UK Final Salary Pension Crisis – Possible Solutions
by Dr. Ros Altmann
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Our final salary occupational schemes, which used to be the envy of other countries, have become financially unsustainable. Many members are also discovering that the schemes are no longer safe.
Everyone is looking for someone to blame – but the truth is that fault lies to some extent with all parties involved in UK pensions, who did not allow surpluses to build up enough.
UK final salary schemes are now three times as expensive as those in the US. Without the cushion of surpluses, at best, this will depress profits and competitiveness, as our schemes struggle to find enough money to meet their liabilities. At worst, this could bankrupt some companies.
The reasons for the deficits are many. Falling stock markets, actuarial valuation methods, the contribution holidays and Gordon Brown’s removal of ACT relief have all been cited, but the problem has multiple causes:
The Inland Revenue decided to tax any surplus above 5%, so there was an incentive for companies to spend any surplus, rather than letting them build up while schemes were young and equity returns were strong.
Employers used pension funds as a cheap source of industrial restructuring, by offering generous early retirement benefits instead of paying redundancy. They also took contribution holidays.
Members demanded earlier retirement and benefit enhancements and trustees agreed to this.
Government removed tax advantages, required MFR and indexation and forced more complex and expensive regulation on schemes. Much of the regulation was designed to protect members of final salary schemes. However, the truth is that members’ pension rights are not properly protected. So much so that people can actually pay in loyally for over 30 years and still end up with no pension! The system does not seem to be fit for purpose!
Actuaries’ investment and mortality assumptions proved too optimistic.
Asset allocation relied too heavily on equity returns to fund the schemes. If there had been more diversification, with a much greater exposure to bonds (for example 40% bonds, 40% equities, 10% property, 10% alternative assets) the funds would have benefited from good performance by bonds and property to offset the declines in equities. With mature schemes, more bonds should have been held.
In sum, not only are our schemes more expensive than those in other countries, the liabilities are also inexorably growing as the schemes mature. Surpluses were not built up when there was the chance and now the money is simply not there. It is no use looking back, we must now deal with the situation we are in. So what can be done to alleviate this crisis?
Given that all parties must share some of the blame, it is important that they should also share in the solution. A mature dialogue is required, an acceptance of the need to address the problems without simply blaming other parties and expecting someone else to solve it. Collective responsibility is crucial.
1. Renegotiating the deal
First of all, it is important that employers and workers discuss how bad the situation in their particular scheme is and decide how to move forward. Some employers will not be able to afford to keep their scheme for new or existing members, if the amounts required to make up shortfalls are so great that this would bankrupt the company. Others may need to reduce the amount they pay, or require employees to contribute more in future. Employees will need to decide, as do banks when considering whether to re-schedule loans, whether it is better for them to accept lower pensions and higher contributions or whether they should risk the viability of their employer by insisting on full pension rights.
Agreeing to raise the retirement age, to move to career average, rather than final salary, moving to a hybrid scheme, agreeing to accrue a lump sum, rather than promised pension, changing the basis on which pension is calculated, removing indexation – all these are options which would reduce the burden of pensions. But, of course, they will also reduce the pension and workers must recognise this is inevitable.
2. Tax breaks for companies with pension burdens
Government could consider allowing companies with final salary schemes to have a special tax break if they put in extra contributions.
3. Government take on some of the longevity risk
Government could issue survivor bonds for pension funds, which would shift some of the longevity risk from companies or individuals onto Government.
4. Better diversification of assets
Government should require more diversification of asset holdings, with better match of bonds to meet pension obligations, taking account of the proportion of pensioners to non-pensioners in the scheme.
5. Invest in infrastructure projects
Government might consider offering pension funds the opportunity to invest in major long-term infrastructure projects, which would offer paybacks over a period of, say, 30 years. The payback could be higher than gilts, but lower than would be demanded by private finance initiatives or profit-seeking firms.