Financial
Adviser feature on future of UK occupational pensions

by Dr. Ros Altmann

(All material on this page is subject to copyright and must not be reproduced without the author’s permission.)

---

Employers have
always been considered a vital part of UK pension provision.
However, companies are rapidly pulling out of their traditional
final salary pensions role. Workplace pensions are likely to be
defined contribution in future. The movement away from final salary
schemes is a huge challenge for pensions policy and could deliver
exciting new opportunities for financial services companies and IFAs.

The UK model of occupational pensions has developed over past
decades and, until recently, we prided ourselves on having one of
the best occupational pension systems in the world, with employers
promising lifelong support for their workforce and taking on all the
risks involved in pension provision.

In fact, successive UK Governments kept cutting state pensions with
the expectation that private pensions, invested heavily in equities,
would offset these reductions and also generate adequate provision
for pensioners. The exceptionally high equity returns in the 1980’s
and 1990’s encouraged the belief that equities could be relied on to
always perform well. However, since 2000, falling stock markets,
along with falling inflation, lower interest rates and rising life
expectancy, have left employers struggling with huge deficits in
funds they had not-long-ago thought were in healthy surplus. More
realistic accounting rules and increasingly mature schemes, which
have to pay out generous pensions to more and more pensioners, are
forcing employers to totally reassess their commitment to pensions.
This represents a crisis in future pension provision. Suggesting
sensible, sustainable solutions, requires unravelling some muddled
thinking.

Essentially, pensions have two distinct roles, firstly, providing
social welfare and secondly as an investment vehicle.

The original idea of pensions was to provide some social insurance
for people who were too old to work, so they could survive. This
role would normally be considered a State responsibility, but UK
employers have been fulfilling this role too. The end of final
salary schemes represents employers pulling out of social welfare.

Over time, pensions have also become an investment vehicle, although
this was not the original idea. Pensions help people save while
working, in order to have something to live on when they are no
longer able to work. Defined contribution employer schemes and
personal pensions are designed to help with this aspect of pensions.

The problem with UK pensions policy at the moment is that neither of
these two roles is being properly fulfilled. The social welfare role
of pensions has been hit by continuous cuts in state pensions and
employers retreating from final salary schemes. The investment side
of pensions has suffered from disappointing investment returns,
falling annuity rates and successive scandals, which have undermined
confidence in long-term saving.

In order to improve pensioners’ social welfare, Government decided
to introduce the pension credit, as a means-tested top-up to state
pensions. The majority of pensioners will be entitled to it but this
does not end pensioner poverty because a fifth of pensioners do not
claim their benefits. More worryingly, though, the means-test
penalises private pensions by at least 40% – and for many people by
100% – so it is no longer safe to save in a pension. Pensions are no
longer a suitable investment for many people and financial advisers
cannot safely advise basic rate taxpayers to put money into a
pension. Thus, in trying to provide social insurance via pension
credit, government policy is undermining occupational and private
pensions savings vehicles.

Pension policy is caught in a vicious circle. If we keep going as we
are, the UK is heading for economic decline and huge swathes of the
population in poverty.

It seems that employers are being squeezed out of pension provision,
which is very worrying. It is not just the cost of providing final
salary pensions (which is well over 20% of salary now) but it is
also the uncertainty of the cost, which makes final salary pensions
so difficult for employers. Finance Directors have taken over
responsibility for pensions from human resource departments, leading
to a radical review of employer pension provision. In future,
employers can only really be expected to help with the investment
aspects of pensions, in the form of defined contributions and we
should recognise that they need incentives to do this. Workplace
pension schemes are often now viewed as a company ‘cost’ rather than
a company ‘benefit’ and companies are far less certain that they can
justify providing pensions.

With lifelong employment a rarity and average job tenure only around
five years, employers can no longer be expected to provide social
welfare. The State has to pick up this role. What policy needs to
do, however, is to encourage employers to help with the investment
aspects of pensions instead, in an effective manner through improved
defined contribution pension arrangements.

With more flexible employee benefit packages, the spread of
means-testing in the state pension system and increasing levels of
debt in the population, evidence suggests that most younger people
are no longer interested in pensions. In this environment, many
employers do not want to offer pensions at all and the longer this
situation persists, the lower pension coverage will be. Both
employers and individuals need new and better incentives to provide
pensions, but radical change of our whole system is needed before
such measures can be expected to succeed.

Part of the solution to the pensions crisis seems to me to lie in
having a clear distinction between the two functions of pensions,
with Government taking on the social welfare responsibility and then
encouraging the private sector to provide additional savings on top
of this, free from means-tested penalties. Organising such savings
via the workplace seems to be a sensible route.

