Contracting-out has failed
by Dr. Ros Altmann
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The UK state pension system is in a mess. The sooner the Government recognises the need for radical reform, the better. Contracting-out is a classic example of the problems that the current system creates, for individuals and for financial advisers. The FSA has just released the results of a study it commissioned to look into whether contracting-out has been a good deal for personal pension investors. The results of this research are a damning indictment of our system of contracting-out and highlight the urgency of state pension reform. We are the only country to adopt the policy of contracting-out and I would strongly argue that it has failed.
According to the FSA, most of the 8 million people who have contracted-out are likely to be financially worse off than if they had stayed in the state scheme. The main reason for this is because of the cuts in the rebates which have occurred over time. High charges and poor investment performance were secondary factors. This research follows hard on the heels of the study by consumer group Which?, that shows 4.5million people lost 20% or more of their pension by contracting-out of SERPS.
The OECD recently concluded that ours is just about the most complex system in the world. The basic state pension is far too low and about half of pensioners need to claim means-tested pension credit to avoid poverty. The system of earnings-related state pensions is so complex and the rules have been changed so many times, that almost nobody understands what pension they will get.
What is particularly worrying for the financial services industry, however, is that the FSA is suggesting that individuals may have a claim for mis-selling of appropriate personal pensions, if they were not told that they should consider re-joining the state scheme as rebates worsened. I would strongly argue that it should be the FSA and the Government who have the responsibility to tell people about how contracting-out affects them, rather than trying to blame financial advisers. Advisers did not design contracting-out, the Government did. The system has become more and more complex, and if the FSA knows that people will not get advice, then surely it has a duty to help. The alternative is that millions of people will lose out and such problems will continue to undermine confidence in pensions.
The Regulator knows full well that advisers will not advise people and that the issue is so complex that individuals cannot make an informed choice on their own, yet it states that individuals need to re-consider their contracting-out decision every year. However, it does not say how they should do this.
The FSA also needs to explain why it has taken so long to look at the contracting-out rebates. Its research demonstrates that contracting-out has probably not been good value for many years, but the last official study, published by SIB in 1996, related to data up to 1993. So it is 12 years since the Regulator last looked at this. Surely, if individuals are supposed to revisit this decision every year, the FSA should have thought to look at contracting-out before now.
The FSA’s research suggests that rebates may need to rise by around 40-50% to make contracting-out worthwhile. The problem, of course, is that we are already spending £11billion a year on these rebates and, if the rebates need to rise to, say, £15billion a year, this could only be financed by a big rise in taxes. Is this a sensible use of taxpayers money? The rebates are a generous subsidy to financial services companies, but can this system really deliver long-term value to millions of investors?
I do not agree with the ABI, which is calling for increased rebates, since this will not simplify the state pension system, but merely prolong the problems. With the vagaries of annuity rates and investment returns, surely the time has come for radical state pension reform which phases out the old system altogether.
We need to separate what the state provides for pensioners (a social welfare underpin), from what people manage to save on their own (the investment function of pension savings). No contracting-out to complicate things, no means-test to penalise savings. The state should also provide clear and fair incentives for everyone to save on their own, if they want more than the minimum state pension level.
This would be far better for financial advisers and the industry in the longer-term. The cost of abandoning pension credit and paying a minimum state pension of £110 per week, to all pensioners, would be around £7billion a year. By combining Basic State Pension with S2P, and phasing out contracting-out, the Government would save the £11billion it currently spends on contracting-out rebates. This would leave an extra £4billion or so to spend on better savings incentives too.
Financial advisers could then offer savers a clear proposition: ‘If you want to live on the bare minimum, fine, but if you want more you’ll need to do some saving!’ This is a message which just can’t be safely given right now. Because so many pensioners are entitled to pension credit, which penalises private pension savings by at least 40%, pensions are no longer a suitable product for large sections of the population.
The contracting-out problems do not just affect personal pensions either. The scandal of occupational schemes which are winding-up is even worse. The Government’s ‘Guaranteed Minimum Pension’ – which came from state contracted-out rights accruing before 1997, and the ‘protected’ rights accruing after 1997, turn out to be not ‘guaranteed’, not ‘minimum’ and not ‘protected’. Many members of these schemes are getting nothing from their contracted-out rights and, worse still, the fact that they were contracted-out means not only have they lost their state rights, they have also wasted all their own personal contributions too. There is supposed to be an approval process, to ensure that schemes which are allowed to contract-out can pass a test of adequacy, but this test only happens at the beginning of the contracting-out period. UK Governments have been so keen to get as many people as possible to leave the state pension system, that the oversight of these ‘approved’ schemes has been woefully inadequate. In the end, contracting-out has been a disaster for many people and has contributed to the crisis of confidence in pensions.
The sooner we do away with contracting-out and reform the state system, so that people can understand what the state pension offers, the better. There may be particular circumstances where the flexibility and control of a contracted-out pension pot is valued, where people want to take tax free cash in future, or where single people want to pass on a pension to their heirs, but the majority of the population will need as much state pension as they can get. Only the better off can afford to gamble with their state rights, but millions of ordinary people, who could not afford to lose out, have now ended up with much lower pensions. Given the complexities and potential financial losses that are involved in contracting-out for the majority of the population, surely society would be better served by a pension system which did not rely on spending billions of pounds today, in the hope that people will do better from investment returns and annuity purchase in the future.
Contracting-out is based on an ideology which assumed that investing in the equity market would guarantee good pensions in future, but this cannot be relied upon. The costs and the risks are too high. Private pensions have proved to be unable to match, let alone outperform, the state benefits.
It is easy to blame financial advisers, but the public surely has a right to expect more vigilance from the FSA. If the FSA study shows that contracting-out does not offer good value for this year and next year, and that the S2P is likely to offer a better pension, then people should be told. Even the Government has admitted, in Parliament, that rebates for those in their 50’s are not generous enough to match SERPS, yet most of these people are probably unaware of this.
The UK pension model has failed. The sooner we get rid of the complexity of our current state pension, abandon contracting-out and introduce radical reform, the better. We need a better state pension, without means-testing penalties, that can take care of social welfare for pensioners. Hoping that equity investment and annuity rates will deliver reliable welfare benefits for future pensioners is just not sustainable. When it fails, pensioner incomes suffer and this undermines confidence in the whole system. We need to finally bury the old ideology and move forward into the 21st Century.