The pensions story of recent
months has been the closing of final salary pensions schemes to new employees
by large private companies. More than
half of the FTSE 100 companies have now taken this step, and the rest are
likely to follow suit. The purpose of
the step is, of course, to save the companies money.
In final salary schemes, which are
almost universal for public sector workers, the pension paid on retirement is a
guaranteed proportion of final salary, determined by an employee’s number of
years of service. For that reason, this
kind of scheme is also known as a “defined benefit” scheme. Every employee knows in advance what he is
going to get on retirement. In the very
best schemes this may be as much as two-thirds of final salary.
There is another type of
occupational pension scheme, known as “defined contribution” (and also as
“money purchase”). In common with all
personal pension schemes on the market, the pension to be paid by a defined contribution
scheme on retirement is unknown until retirement.
Contributions are paid
into a fund, which is invested in the stock market. The size of that fund on retirement depends, not only on the
contributions paid in, but on the performance of the stock market and the skill/luck
of the people who managed the investment – none of which can be predicted at
the outset. And what that fund will buy
at retirement by way of an annual income is equally unpredictable from a
distance of 30 or 40 years. In the past
ten years or so, for example, annuity rates have halved, which means that a
person retiring now needs double the size of fund at retirement to buy the same
annual income as 10 years ago. What
will happen to annuity rates in future years is anybody’s guess.
Many private companies are now
offering these defined contribution schemes to new employees instead of final
salary schemes. Needless to say, senior
executives will in the main keep their final salary pensions, along with all
their other perks.
Following the Government’s lead
The Government has been rather
quiet about this trend away from final salary pensions in the private sector,
even though it has got dramatic implications for retirement incomes in years to
come. The Conservative opposition has
been utterly silent. This is not
surprising since the Government is in the process of terminating the national
salary related pension scheme, SERPS (State Earnings Related Pensions Scheme),
introduced by Barbara Castle in 1975.
SERPS
was an attempt to produce on a national scale the kind of salary related
pension schemes that were available to public sector workers and to many
workers in large private companies, the very schemes that are being closed to
new employees today. Being a national
scheme, a worker did not have to stay with the one company all his working life
in order to get the full benefit of it.
Together
with an earnings linked basic pension, the aim of SERPS was to provide an
income in retirement that was around 50%, not of final salary, but of the best
20 years’ earnings, uprated in line with earnings.
The Conservatives began the
process of destroying it as soon as they came to power in 1979 by linking the
basic pension to prices instead of earnings.
A few years later they legislated to reduce SERPS benefits from the year
2000 onwards and to encourage people to contract out of SERPS and invest in a
defined contribution private pension with no defined benefit on retirement.
Rather than undo the damage done
to the national salary related pension scheme, New Labour accepted that the
basic pension should remain linked to prices, and are intent upon completing
the destruction of SERPS (which has been renamed the Second State
Pension). The aim is to force everybody
with income above around £10,500 a year to reject the comparative certainty of
a salary related pension and opt for a private scheme with no defined benefit
on retirement.
Private companies are now ending
final salary schemes. The Government
should be congratulating them for having the good sense to follow the
Government’s example, albeit about 15 years after the Conservatives began the
destruction of the national salary related scheme.
Transferring the risk
Employees usually contribute a
percentage of their salary to final salary pension schemes. But crucially it is employers who have the
responsibility for making sufficient contributions to guarantee that the
pensions defined under the scheme can be paid to employees and ex-employees on
retirement.
This was not a problem when stock
markets were rising steadily, as they did through the 90s. Then it was easy to grow the company pension
fund sufficiently fast to meet the current and predicted demands upon it. Indeed, ten years ago it was not unusual for
a company to take holidays from contributing to its pension fund, because stock
market growth had made employer contributions unnecessary.
Now, times have changed. Stock markets have fallen all over the world
and, to make matters worse, ex-employees are living longer. To keep final salary schemes viable
employers are having to make higher and higher contributions – which is why
they are closing schemes to new (and in some cases to existing) employees and
offering “defined contribution” schemes instead with no guaranteed pension on
retirement.
Generally speaking, companies will
contribute to these schemes as well, typically around 5% of each employee’s
salary. This is around a third of what
they are paying into final salary schemes at the moment – the latter varies
greatly depending on, for example, the age structure of the workforce.
Apart from this immediate
advantage, the great advantage of “defined contribution” schemes is that
companies know what they are going to have to pay throughout the lifetime of
the scheme. They will never have to increase
their contributions to guarantee a certain level of benefit for their retiring
employees. The downside is that they
won’t be able to take contribution holidays no matter how much the stock market
rises.
The key difference between the two
types of scheme is that with “defined benefit” schemes the investment risk lies
with the employer, whereas with “defined contribution” schemes that risk is
transferred to the employee. If he is
lucky, and the stock market rises dramatically during his working life and interest
rates are high at the time his retirement, he may retire on a very good pension
even with a “defined contribution” scheme.
But if it appears that his pension is going to be inadequate, it will be
up to him to make additional contributions (or to save in some other way) in
order to increase his retirement income.
The introduction of a new
accounting standard, FRS17, has been a factor in this rush away from final
salary schemes. This obliges companies
to make an annual review of their pension scheme’s assets and liabilities and
publish the results in their annual accounts.
