How can we create a fairer pension system for all?

by Dr. Ros Altmann

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Over the past few years, the pensions crisis has worsened significantly. Government has tinkered and fiddled, but failed to introduce much-needed radical reforms. The first baby-boomers reach age 65 next year and millions more will reach their 50s and 60s in the coming years. They are heading for a miserable and poor old age.

Final salary pension schemes are almost all now closed and money purchase pensions have not worked out as expected. Pensions have been a big casualty of the measures taken to fight the credit crisis. Record low interest rates have led to soaring pension liabilities and plunging annuity rates, both of which make pensions more expensive. Added to this, life expectancy has increased far faster than actuaries predicted, which is great news in many ways, but further increased pension costs.

How was this crisis allowed to develop?

After the 1990’s, it became clear that pension funds were in trouble and equity markets could not be relied upon to deliver good pensions, but Government ignored the problem. In fact, it even introduced measures that discouraged saving, just when it should have been ensuring the baby-boomers saved more to provide for their upcoming retirement. The FSA’s ‘light touch’ regulatory system operated asymmetrically, making it far too easy to borrow – no questions asked, self certification, no risk warnings – and far too difficult to save in a pension – full fact finds, reams of paperwork, risk warnings and so on. I have often wondered whether, in fact, the Government was far more interested in boosting short-term growth, by encouraging borrowing and spending, rather than responsibly ensuring retirement savings were adequate.

The state pension has been cut year after year, and private pensions have worsened, resulting in inadequate income for a significant proportion of future pensioners. In addition, state pension reforms have undermined pension saving incentives. The introduction of mass means-testing, via the Pension Credit, has left nearly half of pensioners at risk of means-testing penalties to their private pensions. Pensions have become an unsuitable product for many low or moderate earners (ISAs may be more appropriate).

Top earners have fared much better, as generous top-rate tax relief and expanding annual contribution limits increased pension saving opportunities. However, most others are not so well provided for. As pensions have declined for all but the very wealthiest or highest earners, the divide between pension haves and have-nots has grown enormously. Meanwhile, traditionally generous public sector pension provision remained intact, so policymakers were insulated from the pensions crisis building up in the private sector.

There have been several major problems.

Firstly, we have an inadequate, ludicrously complex state pension. The full Basic State Pension pays just £97-65 a week – about the lowest in the developed world. Many women are excluded altogether if their working income was below the National Insurance minimum. There is also a Second State Pension, but not all pensioners receive it and it pays different amounts depending on which year National Insurance contributions were made. This complexity means most people do not know how much their state pension will be.

Furthermore, anyone over 60 without much income, can receive £140 a week in Pension Credit to which nearly half of pensioners are entitled, but the means-test penalises their private pension income. Thus the state pension system undermines private pension saving.

Secondly, as traditional final salary schemes close, fewer workers can rely on their employer to fund their retirement. Replacement money purchase pensions are much less generous and much more risky.

Thirdly, the complexity and poor performance of pensions, several high-profile scandals, and rising indebtedness have shaken confidence in pensions. The UK’s once-strong retirement saving culture has withered. People not close to retirement are reluctant to put money into a ‘locked box’ which they cannot touch for many years under any circumstances.

Fourthly, ordinary savers have been excluded from the financial advice process. They need help to understand the complexities of financial products and pension saving, but regulatory burdens have made advice too expensive for the mass market.

Finally, annuities are not working properly. The open market option has failed and far too many people buy the wrong kind of annuity at a poor rate, without advice and are then locked in for life. Nearly half a million annuities are bought every year and the number will rise sharply in future as more baby-boomers reach retirement. Urgent changes are required, before even more people end up with much less retirement income than they could have, vulnerable to rising inflation – and at risk of leaving partners with no pension after buying the standard ‘default’ single life, level annuity.

What can be done to remedy these problems?

Radical reform could improve pension outcomes and alleviate the worst unfairnesses.

The most important is state pension reform. The state should pay a decent minimum pension to all, without mass means-testing. Until there is an adequate social safety net for pensioners, private income cannot safely be built up for retirement. The State Second Pension, Winter Fuel Allowance and other free benefits could be rolled into a more generous state pension, paid to all, and then taxed back from the better-off.

Raising the state pension for all to at least the Pension Credit level, even if paid from a later age, is a necessary condition for improving the fairness of our pension system.

Everyone would understand what the state pension will pay and the private sector could then safely provide additional retirement income, to supplement the social welfare minimum.

Extending financial education, advice and planning will help those preparing for retirement. Government is proposing a national financial advice service and annual financial healthchecks. These cannot come soon enough, but why not also incentivise employers to offer financial education and even independent advice to their workforce with tax breaks for financial courses?

Increased pension flexibility, including allowing money to be accessed early, at least in an emergency, would encourage more workers to contribute to pensions in the first place – especially those further from retirement.

Or we could introduce ISA/pensions for those reluctant to lock money away immediately, where part of each pension contribution goes into an ISA and the rest into a pension. ISAs are more suitable for younger workers unsure about their long-term future, or those who have not yet bought their own home.

The annuitisation process also needs immediate radical reform, preferably scrapping mandatory annuitisation entirely. Forcing people into an irreversible financial product seems unwise and annuity rates could well worsen further. As DC schemes spread and as more employers look to shed the risk of their final salary liabilities by ‘buying out’ with annuities, coupled with increased EU solvency regulation, pressure on annuity rates will rise. This means annuities are not necessarily the best way to secure retirement income. Annuities offer longevity insurance and a mortality cross-subsidy, but it is not clear that forcing people in their 50s or 60s to annuitise is optimal, now they are living much longer and with many other options are available.

Of course, if the state provided a flat-rate universal pension, without means-testing, it would not need to force annuitisation. However, if mandatory annuitisation does continue, regulation of the sales process must improve. The FSA currently appears to consider annuities are a ‘no risk’ option for pension income. That is wholly misguided. Many people buy an unsuitable annuity, without any regulatory protection and ‘commission’ can be automatically deducted by the annuity company although customers receive no advice. Annuities are priced as a product sale, but not regulated as such.

No other investment product is so inadequately regulated. ‘Default’ single life, level annuities, often at very uncompetitive rates, can be offered without explaining the implications for a partner if annuitants die sooner than expected, or if inflation rises sharply during retirement or, indeed, if poor health could achieve an enhanced rate elsewhere.

The FSA should not allow annuities to be sold in this way. Customers must know the most important questions they need to consider before buying, to help them find the right annuity and best rate. Preferably, they should receive basic advice before purchasing this irreversible product. Only if they have signed a form that confirms they have considered the crucial questions and looked around to ensure they are being offered a good rate, should annuity sales be permitted. Many people would be better off taking a tax-free lump sum and leaving their pension invested for longer, but they are denied that chance. This leaves too many widows at risk of poverty if their husband’s pension dies with him, leaving them dependant on the state. This problem will increase as the population ages and needs to be addressed urgently.

Reform of state pensions and the annuitisation process are two important elements of improving the fairness of our pension system. Increasing access to financial education and advice, helping people understand financial planning and perhaps recognising the benefits of both saving more and working longer, will be important ways of ensuring a more prosperous future for us all. Removal of the Default Retirement Age and encouraging part-time work at older ages, rather than full-time retirement, would also increase older people’s incomes.

In fact, this is important for old and young alike. If millions of baby-boomers retire without much income, consumption and output will fall, leading to economic decline and falling income for everyone. It is, therefore, in all our interests to get pension reform right.

I hope the Government will finally rise to the challenges we face as the pensions crisis gives way to a ‘pensioners’ crisis.