A great deal has been made of the decline of final salary pension schemes. But while this has been galling to some, it at least makes economic sense from an employer’s perspective. The schemes typically account for around 15 per cent of a pensions payroll, hike up administration costs and have uncertain contribution rates. Alternatives like money purchase schemes cost employers half the money and create half the headaches. And final salary schemes reward long service with one employer – something of a rarity these days.
The problem lies with the shift in emphasis that this signals. The TUC expressed concern that responsibility for pensions is being transferred from the State and employers to individual workers and far fewer people will set up adequate pensions as a result.
A study by KPMG Pensions research backs this up. It found that the rejection of final salary schemes could cut pensions by up to a third and leave people financially short when they retire. Currently, they believe that 43 per cent of companies running defined contribution pension schemes are contributing 5 per cent or less. In a typical final salary scheme, companies average contributions of up to 10 per cent.
Confusing alternatives also cloud the issue. At launch, stakeholder pensions were supposed to provide a retirement safety net for the low paid. However, it is the well-off who have rushed to take up a stakeholder policy because it enables them to safely invest a percentage of their money.
A study by Marks & Spencer, which surveyed 1,598 adults aged 18 to 65, found that only half of the population know what a stakeholder pension is. And 41 per cent have not taken out a pension because they cannot afford to – exactly the situation that stakeholders pensions were introduced to avoid.
The same principle can be applied to almost any aspect of pensions. Thousands of people with private pensions were recently urged to switch back to State Earnings Related Pension Scheme (Serps) by Legal & General, Prudential, Standard Life and Equitable Life – the big insurers saying that private pensions will not provide comparable funds to the state scheme.
Prior to this, the Government announced proposals to give fixed-term workers the same right to company pensions as permanent staff – something the CBI and the Employers Forum on Statute and Practice (EFSP) say is unworkable. The CBI estimates it will lead to £13m in unnecessary administration costs and £98m in extra pensions contributions when it is implemented in July.
Increased regulations, bureaucracy and legal obligation (FRS17) and increased life expectancy have also combined to increase the cost of pensions.
Firms like ICI, BT, Iceland and Ernst & Young have looked to the demographic costs of the future and realised that their final salary pensions schemes have to be closed to new, and in some cases, existing members.
The result is a pensions situation that, while not necessarily in chaos, is certainly confusing and edging ever further from the stability of previous years.
The UK pension system is in peril. For more than 20 years the State has been retreating from the provision of an adequate retirement income for all citizens. In the past, employers recognised they had a responsibility to help workers save for retirement, however, this social contract is now under threat with the State’s retreat from pension provision being matched by the employers’ headlong rush away from good, defined benefit pensions.
The fundamental principal on which the TUC’s pension policy rests is that all workers must have a secure income in retirement that enables them to maintain a standard of living similar to that which they enjoyed in their final years of employment.
The state pension is the foundation stone of the system and this needs to be built on by employers and individuals saving through decent occupational pensions schemes. Employers should be able to make membership of occupational pensions a condition of employment, and employers should also be compelled to contribute to an employee’s pension. The simplification of pension legislation should also go some way to improving the current complexity of pension provision.
The challenge for the future is to ensure those workers without access to occupational pensions are, in the future, given access to a quality pension. Stakeholder pensions were intended to achieve this objective, but without significant employer contribution the full potential of stakeholder is unlikely to be fulfilled. The really big issue is not the nature of provision, but the amount of employer contribution. Low contributions to money purchase schemes are the major failing of those schemes at the moment.
If this trend is not directly addressed before the balance between DB and DC shifts much further, we will condemn future generations of retired employees to a life on means-tested benefits rather than high-quality occupational pensions.
It has been easy to feel rather smug about UK pensions. They have long looked in rude health compared to many of Europe’s state-sponsored, pay-as-you-go schemes. The linchpin of UK pensions has been the funded, defined benefit company pension scheme. But with timing that could not be more damaging, UK company pensions have been hit by a quadruple-whammy.
Firstly, people are living longer, therefore drawing pensions for longer. Secondly, a low inflation, low interest rate economy is not conducive to enduring double-digit investment returns. Also, the global economic slowdown has forced many companies to focus on costs. Trimming, or at least holding down, the cost of employee benefits is tempting and relatively easy to do in a soft labour market.
Lastly, we have a new accounting standard, FRS17, which highlights pension fund deficits in company accounts. Coming as it has, after the worst couple of investment years for a decade, many schemes are in deficit, leaving employers uncertain about carrying the financial risk of defined benefit pensions.
