient, poorly understood and also costs enormous amounts of money. Government spends about £10billion a year on tax relief for pensions, over half of which goes to top-rate taxpayers. A more equitable and effective system could be to move away from using tax relief as an incentive mechanism and introduce a system of matching payments. For example a 'government savings incentive' which offers everybody an extra £2 for every £3 they put into a pension, up to a certain limit each year. This would be much easier to understand and a much more powerful incentive for those who most need incentivising.

In addition to this, better incentives are needed to encourage employers to offer pensions and contribute to them. At the moment, evidence suggests that smaller and medium sized employers, in particular, are questioning whether money spent on pension contributions in money well-spent. Finance Directors consider pensions a company cost, rather than the traditional idea of pensions being a company benefit. We need new incentives for employers to set up pension schemes, or to make contributions.

3. Auto-enrolment, not compulsion

Of course, the Government is also considering the idea of compulsory contributions and has set up the Pensions Commission to look into this. The Commission's second report, due around September 2005, will consider whether our system of voluntary pension provision is working, or whether compulsion would be a better policy option. The jury is out on this one, but my own view is that, if we can reform the state system so that it pays a decent minimum pension to all older people, and then put in place suitable incentives for savings, we will not need to resort to compelling people to save at all. It would be up to them. The amount they would get from the State would be clear and they would then have free choice as to how much extra they might want to provide for themselves in the form of a pension. There is very little evidence that compulsion actually increases overall savings levels and the level of contributions people would need to make is likely to be very high, which would have potentially damaging consequences for the economy.


There are enormous changes ahead for pensions in 2005 and beyond. All pension arrangements are likely to be reviewed and occupational pension provision will continue to move away from traditional final salary arrangements. Whilst the Government's reforms so far are well-intentioned, a radical overhaul of the state pension system is still required and much clearer and better incentives for pensions in future.

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