by Dr. Ros Altmann
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9 February 2009
Latest Government report* claiming almost everyone will be better off saving in personal accounts is fundamentally flawed. Personal accounts could make pension provision worse, not better. There are several problems:
- The uncertainty of annuity rates is totally ignored
- Assumed investment returns are too high. Assumes 80% invested in equities with 5.1% return above inflation, implying workers taking substantial risks, which may not be rewarded. If returns are lower, they will not even get back £1 for £1!
- Employer contribution is treated as a ‘tax’ that goes into the pension fund but is not part of workers’ pay. It will replace Government means tested payments later
- This is a whitewash – its conclusions are misleading and do not stand scrutiny.
- If a financial company put out such misleading material it would be breaking the law under FSA rules!
The Government has just published its ‘research’ on how personal accounts pensions would be affected by means testing. Surprise, surprise, the findings are said to show that almost nobody will lose out in retirement after saving in a personal account. It is absolutely breathtaking to read the detail beyond these headlines, because the analysis certainly does not bear out the Government’s conclusions.
All that this research suggests is that if workers put £1 into a personal account, ignoring the fact that their employer puts money in as well, they might get back £1 on retirement! Wow, what a great deal. Invest £1 today and when you retire it may still be worth £1 – even after inflation! Wow.
What the report does not highlight, however, is that even this incredibly unambitious return would only be achieved if the investment assumptions hold. The assumed asset allocation holds 80% in equities for most of the time, then switching into bonds in the ten years before retirement. And the equities are expected to return 5.1% above inflation, with bonds yielding 1.6% real (even though real yields are currently much lower than this!) So the investments in the personal account have to outperform inflation by 5.1% every year for many decades, in order to just get £1 back. If these ambitious investment returns are not achieved, then workers will not even get £1 back for each £1 they put in.
And there is no mention of the fact that those who contribute to personal accounts will almost all end up having to buy an annuity with the accumulated savings. So the assumed annuity conversion rate is also crucial to this assumption of getting back £1 for each £1 put in. All we are told in the Appendix to the Government’s report is that the annuity will be a single life, index-linked ‘calculated gender/age/birth cohort annuity rates based on market rates’ (page 114, appendix Table A.1). What on earth does that mean?!
What ‘market rates’? Is this today’s rate? If annuity rates keep falling then the calculated £1 return will again not be achieved.
This report is being used to try to pretend that means-testing penalties on pension savings can be ignored when designing personal accounts. That is dishonest. Furthermore, the report only considers the individual’s own contribution and ignores their employer’s contribution as if employers’ contributions are some magic money that appears in their pension account at no cost to themselves. The employer contribution will be part of the employees’ pay structure. If workers choose to put 4% of salary into their personal pension account, then the employer will have to add another 3% of salary. This, however, is part of the labour cost budget, so the higher the contributions to personal accounts, the lower the available money to pay workers overall. That will affect pay and employment levels. Such effects are, however, conveniently ignored in these calculations.
In fact, the employers’ contribution to personal accounts will act like a tax on labour. Instead of the Government collecting higher taxes from employers, it will require this money to be put into personal accounts. These will then help provide pension income in later life, which for many workers will merely replace means tested benefits that would otherwise be paid by the Government anyway! So the tax system is being diverted via personal accounts, but the workers themselves will not necessarily be better off. Especially if the investment returns do not match expectations.
The truth is that it is impossible to be confident that people putting money into personal accounts now would actually be better off when they retire. The investment assumptions used in this study are optimistic and require substantial investments in higher risk assets. The annuity conversion uncertainty is completely ignored.
If the state pension system continues to means test 40% or more of pensioners, personal accounts cannot work properly.
Why is there such a consensus around this subject then? It seems to me there are powerful vested interests, operating with short-term time horizons, which will benefit from the introduction of personal accounts. For example, politicians support the system because they will claim credit for having encouraged so many more people to contribute to a pension. Financial companies support them because many of them will earn fees on managing the money that builds up in these accounts. Large employers support them because most large employers are already contributing to pensions, but in almost all cases they are paying in more than the 3% minimum required. Therefore, large employers see a potential opportunity to cut back from higher current levels towards the 3% lower minimum.
However, there a huge longer term dangers for the workers who are automatically enrolled into these personal accounts. The short-term benefits will be reaped early by politicians, financial companies and employers. They will be long gone before the trusting workers discover that their personal account has not delivered much for them. In some cases, they may find that their neighbour who opted out is getting means tested help instead anyway. In some cases they may find that their investment returns were so poor that their pension is worth next to nothing and some may be hit by very poor annuity rates when they retire. All along, these workers would have been relying on the fact that they were saving in a Government-designed private pension that was supposed to deliver them a good pension. Many workers will end up even worse off than they would have been without personal accounts because their employer cut back from today’s average contribution level of over 7%, to the ‘official’ 3% level. This ‘levelling down’ is at least a big a threat as means testing penalties.
In fact, it could be that personal accounts will end up making pension provision worse in this country, rather than better. But, of course, by the time people realise this, today’s politicians and officials will be living on their fully inflation-proofed public sector pensions, divorced from the reality of those struggling to get a decent pension from their personal account.
Dr. Ros Altmann
NOTES FOR EDITORS:
* The DWP report is titled “Saving for Retirement: Implications of Pensions Reforms on Financial Incentives to Save for Retirement” Full report http://www.dwp.gov.uk/asd/asd5/report_abstracts/rr_abstracts/rra_558.asp
The Government has said “This report makes clear that most people can expect their savings to make them better off in retirement. Even after inflation, virtually everyone can expect to get back more than they put away.” The report does not make this ‘clear’ at all. The conclusions only apply if the investment assumptions work out, if annuity conversion works well and if the employer contribution is not considered as part of the money you put into your personal account.