So what changes do we need? Introducing a £110 a week citizen’s
pension, indexed to earnings, would deal with social welfare,
without undermining the investment role of pensions. The basic state
pension and state second pension would be merged and everyone would
be entitled to this basic minimum. This would then leave the private
sector free to offer savings and investment products to all, with a
clear message that financial advisers could give to clients.
Government provides enough to live on, but only just. Anyone wanting
a better lifestyle later will need more. If your employer can help,
so much the better.

Abandoning S2P and the complexities of contracting out could save
£11billion a year of contracting out rebates, easily financing the
£7 billion a year cost of a citizen’s pension. This would end state
earnings-related pension provision, but is this a problem? Firstly,
S2P will become flat-rate in future anyway, and secondly, why should
society ensure that higher-earners also receive higher pensions?
Surely it is up to individuals how much they save and a
well-functioning financial services sector should be able to provide
attractive pension products.

Once the State takes care of basic social welfare, it would not
longer be essential to force people to contribute to pensions or to
require them to annuitise their savings. There would be freedom of
choice, but it is in the social interest to encourage people to save
if they can.

Since it can no longer be automatically assumed that employers have
a duty to provide pensions, they are likely to need meaningful
incentives to offer pensions to their workforce. Workplace provision
is much more cost-effective than individual pension arrangements, so
employer schemes are important and employers would have an important
role in facilitating pension saving. Individuals, too, need better
incentives. Just relying on tax relief – which gives least help to
those who need most – is unfair and inefficient. Matching incentive
payments, say an extra £2 for every £3 everyone contributed, would
be fairer and more effective. Extra rewards for employers who ensure
generous pension contributions for their staff could also be
helpful.

So, in future, employers can provide access to pensions and perhaps
be encouraged to contribute on behalf of their employees, because
the workplace is a useful way of pooling resources and harnessing
economies of scale. Financial advisers can help employers to do
this.

To sum up then, solving the pensions crisis requires urgent radical
changes. The Government should provide a universal Citizen’s Pension
to take care of social welfare, sweeping away the complexities of
S2P, contracting out and pension credit. In addition, the State must
provide fairer and more powerful incentives to encourage employers
and individuals to fulfil the savings element of pension provision.
Financial advisers and financial services companies have a key role
to play. Their challenge is to help companies and individuals
understand what can be done to achieve successful investment returns
for the future in a defined contribution pension arrangement.
Organising the investment side via the workplace is the best way to
achieve economies of scale and advisers should be preparing to help
employers and individuals manage the change from defined benefit to
defined contribution pensions.

By assuming these high returns would last into the future, employers
thought they could provide generous final salary pensions at very
low cost! Indeed, employer pension schemes – many of which were
established in the 1970’s – did so well in the bull markets, that
actuaries suggested these schemes were in surplus and that employers
could reduce their contributions and enhance members’ benefits. In
the industrial restructuring of the 1980’s and 1990’s, it proved
very convenient to fund redundancy costs via a pension scheme in
surplus, by offering generous early retirement packages. In fact,
the Inland Revenue was tempted by these surpluses too and to tax
surpluses above a 105% statutory level. Policymakers took the
opportunity to pile extra burdens onto employers’ schemes, requiring
them to provide spouse cover, inflation-linking and revaluation of
leavers’ pensions.

When employers started providing pensions, lifelong employment was
much more the norm. Loyal workers served their employer straight
from school and stayed with the company until they were too old to
work. Employers felt a paternalistic duty to look after these
employees once they had left the firm. It gradually became the mark
of a ‘caring’ employer to provide a ‘decent’ pension for their
workers. Worker representatives pushed for better coverage, more
generous provision and human resources departments insisted that
they needed to offer good pensions in order to attract the best
employees. The final salary pension was seen as the ‘gold standard’
of company benefits, in which the employer promised to pay a
pension, based on the member’s final salary, for as long as the
worker lived after retirement. While schemes were young, no-one
worried much about the long-term costs of this. However, most final
salary schemes now have to pay out huge amounts in pensions each
year, so they do not have the luxury of waiting and hoping that
equity returns will be high enough in the long term to meet their
liabilities. Employers are struggling with huge deficits, as the
costs of continuing to offer final salary pensions are far higher
than they ever dreamed of when they started these voluntary schemes.

Policymakers would still need to encourage the investment element of
pensions, to give as many people as possible more than the state
minimum, but compelling employers or individuals to save is not the
answer. Many employers and individuals are in debt and forcing them
to contribute, would damage economic welfare. In any case, extra
pension contributions would have to come from somewhere, and would
reduce wages, investment, employment or profits. However, ‘soft
compulsion’, including contributing part of each year’s pay rise
into a pension, or automatic enrolment into company schemes, while
still allowing people to opt-out, would still allow for individual
choice.