Article in ‘Public Servant’ Journal ‘ New Thinking on Pensions’

by Dr. Ros Altmann

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The past few years have witnessed dramatic changes in employer pension provision and  pensions are hitting the headlines as never before.  Not long ago, our pension system was the envy of most other countries.  Although our state pension was one of the lowest, this was offset by generous occupational schemes.  However, the ‘gold-standard’ final salary pension is rapidly disappearing from private sector employment and is being replaced by much less generous alternatives, meaning that, unless individuals make up the difference, overall pension coverage will fall significantly in future.  That is the heart of the pensions ‘crisis’ that is the focus of so much concern these days.  What is going on?

Let’s go back to basics and consider what a ‘pension’ really is.

Originally, ‘pensions’ were money paid to older people, to support them when they were physically too old to work, to prevent destitution.  So, pensions were ‘social insurance’, for older people who outlived their earning capability.  Social welfare is normally a state role. 

Over time, however, ‘pensions’ grew into something else too – long-term savings vehicles – putting money aside while working, to have savings to fall back on in later life.  Long-term savings are really an individual’s responsibility.

It would have been helpful if the ‘long-term savings’ part had been called by a different name, with the ‘pension’ only referring to the social welfare underpin, however, the social welfare and private savings concepts of pensions – which are really quite different – have become completely confused in modern vernacular.   

Paternalistic 20th Century employers, who wanted to look after loyal lifelong workers, are responsible for this confusion.  Employer pension schemes took responsibility for the social welfare function of pensions, often in defined benefit arrangements.  Some employers asked workers to contribute to the schemes too, so they became a hybrid version of the two types of pension – partly social insurance but also partly long-term savings, with workers deferring some pay, in exchange for future old age support.  

Over time, offering pensions as a ‘company benefit’ became the norm.  Companies with good pension schemes would expect to attract better staff, partly compensating for difficult lifetime working conditions.  For public sector employees, of course, generous pensions often made up for lower levels of pay. Until recently, pension schemes were an established part of UK corporate life, without people really questioning the rationale for employers providing such social welfare. 

This traditional thinking has now been exposed to the chill winds of modern reality.  Defined benefit pensions have become far too expensive for today’s private sector employers, especially as social welfare pension obligations are usually picked up by the state in other countries.  As global competitive pressures intensify, traditional UK pension schemes saddle employers huge additional labour costs, which are damaging profits.  Final salary pensions add well over 20% of salary to labour costs and, if competing with firms that do not offer such benefits, companies struggle.   In fact, as inflation and longevity keep increasing costs, each year that employers continue their final salary schemes, costs per worker rise about 5%.  So workers with final salary pensions are receiving a hidden annual pay rise of around 5% and corporate managements are waking up to these realities.

Indeed, UK final salary pensions are far more expensive than elsewhere.  Mandatory revaluation, spouse cover, indexation and regulation have vastly increased pension liabilities and employers find they have become locked into huge open-ended commitments that they never intended to take on.  But it is not just the level of cost, it is also the uncertainty of the cost which makes final salary pensions inappropriate in 21st Century capitalism.  Increasing longevity, falling interest rates and disappointing investment returns make it impossible to budget properly for future pension expenses.  Furthermore, with frequent changes in corporate ownership and average job tenure only around 5 years, employers no longer feel loyalty to former workers. 

Small wonder then, that employer pension schemes are now considered a ‘company cost’ not a ‘company benefit’.  Finance directors are taking over pension decisions from human resources departments and have decided that open-ended liabilities are not consistent with cost control and shareholder satisfaction.

Of course, public sector workers are in a somewhat different position, as their employer has deeper resources than most private companies.  In addition, if public sector workers have offered lifelong loyal service to the country, then a defined benefit pension may be an appropriate reward.  The problem, however, is that if these pensions are dying out in the private sector, taxpayers may become unwilling to finance such benefits for public sector workers.

So what does the future hold?

If private employers cannot provide social welfare, they could facilitate the long-term savings aspects of pensions, in occupational money purchase arrangements, or personal pensions.  Unfortunately, however, after successive scandals, confidence in pensions has fallen and many people are now reluctant to lock their money away into pensions at all.

The automatic expectation that pensions are a core company benefit is changing, especially for younger workers who have big student debts or are struggling to buy a first home.  Indeed, pensions may not be suitable investments in the early stages of a career.   This has led to increased popularity of flexible benefit packages, which allow workers to choose what benefits they prefer.  In such arrangements, employers earmark an amount of money per worker, (a particular percentage of pay) to finance non-wage benefits and workers then choose how to allocate this money.  Some pension, loan repayment, health insurance, car allowance?  Such flexible benefit packages are probably more suited to modern workers than just being offered pension contributions. 

Especially after April 2006 pension tax simplification reforms, it will be far easier for people to leave ‘pension’ decisions (i.e. private savings) until later in life.  There will not be such a rush to start when young, because people can contribute much more to pensions later.

The bottom line is that pensions are changing and we must all consider what this means for us.  In future, I think the State should provide a basic social welfare underpin as a ‘citizen’s pension’ and the rest should be up to each individual.  How much long-term savings they make, to provide their later life income, or how much part-time work they do, should be a personal decision.  Rather than underwriting social welfare for decades into the future, companies can help their workforce with access to savings products, part-time work and other benefits, but the ultimate decision about how much to put into a ‘pension’ will be up to individuals themselves.  Where that will leave public sector pensions is an interesting question.