Defined Ambition pensions, why and how?
by Dr. Ros Altmann
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A watershed period for UK pension provision – facing up to reality that we have transferred pension risk completely onto workers
Ministers admit to extreme uncertainties facing those about to be auto-enrolled into defined contribution schemes
Can we find middle ground, with employers still taking some of the risk but not all?
Traditional defined benefit schemes no longer available: Steve Webb, Pensions Minister, has bravely hit the airwaves this morning to highlight the Government’s concern that the current pension system will leave millions at the mercy of the markets when it comes to their retirement security. He rightly points out that final salary pensions are becoming extinct in the private sector, with defined benefit pension provision having proved too risky and far too costly for companies to guarantee. The traditional UK employer pension, whereby sponsoring firms guarantee to take on all the risks of future pension provision, is no longer available to most workers. Shell was the last of the FTSE100 companies to pull out of final salary pensions for new workers.
Employers can’t underwrite open-ended commitments for so many decades: After decades of pension promises – many of which have been broken when firms have folded in bankruptcy, leaving workers without the pensions they were expecting – companies and shareholders have woken up to the full extent of the risks of underwriting pensions in a world of ever-rising longevity, unstable inflation and volatile asset market returns. The reality is that final salary or defined benefit pensions are open-ended social welfare-style commitments that do not fit with 21st century capitalism. Today’s employers – even huge multi-national firms – cannot guarantee to be around in 70 or 80 years’ time to pay promised pensions to their younger workers. Indeed, even in the next 30 or 40 years, these firms may fold or be taken over by other companies without any appetite to assume this kind of unlimited pensions risk.
So what are the risks of providing guaranteed pensions: The risks that employers have been taking on include:
- Longevity risk: the risk that workers live far longer than expected in future years, so employers have to keep on paying pensions for far more years than budgeted for
- Partners longevity risk: UK defined benefit pensions automatically cover a partners and often dependent’s pension as well, so the longevity risk applies to more than just the worker
- Investment risk: the risk that the investments do not perform as well as forecast and employers have to make up the shortfall
- Investment charges risk: the risk that investment management charges rise much higher than anticipated, thereby reducing future returns
- Salary inflation risk: the risk that salaries rise much faster than expected and, with final pensions tied to final salaries, this will increase the cost of the pensions due at retirement
- Inflation risk: As UK final salary pensions are inflation-linked, if inflation rises more than expected in future, the costs of future pensions will be higher
- Regulatory risk: the risk that future Governments will impose bigger regulatory burdens or tax increases on pension funds, as has happened in recent years. Regulations included covering partners, providing protection for workers who have left the firm and reductions in dividend tax credits
- Administrative cost risk: the risk that the costs of administering pensions will rise faster than expected in future
- Annuity/interest rate risk: the cost of buying pensions in future will be related to the future cost of annuities and this depends on future interest rates, with lower rates leading to increased costs
Pensions are like social welfare, but equity returns could not keep up: A defined benefit pension underwrites these risks, with employers having to shoulder these burdens for many decades into the future. This is more like social welfare, which would usually be a Government responsibility. There was an expectation that somehow clever investment managers would always generate sufficient returns to ensure that the pension funds could cover all these risks – particularly a faith in stock market and other risky investments that would generate high enough returns to pay the pensions. This has not worked!
Defined contribution pensions put all these risks on the workers: The closure of defined benefit schemes has led to a move towards defined contribution arrangements. Under these arrangements, the employer’s only obligation is to pay in a defined amount of money every month to their employees’ pensions and that’s it. They do not carry any of the risks associated with pensions – all the risk falls on the workers themselves. They carry the risk that the investments won’t work out, that they will have to pay high charges, that taxes may change, that they and their dependents will live much longer than expected and that annuity rates and inflation will move against them in many years’ time.
Massive social transfer of risk: So we have moved from a world where private employers shouldered almost all the risks of pension provision, to one where they shoulder almost none of the risks, with workers themselves facing huge uncertainty.
Government looking for ways to redress the balance, with employers taking back some of the risk – Defined Ambition!: The Government is now suggesting that it wants to find ways that employers might be willing or able to ‘share’ more of the risk of future pensions with their employees. The current system of defined contribution means no worker can be sure what their pension will be in future. If they want to start their pension age a particular age, say 65, they will not know how much it might be (this will depend on future longevity, investment returns and annuity rates). If they want a particular amount of money to live on in retirement, they will know at what age they may have saved enough and achieved enough investment return to be able to draw that pension (it will depend on investment returns and annuity rates in future). They will also not know whether their pension will be protected against inflation. There are various ways in which the employer may be able to share some of the risk.
Cash balance plans: Under this arrangement (popular in the US and also introduced by Morrison’s in the UK) the employer promises to pay workers a specific sum of money when you retire. So the contributions employees and the employer pay in are put into a fund and the expected investment returns are calculated to aim to provide a lump sum in retirement. The employer therefore takes on the risk that investment returns before you retire are lower than expected and will promise to make up the difference. However, once the worker retires, he or she carries the risk that they will live longer than expected, and has to decide how to get an income from this sum of cash that they have received. So employers take the risks up to retirement and workers take the risks after retirement.
Collective Defined Contribution: These plans are popular in the Netherlands and are a form of ‘risk-pooling’ with workers contributing to a fund during their working lives and employers promising to pay a particular level of pension that actuaries have calculated will be affordable from the pension fund in future. If the investment returns are as expected, then future workers will get that level of pension, but if returns are below expectations, then future pensioners will receive reduced pensions, so there is an element of inter-generational cross-subsidy and risk.
Aspirational plans: New types of pension arrangement could be introduced, in which there is far more flexibility about the amount and date of pension receipt. The employer could promise to ‘try to’ pay a particular level of pension, or to promise to pay an amount within a range, for example that the employer would hope to pay 30% of final salary but that this could be a range of 10% to 50%, or some other figure, depending on future investment conditions. This would give a bit more certainty to workers, and a lot less risk for employers than current defined benefit plans.
The bottom line is that we must think differently about pension realities. What we really need is for people to understand that pensions don’t grow on magic trees and we cannot really predict what future pensions will be in many decades from now. Saving in a pension does not guarantee any particular level of future income – the past guarantees are unaffordable. The glaring inconsistencies between pension expectations and reality are finally coming to be recognised. Private sector employers have understood that the costs and the risks are far higher than appreciated – partly because of the good news that people are living much longer than in the past and partly because investment returns have not kept up with pension costs in the way that was assumed.
We are at a watershed in pensions – we need honesty ahead of auto-enrolment: The current debate is the start of new thinking on pensions. As millions of workers are about to be automatically enrolled into pensions for the first time, it is vital that they understand that this does not mean their retirement income is going to be fine. Paying money into a pension does not guarantee any particular level of pension out. The state pension reforms need to provide a minimum social security base of retirement income, which people’s own savings and employer contributions will supplement, but we do not know exactly how much they will receive. Employers will not guarantee to support people for ever-longer periods of retirement and investment markets cannot provide those guarantees either.
Having transferred pension risk almost entirely away from employers and onto workers, can we now find middle ground? The risks and costs of pensions are very high and have risen sharply over time. Having transferred the risks of pensions from being almost entirely on employers, to now being almost entirely on employees, can we find some kind of ‘middle ground’ where the employer keeps at least part of the risk and shares this with workers? That is Steve Webb’s aim with ‘Defined Ambition – or Defined Aspiration’.