Occupational Pensions In Future
by Dr. Ros Altmann
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Over the past few years, the future for occupational pension schemes in the UK has changed dramatically. The once-prevalent final salary schemes are now mostly closed, at least to new members if not to all and it seems that such schemes will not continue longer term.
Over the past twenty years or so, UK Governments have tried to offload pension costs onto employers but, because the costs of delivering pensions have risen substantially, employers have found they can no longer afford to underwrite open-ended, generous pension provision for their workforce and many are struggling with huge deficits in their final salary schemes.
Even in the public sector, rising pension costs, against the background of large fiscal deficits, have led to a reassessment of public sector pension provision. The recent interim report from the Independent Public Service Pensions Commission seems to have heralded the end of final salary pension arrangements for public sector employees too. Lord Hutton’s report concluded that final salary pension schemes are ‘inherently unfair’, as they favour high earners and discriminate against those who do not rise rapidly through the ranks. He suggests that career average pension schemes could replace final salary, and also that public sector workers should be expected to contribute more to their pensions, as the burdens have so far fallen unfairly on taxpayers. The interim report suggests that an average increase of 3% in employee contributions might be required, although lower-paid public sector workers may not be asked to contribute as much extra as higher earners. The final report will recommend which type of pension provision should be offered to public workers in future.
In the private sector, defined contribution schemes are replacing defined benefit plans for most employers – and this is likely to be the standard for future pension schemes. With a defined benefit scheme, the employer takes on the risks and costs of pensions, and will bear the risks of investment performance, salary inflation, longevity, interest rates and regulatory changes. In defined contribution schemes, these risks are generally borne by the members, with employers merely promising to make specified contributions, but no promise is made of what pension employees will receive in retirement.
Thus, as people are living longer and expecting to spend many more years in retirement than used to be the norm, a pensions crisis has developed. Government can no longer rely on employers to pay good pensions to offset the declining level of state pension and workers are increasingly at risk of an impoverished old age, depending on means-tested benefits to avoid penury. In order to address this risk, Government has recently embarked on a pension reform programme designed to increase participation of employers in providing pensions and also to increase the numbers of workers saving in a pension scheme.
From 2012, there will be a national system of automatic enrolment, with workers being compulsorily opted into a workplace pension scheme and having to consciously decide to opt out if they do not want to contribute. Every employer in the UK will be obliged to enrol all workers over age 22 and earning above about £7,500 a year, into a pension scheme. The employer will have to contribute 3% of salary above the national insurance lower threshold, as long as the worker contributes 4% and taxpayers will add a further 1% of salary in basic rate tax relief. This will be a fundamental change in occupational pension provision in this country and is designed to ensure that more workers have their own private pension arrangements in retirement.
For those employers who cannot or do not want to find a pension provider, the Government is setting up the National Employment Savings Trust (NEST), which will be a low cost pension scheme, specifically designed for low to moderate earners, run by publicly appointed trustees who will also select fund managers and default investment options. The NEST scheme will be available to all employers, but the maximum amount of contributions permitted per worker will be £3,600 a year, so higher earners would be unlikely to join. This will be a defined contribution scheme, with workers bearing most of the risks and they will not be sure what pension they will ultimately receive on retirement. However, the very low cost structure is supposed to ensure that they obtain better value than most private sector schemes.
My fear is that future occupational pensions for many people could be damaged by the introduction of auto-enrolment and NEST, because employers may well take the opportunity to cut back their pension contributions to the NEST minimum. Currently, employers who do provide pensions for their workers are contributing an average of 6% of salary, but the new NEST scheme offers them a chance to cut back to 3% (and the initial contribution level will only have to be 1% of salary). This risk of leveling down poses a threat to current workers, but it is hoped that it will not be a significant problem.
This is a huge experiment and other countries will be watching closely to see how auto-enrolment and NEST work out over the coming years. Workers will need to decide whether to stay in or opt out and even if they opt out, they will be automatically re-enrolled every three years or so, in order to try to encourage them to save in a pension.
In order to help improve the attractiveness of this workplace pension revolution, the Government has recently announced a radical reform of state pensions. At the moment, the state pension system actually undermines private pension saving, because nearly half of pensioners are entitled to means-tested pension credit in retirement. When they claim pension credit, they will lose much, or even all, of their private pension. The proposal to pay all newly retiring pensioners, who have a full National Insurance record, at least £140 a week will remove the risk of mass means-testing for future new pensioners.
Without this reform, pension saving would be an unsuitable investment for the many low and moderate earners in NEST. They would face the risk of having their pensions penalized by the state system in retirement. By paying a simple, flat-rate pension of £140 a week, the Government would make it clear to everyone that if they want to have more than that in retirement, they will need to save to provide themselves with extra income, or keep working longer.
As occupational pension provision moves away from traditional final salary schemes, it becomes ever more important to help people feel safe about saving for retirement. I hope that the Government will rise to the challenge and secure a better future for us all.