At the end of 2006, the government finally published its landmark Pensions Bill, outlining sweeping changes to the state pension system.
The Bill included most of the recommendations outlined by Lord Turner’s Pension Commission, which reported last May. Increasing life expectancy means that the state pension is being drawn by more people for longer. So, not surprisingly, Lord Turner’s report found that the current system is unsustainable.
The Bill had its second reading in January, and reforms in it include re-establishing the link with earnings and improving the state second pension. According to the Department for Work and Pensions (DWP), by the 2050s, someone who contributed for most of their life through working or caring would be entitled to around £135 a week from state pensions in retirement – instead of between £90 and £100 without reform.
The key proposals
A higher state pension linked to earnings, rather than inflation.
Increasing the state pension age gradually in line with life expectancy. It is proposed to rise to 66 over two years between 2024 and 2026 and then from 66 to 67 between 2034 and 2036 and then to 68 in 2044 to 2046.
In the next parliament, the government hopes to launch a low-cost private pension savings scheme, called the personal account, in which employees over the age of 22 and earning more than £5,000 per year will be automatically enrolled into if they are not already saving for a pension.
Employers that do not already contribute to an occupational scheme on behalf of their employees will be compelled to contribute a minimum of 3% of employees’ salaries into the personal accounts. Employer contributions will be phased in over a period of at least three years.
Employees will contribute 4% of their salary into their personal account, with an additional 1% contribution from the government in tax relief. Employees can choose to opt out of the scheme, which means their employer would not have to contribute either.
Rewarding ‘social contributions’ by people who cannot work due to carer responsibilities by cutting the number of qualifying years needed to receive a full basic state pension to 30 in 2010.
The state second pension, which provides a top-up to the basic state pension, will be switched to a flat-rate pension from around 2030.
What this means for employers
Employers will have to ensure that by 2012 their pension scheme can automatically opt staff in. They will also have to ensure that the contributions they make to the scheme are at least equal to 3% of workers’ salary.
The CBI estimates that this will cost business £2.3bn. This will mostly affect smaller firms that currently pay less than 3% into their employees’ pensions. There is, however, the possibility that employers that contribute more than 3% may reduce their contributions to come into line with Turner’s recommendations.
Calculating the value of your pension
Last month, employers received a pensions funding boost after the government finally made an announcement about how transfer values would be calculated. Minister for pensions reform James Purnell revealed that the values would be calculated according to the expected cost to the scheme of providing the pension. Businesses had feared that a more expensive calculation would be used, adding billions of pounds to company costs. These new arrangements are due to come into effect in April 2008.
According to the Department of Trade and Industry, the regulations will make the following points:
The trustees of the pension scheme will be responsible for determining the actuarial assumptions used to calculate transfer values.
Trustees will be required to determine the assumptions in the calculation of transfer values, based on their ‘best estimate’.
The trustees will be required to use a discount rate in the calculation of transfer values that reflects a ‘best estimate’ of future returns, having regard to the existing asset mix of their scheme.
Trustees will still be able to reduce transfer values where the pension scheme is under-funded.
Trustees will be allowed to deduct any reasonable administrative costs incurred from the transfer value.
Trustees will have to provide further information to members considering whether to transfer.
The key is to budget now for the new measures, so that bigger pension contributions will not mean a sudden spike in costs. One solution may be for employers to consider reviewing their total remuneration package to absorb the extra costs. This may mean cutting other employee benefits or bonus schemes.
As for ensuring staff can automatically opt in to the pension, this will be down to an organisation’s pensions provider. According to Deborah Cooper, a pensions expert at consultancy Mercer HR, no providers currently offer this facility on their products, but she says it could pay to stick with your current provider and hope they come up with the goods.
“Pensions should be long-term products, so you don’t want to have to review the scheme every few years. Employers should be challenging their provider to come up with a solution that complies with the rules and is cost-effective, especially in smaller schemes where the economies of scale do not exist,” says Cooper.
There may also be help available from the government. The DWP has formed a Simplification Advisory Group with industry representatives who are tasked with lessening the burden on employers who provide pensions, while protecting the rights of scheme members. What this will actually mean in cost benefits is, however, unclear.
At the same time, many staff may choose to invest in their own schemes, known as Self-Invested Personal Pension (SIPP) schemes (see box, left). Employers will then have the option to pay a portion of salary into these personal schemes, continue to pay into an occupational scheme, or both.
With the government constantly reducing the amount of control it has over individual pensions, the onus going forward will be on employers and staff finding the right balance between personal and corporate schemes.
Pensions – the next generation
Jonathan Watts-Lay, a director at financial education specialist JP Morgan INVEST, says that pensions will move higher up the corporate agenda this year. Here are his predictions for 2007 and beyond:
Companies will start to evaluate why they offer occupational schemes. Last April, changes to pensions rules (known as A-Day) enabled employers to make their schemes more flexible, but few took full advantage of this.
As more employees take on personal pension schemes such as Self-Invested Personal Pension (SIPP) schemes, the market will become inefficient as many workers will end up with at least two pensions – an occupational scheme and a personal one. However, by contributing to a personal pension, organisations can contribute more, as they won’t have the administration costs of the occupational scheme. This could result in a ‘win-win’ situation, where employers make cost savings, and workers receive larger contributions.
More organisations will begin to fuse other employee benefits with pensions. For example, if companies offer a share incentive plan, they can drive more value from their capital by making it easier for staff to invest the value of their shares in their pension and benefit from double tax relief.
Financial lifestyle education will become more important. If companies don’t educate employees about investing in a pension, the long-term effect is that more staff will need to work beyond 65, creating potential issues around age discrimination.
More employers could face litigation as staff complain that they did not receive enough information or education about pensions, and enter retirement without sufficient funds. One HR manager has already been banned by the UK’s pensions regulator from being a pensions trustee after lying to senior managers about the transfer value of his company’s pension scheme.
Some organisations will begin to offer ‘salary sacrifice’ options, where employees can boost their pension fund beyond standard contributions by sacrificing another area of reward, such as holiday. The resulting saving on national insurance can be shared between the employer and employee.
Kirstie Redford is a freelance journalist specialising in personal finance. She regularly writes for Moneywise magazine and last year won an award for Best Consumer Advice at the British Insurance Brokers’ Association’s Journalist of the Year Awards.
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