The choice for employers of how to deal with pension provision is far from black and white. The idea of a wholesale switch to defined contribution pensions is oversold. We are likely to see more employers setting up schemes which share the risks and rewards more evenly between employer and employee, with average-earnings related pensions and other innovative pension plan designs.
The Government has a role to play here. Employers are not required to set up pension schemes, but if they do, they face a quagmire of legislation, requiring them to provide benefits in specific forms and fund their schemes to a minimum level. The Government needs to listen to the recommendations which come out of the Pickering review. It also needs to allow greater flexibility for employers to provide the sort of pensions which best suit their business and their employees.
What with the confusion over contracting-out, the demise of final salary schemes, and the miss-selling of Equitable, you could be forgiven for thinking the UK pension system is about to collapse. Of course, it is not that bad, but there are problems.
The 1980s and 90s were great for pensions. Good demographics and high investment returns allowed a significant increase in provision. People are leaving the workforce at an earlier age, in spite of a significant increase in life expectancy.
This is not sustainable in less benign times, and symptoms are emerging. There are many untidy patches to the state scheme. Lower real interest rates mean a higher cost to promise a given level of final salary pension, and companies are wary of the increased cost and risk.
What needs to be done? Firstly, the Government needs to recognise the change and give clearer signals to help plan the future. It should simplify its own offering, looking to ensure the State provides for those who cannot, but making it clear the majority need to save more privately.
The Pickering review, due in the summer, also provides an opportunity for the Government to start tidying up the confusion of initiatives, including simplifying state pensions. And there are signs of progress. Although stakeholder pensions are not reaching their original low-earner targets, they have created the ‘1 per cent world’ of ‘cheap and cheerful’ private pensions for the middle earner.
The trend towards fewer final salary schemes is unstoppable – regulation (MFR, FRS17) may have been ham-fisted, but it has surfaced genuine underlying risks and cost increases which many companies find unacceptable.
So be it – a decent money purchase scheme where the risks are clear may be better than final salary without adequate employer backing. And employees will be more interested – understanding of the importance of pensions is set to grow and grow.
“It is a turbulent time for occupational pension schemes. Many companies are closing their final salary schemes and unions are partly blaming employers. It all seems a far cry from the election year of 1997, when many company schemes were comfortably in surplus and some were enjoying contribution holidays. But why are companies taking these decisions, and why now?
Of course, the current economic environment is very different. Stock market growth has slowed, leading to valuations that reduce the predicted pension pot. And the population is ageing, which means pension schemes are funding ever-growing liabilities. Pensions are looking like a risky venture, and final salary pensions, where all risks are borne by employers, are looking like a cost that many businesses can ill-afford to bear.
But what should we be doing? Few people would relish the idea of working into their 70s to secure a decent pension. The Government does not want to pick up the bill – it wants to expand the private sector pensions market from 40 per cent today to 60 per cent by 2050. But companies can’t go to the wall to fund their pension scheme. The Government should be encouraging the development of occupational pension schemes, but it is clear that, since 1997, things have got worse rather than better.
In 1997, the Government took £3bn per year out of pension funds by removing dividend tax relief – a measure that could cost employees even more than a rise in income tax.
Now there is FRS17, which forces companies to account for pension schemes on a snapshot basis, even though pension funds deliver returns over the long-term – creating enormous volatility in company accounts. For some companies which were already considering whether they could continue to afford final salary pensions, this measure has pushed them over the precipice.
So from a business perspective, what should the Government be doing to encourage pensions rather than discouraging them? Firstly, replacing the minimum funding requirement was welcome, but careful negotiation is needed in the EU if the gains made by its abolition are not to be reversed by the pensions directive; FRS17 should also be modified to allow smoothing of asset values. Most company pension schemes are heavily invested in volatile equities and a shortfall in one year could easily turn into a surplus the next.
The Government also needs to throw its weight behind the pensions simplification review. It is time to think the unthinkable – regulators cannot protect all pension scheme members all the time from every conceivable eventuality. Finally, the Government should find ways to return the money taken from pension schemes by the removal of dividend tax relief.
If the Government wishes to encourage the development of occupational pension provision, it must be less prescriptive in its attitude towards pension regulation.”
UK company pension assets exceed 90 per cent of GDP, compared to just 5 per cent in France. At the same time, state pensions consume 3 per cent of UK GDP, compared to around 14 per cent in Italy. Judging by these figures, if there is a pensions crisis, it is not in the UK.
Nevertheless, high-profile companies abandoning defined benefit (DB) pension schemes – where pension is defined in advance based on salary and service – in favour of defined contribution (DC) schemes – where contributions are defined but pension depends on investment returns and the cost of annuities – is creating an illusion that ‘DB is good, DC is bad’.
