Why We Must Have an Insurance Protection Scheme for Pensions – Financial Adviser
by Dr. Ros Altmann
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Occupational pensions are considered to have been a huge welfare success story in the UK. Employers have provided generous pensions for their workforces and, until recently, our funded company schemes were the envy of others. The schemes were set up under trust, keeping pension assets separate from the sponsoring employer, with trustees to look after members’ interests, to ensure that, even if the employer failed, the pension assets could not be touched.
However, the Maxwell scandal showed that an unscrupulous employer could appoint his own trustees and plunder the fund’s assets, so changes were made. From 1997, measures were brought in which were supposedly designed to improve the protection of members in company schemes. The previous Government introduced the Minimum Funding Requirement (MFR), placing controls on funding levels to ensure ‘proper’ funding, and a regulator was set up to oversee occupational schemes. In addition, the changes introduced member nominated trustees, insisted on inflation proofing all pensions and imposed expensive, extra controls on pension fund operations. Every penny of contributions had to be made on time and in accordance with the rules, so that everyone was led to believe that accrued pension rights were clearly protected in law. Millions of people have been contributing regularly to their employers’ schemes, in the belief that their pension rights are secure. Unfortunately, this is not the case. In fact, the 1997 changes actually drastically reduced the protection for many scheme members. So much so that they can pay into the scheme for 40 years or more, can transfer thousands of pounds in from another scheme and still end up with no pension at all! The regulations have looked after the pennies, but have allowed the pounds to disappear out of the fund on wind-up.
In fact, the compensation payments made under the pensions mis-selling scandals did not take this situation into account at all. It was always assumed that an employer’s final salary scheme was better than a personal pension. However, it is possible that some people may have been compensated incorrectly. If their employer subsequently failed, they may actually have been better off in personal pensions than staying in the company scheme. This is only true of private sector employers, of course.
The government has now recognised that this situation is unacceptable and has proposed changes to improve the security of pension contributions in future. On June 11, the DWP announced that an insurance scheme will be introduced to ensure members will receive at least a certain minimum level of pension if their employer fails. It is amazing that it has taken so long for this to be brought in. We protect holidays, bank and building society accounts, but not pensions. All other countries have some insurance in place and we also have pension insurance for cases of fraud, but not for insolvency. This means that pension rights of members are better protected when they work for a crook than for an honest, law-abiding employer.
Precisely how the new UK insurance scheme will work has yet to be decided. It is expected that all schemes will be required to pay an annual insurance premium, to take over pension obligations if the employer fails with insufficient assets. Of course, as with all pension issues, the devil will be in the detail, but there are several important elements. The Government is looking closely at the experience of insurance arrangements in other countries, hoping to avoid mistakes they have made. The US scheme – Pension Benefits Guaranty Corporation (PBGC) – provides helpful precedents.
For example, it is vital that premiums are related to scheme funding levels. The better funded the scheme is, the lower the premium. This is to avoid ‘moral hazard’ problems experienced in the early days of the PBGC, when struggling employers deliberately under-funded their pension schemes without penalty, knowing that the pensions would be protected. The most likely structure will be a flat rate levy for each scheme member, plus an additional amount related to scheme funding levels and security. Employers and trustees would then know that a decision to fund the scheme less well, would carry the penalty of higher insurance premiums. Employers may be allowed to ask members to pay the flat rate levy for their insurance, but the element related to funding should be borne by employers, since they have the ability to fund the scheme better. It will be important also for the insurance scheme to have powers to look through the capital structure of a company, to ensure that underfunded schemes in subsidiaries of solvent companies are not just dumped on the insurance.
One obvious problem is that there is no agreed standard to measure what ‘adequate’ funding should be. Government has proposed that the MFR should be replaced by ‘scheme specific’ funding, which will not be a uniform approach. For insurance purposes, a funding standard is essential. If this standard places greater emphasis on bonds than the traditional asset allocation of UK final salary schemes, there may be implications for the costs of pensions and for asset prices.
The insurance scheme is unlikely to cover pension benefits in full. There will be a ‘cap’ on the amount of annual pension paid out, which would be in line with other financial compensation schemes, such as for banks. Even if you have £1million in your account, if your bank fails, you will still only receive about £30,000.
The insurance scheme will set up a ‘Pension Protection Fund’ which will hold all the pension fund assets of insolvent employers’ schemes. Rather than buying annuities for each pensioner, this central fund would pay out the pensions as they fall due. This reduces the costs of administration, independent trustees and avoids having to buy annuities. In addition, the investments would earn income over time.
Some employers and, indeed, pension fund professionals, have criticised the insurance proposals. They argue that the extra costs of insurance will be a dangerous added burden on companies. My response is that, without an insurance arrangement in place, employers should not be making pension promises. If employers cannot afford the insurance premiums, how can they afford to pay the pensions? There are no guarantees, which is why insurance is essential. We have learned that no employer is safe from insolvency (who would have thought Enron or Marconi could collapse?) and that apparently well funded schemes can rapidly become underfunded, as markets and interest rates fall sharply. If no insurance is brought in, members would need to be warned that their pension contributions are not secure. This could undermine defined benefit pensions and further erode confidence in our system. Thousands of workers have found that their pension contributions can disappear and, under current law, a ‘promised’ defined benefit pension is barely more secure than buying shares in the company of their employer.
At the end of the day, if we want people to put money into employer pension schemes, it is essential that this money is safeguarded for them if the employer fails. An insurance scheme – which must ultimately be underwritten by the Government in extremis – is by far the best way to achieve this.