Financial Adviser feature on the proposed new personal pension accounts

by Dr. Ros Altmann

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So at last we have it.  The big idea for increasing pension savings – personal accounts.  In theory, developing a low-cost national savings scheme – aimed particularly at moderate to low earners – and automatically enrolling people into it, makes sense.  Unfortunately, as Albert Einstein said, ‘in theory, theory and practice are much the same.  In practice they are not’.

The problem is that, because of continued mass means-testing in the state pension system, hundreds of thousands of people could end up saving in a pension that is not actually ‘suitable’ for them.  

The Government says people are not contributing to pensions for three main reasons.  Firstly, high charges. Well, we all know that is not the reason.  Stakeholder proved that.  Secondly, inertia – auto-enrolment is designed to overcome this.  Thirdly, the ‘complexity of the current system which means incentives are not clear’.  However, even with the latest state pension reforms, at least a third and quite possibly half of all future pensioners will still be entitled to pension credit.  Therefore, their pensions will be penalised by at least 40p in the pound, some people will lose their entire pension in the means-test and the unclear incentives remain. The target group of low-earning non-savers are the very people most likely to end up on means-tested benefits in later life. 

This problem of suitability really concerns me.  The Government just seems to think it can ignore the fact that so many people will be wasting their money, but these are real people with real lives, who will come to retire and find the pension the Government automatically enrolled them into was worthless.  Effectively, personal accounts for many people will just have provided their own means-tested benefits, while those who opt out will still get pension credit and will also have had extra salary during their working life. 

What makes the situation even more difficult, of course, is that nobody knows in advance who will be the ones to lose out later.  How many low and moderate earners today can be sure they will be in the top two thirds of the income distribution on retirement?  This makes it impossible to plan properly and means we do not have a safe environment in which to introduce personal accounts.  Likewise, people with high debts, or those closer to retirement, are unlikely to be best advised to contribute, but how will they know to opt out?

Research from the Pensions Policy Institute also shows that those who do not own their own homes are more at risk of losing out in personal accounts.  This suggests that younger people should make sure they own their own home first, before contributing to personal pension accounts.  But then they will not start saving until much later in life and the eventual pension they could expect will not be nearly as large as the Government assumes. 

In fact, the Government’s calculations of the benefits of personal accounts are also open to question.  Again, in theory, the figures for the expected pension to be achieved may sound attractive, but we all know that in practice ‘expected’ returns are not the same as ‘achieved’ returns.  What the Government’s consultation does not address is the vital question of ‘what happens if things go wrong?’

It is not responsible to merely assume that investment returns will be achieved reliably, that annuity rates will stay close to current levels, or that people will contribute without interruption to these accounts.  Real life is very different from this.  What happens if one of the investment funds loses 90% of its value?  There is no consideration of negative outcomes, but there are bound to be people who lose out.  Will they may just be abandoned by a future Government?  They must be clearly told of the risks they could face.

Having witnessed members of failed final salary schemes, losing their whole life savings with no warning, it seems that history could be about to repeat itself.  In the 1990’s, the then Government wanted, as now, to encourage more people to contribute to occupational pension schemes and wanted to make sure that employers offered good workplace pensions.  After the Maxwell scandal, Government introduced measures designed to reassure the public that these pensions were safe and did not think through what might happen if the protections failed.  Policy makers just assumed the future environment would be like the past, equity markets would deliver strong returns and employers would keep running their schemes.  Sadly, this was not to be and in practice tens of thousands of people lost their entire pension.  But the politicians who designed the 1995 Pensions Act are no longer in power and today’s politicians refuse to compensate those who lost out as a result of Government assurances of protection which turned out not to be there.  Members were encouraged to contribute to their employer schemes, were assured their money was safe, could not have any other pension  and, having lost everything, they are being told they should not have contributed to the company scheme without taking proper advice.  At the time, of course, they were not told such advice was needed and they relied on information provided by the Government which explained the benefits without mentioning the risks.

Here we are, in 2006, making the same potential mistakes again.  The system of personal accounts will be run without proper advice, people will be automatically enrolled and may lose all their money, but there is no protection for them.

Importantly, personal accounts will be occupational, not personal pensions.  Therefore, there will be no FSA protection, no ‘cooling off’ periods after the first contributions, no ‘know your customer’ or ‘suitability’ checks, just ‘generic advice’.  Employers will be able to promote their schemes with no fears of future claims for mis-selling.  If low to moderate earners really understood the risks, most may be reluctant to contribute at all.  But they will possibly not find out until it is too late.

In fact, the real problem here is that these are pensions.  Once the money has been contributed, people cannot get it back again.  It is locked away.  This makes it even more important to try to ensure suitability, but this has been overlooked in the present proposals, possibly because, in practice, it is almost impossible to know if these accounts will be suitable investments for a particular individual.  This is not just because of future investment or annuity risks, but more particularly due to the uncertainties of the state pension environment and means-testing.

Personal accounts are potentially dangerous and could actually worsen private pensions for significant numbers of people.  By recommending a level of employer contribution which is so far below what most employers are currently contributing, many companies will inevitably be tempted to cut back to the minimum.  As soon as any economic slowdown occurs, reducing pension contributions by switching to the ‘national Government-approved’ scheme would be an easy way of cutting costs.  Once cut, contributions are unlikely to be increased again, so many workers currently in occupational schemes will end up with lower pensions. 

Additionally, a 3% employer contribution works much like a national insurance increase for employers not currently contributing to workers’ pensions.  These employers, particularly smaller companies whose workers the personal accounts are aimed at, are likely to try to encourage their staff to opt out.  3% put into a pension is money that could otherwise be paid in higher salary.  This is not ‘free’ money, it is part of workers’ pay.  Suggestions that employees are only contributing 4% while the employer is putting in 3% are somewhat disingenuous.  The employee is ultimately contributing the whole 7%.  That is again why many low or moderate earners are likely to opt out.  Offering staff the chance of higher salary today, or the possibility of locking money away into a pension that may or may not deliver good value later on, may well discourage many from joining.

So could these accounts be made to work properly?  In theory yes.  If the pensions are not counted in the means test, suitability problems would be more manageable.  If a lower maximum contribution than £5000 a year were introduced, there may be less negative impact on existing schemes.  If downside protection could be put in place to insure against big capital losses and if advice were available to people with high debts or interrupted careers and also to help people choose the right annuity before retirement, then the system might work well.

Sadly, in the real world, these conditions will not be met, so in practice I hope that this big idea will not actually be implemented and, if I were running a financial services company, I would tell Government I want nothing to do with these proposed personal accounts.