Companies want to reduce the financial risk of DB and are tempted to use developments such as new accounting rules as a scapegoat for change. Experience shows that employer contributions to DC schemes will generally be lower than the amounts paid into DB, so not only is risk being transferred to employees, but companies are putting less money into their pension plans.
The demographics also add to concerns, as people are living longer and retiring earlier. The fact most of us are so confused by tax incentives and pensions in general combines to leave few people saving enough for retirement.
If HR professionals gave more attention to the proportion of employment earnings replaced by pension, a more balanced approach to risk and increased employee awareness of the importance of retirement, some savings might emerge. From government, one straightforward set of tax incentives to encourage retirement saving would also help, as would part DC funding of UK state pensions.
Sadly, the Government is likely to put-off such radical action.
Employees will probably be slow to recognise that their pension assets might be worth more than their home and continue to retire early. Companies look certain to continue to implement low contribution rate DC plans and may ultimately feel obliged to top-up company pensions with ex-gratia payments, or re-discover an element of DB.
Every week the list of companies switching from final salary pension schemes to money purchase schemes grows longer. Many companies are blaming their sudden change of heart on the FRS17 accounting standard, but the truth is that fundamental problems for the future of funded pensions have been building-up over a period of years and will remain unless pension provision is completely overhauled.
To put all of the blame on FRS17 is to shoot the messenger. It is not the accounting standard, which has created a deficit in company pension funds; primarily, it is the combination of increasing life expectancies and a fall in returns that have put such pressure on funds. FRS17 has highlighted these in a rather dramatic way, but has not created a problem that did not already exist. The important issue is not creating a scapegoat, but finding effective, long-term solutions to the pension crisis, which will ensure all future pensioners are provided for.
The switch from DB to DC is made far more serious by the fact that many firms are using the opportunity to slash their overall contributions. Therefore, the first response to this would be to try to ensure companies put adequate sums into pension funds on behalf of their employees.
The introduction of a compulsory minimum contribution for all employers would be one response to this problem. This could ensure that ‘good’ employers who contribute significantly into their employees’ pensions were not undercut by those who did not. This may also need to be complemented by allowing employers to require all employees to be members of the scheme as a condition of service.
It is important to remember, however, that company provision is only part of the jigsaw. For many employees who do not have access to an occupational scheme, an employer contribution to a stakeholder pension could provide a kickstart to the Government’s goal of extending pension coverage among people on modest incomes. There is plenty of evidence the offer of an employer contribution can be a key determinant of whether employees take out a pension, and compulsory employer contributions could make a real difference to the take-up of stakeholder.
A move from final salary to money purchase schemes is bad for some employees but good for others. But a reduction in overall rates of employer contributions is bad news for all employees. The Government must take an urgent look at strategies to increase employer contributions and look seriously at compulsion if a strategy of incentives fails to achieve that goal.
At the moment, it seems everybody has a plan for pensions policy. We are hearing too many quick-fix ideas that could leave tomorrow’s pensioners out of pocket.
I believe the structure of pensions now in place after our reforms, which will be completed with the introduction of Pension Credit, is fundamentally sound.
For various good reasons, layers of regulations had been loaded onto the pension regime resulting in too much red tape. That is why we started a radical review of regulation with the aim of simplifying the system. Alistair Darling will receive the report in June and set out proposals on which the Government will consult.
Employers are key to these plans and we hope they will join us to cut back on regulation that holds them back, which is expensive in time, money and resources. If employers show the commitment to their workforce by contributing in their future, there is a high probability that this commitment will be reciprocated. The results will be seen through improved morale and help with recruitment and retention.
We must preserve the powerful partnership between the Government and individuals in which the state pension provides the main building blocks of income in retirement, and that individuals boost that income by contributing to private schemes or the State Second Pension.
Our commitment to the basic state pension was underlined this month when it rose by another £3 a week for a single pensioner and £4.80 for a couple. It is in order to strengthen this partnership that we have introduced the stakeholder pension to encourage those on moderate and higher earnings to put more towards their retirement.
The new Pension Credit will ensure people see a reward for their thrift by receiving a top-up to their pension. When it is introduced from October 2003 there will be a simple assessment of income in order to calculate individuals’ eligibility.
I began by warning that so-called easy solutions often prove very costly, but it has been true for a long time now that most people probably ought to be saving a lot more than they actually do, especially now we are living longer.
That’s one of the reasons why we are introducing pension forecasts, so that within five years most people will receive an annual statement that will tell them how much – or in too many cases – how little they will get in retirement.