It is reckoned that this will show that around half of the UK’s largest
500 companies have pension liabilities that exceed assets. For example, BT, which closed its final
salary scheme to new employees last year, had a £3bn shortfall in its £25bn
scheme (on top of £30bn debt in its core business). The need to reveal such bad news in annual accounts with its
inevitable depressing effect on share value has added to the pressure on
companies to close their schemes.
Great success story
Final salary occupational pension
schemes have been the great success story of pensions in Britain. They have provided good pensions for middle
and higher earners and individuals with stable employment patterns. They have enabled many workers to retire on
good incomes in the 80s and 90s. Around
7.5 million people are currently in receipt of an occupational pension at some
level.
Over 10 million are accruing
rights to occupational pensions (of which around 90% are defined benefit). There are about 7 million inactive members
of occupational pension schemes.
Defined benefit occupational
pensions are the norm in the public sector, most them being paid out of current
expenditure rather than out of a fund invested in the stock market. In the private sector the trend away from
defined benefit pensions did not begin today or yesterday but it has now become
a flood that is probably unstoppable.
In future employees in the private sector are going to have to bear the
investment risk in defined contribution arrangements.
However, people on average or
above average incomes, with perhaps 10% of their income going into a defined
contribution scheme over their working life, are likely to retire on a
reasonable pension to top up their basic state pension, unless there is a stock
market crash. This is not nearly as
secure as having a final salary pension, with companies bearing the investment
risk, but it will be more than adequate in all probability.
But
the situation for workers on lower incomes is in a complete mess. The fundamental reason for this is that it
is possible for employees to retire after a full working life with state
pension entitlements well below the Income Support level. And if the basic pension continues to rise
in line with prices while Income Support rises with earnings, this gap will
increase as the years go by.
Since New Labour came to power in
1997, they have raised Income Support levels for pensioners dramatically, from
under £70 a week for a single person in 1997 to nearly a £100 a week now, by
raising the pensioner premiums, that is, the extra benefit received at age
60. Income Support levels for
pensioners have been rising in line with earnings or better and the Chancellor
has promised that this will continue until the end of the current
Parliament. This strategy of raising
the income of poorer pensioners through the Income Support system was the New
Labour alternative to raising the basic state pension for everyone and
re-linking it to average earnings instead of prices.
Income Support for pensioners has
been renamed the Minimum Income Guarantee but it remains Income Support in all
but name.
On the face of it, this seems a
reasonable strategy. Concentrating help
on those who need it most sounds fine.
But unfortunately it involves a means test, and as with all means-tested
benefits take-up is much less than 100%.
Out of the 11 million pensioners in the UK today, approximately 1.7
million receive Income Support, but it is estimated that up to 670,000 more are
entitled but do not apply and miss out on £20 a week on average.
Also, like all means-tested
benefits, Income Support produces perverse incentives. Pensioners with modest savings or additional
pensions may be excluded from Income Support (assuming they declare them). For example, a pensioner with savings worth
more than £12,000 is not entitled to Income Support at all and if his savings
are between £6,000 and £12,000 his Income Support is reduced by up to £24 a
week. This causes resentment among
those with modest savings, since it penalises prudence.
Also, if a pensioner has only a
small pension on top of a basic state pension, it may not increase his actual
income at all. In 2002-03 the Minimum
Income Guarantee for a single pensioner is £98.15, which means that a single
pensioner with income below £98.15 (and less than £6,000 savings) will have his
income topped up to £98.15. So if a
person has a full basic pension of £75.50, an additional pension of up to
£22.65 a week makes absolutely no difference to his total income – it will
always be topped up to £98.15, no more no less. Similarly, if he has additional pension of £25 a week, he will not
be eligible for Income Support and his total income will be a mere £2.35
greater a person who had no additional pension.
Obviously, small additional
pensions are literally worthless if they don’t bridge he gap between the basic
state pension and the Minimum Income Guarantee, and even if they do bridge the
gap they are worth much less than their face value. So, why should people put money into an additional pension if the
end result after many years of contributing is either no extra income, or very
little extra income, on retirement above the Minimum Income Guarantee?
Today, the difference between a
full basic pension and the Minimum Income Guarantee for a single pensioner is
over £20 a week. For nearly a million
people who haven’t worked a full working life (44 years for a man, 39 for a woman)
and therefore do not receive a full basic pension, the gap is larger. What is more, the gap is scheduled to grow
at least until the end of this Parliament – because the basic pension will rise
in line with prices, whereas the Minimum Income Guarantee will rise in line
with earnings.
If
uprating continues to be done on these bases, the gap will continue to grow (so
that by 2040 the basic pension will be less than half the Minimum Income
Guarantee). Consequently, individuals
will need larger and larger additional pensions to bridge it – and remember
that even if an additional pension is sufficient to bridge it on retirement, 20
years later the gap will have grown and that may no longer be the case.
It is against this background that
the Government is trying to persuade people with below average incomes to take
out so-called Stakeholder pensions. By
last October, employers with more than 5 employees, who do not already offer
access to a pension scheme, were required to offer their employees access to a
Stakeholder pension.
These are a new form of private
pension introduced in April 2001, and are aimed at people with income in the
range £10,500 to £24,000 a year. They
have the advantage of being more flexible and cheaper than earlier forms; more
flexible in that people can contribute as little as £20 a month, and stop
contributing at any time without penalty; and cheaper in that the annual charge
levied must be less than 1% of the fund value (which nevertheless may amount to
20% of the fund value over the fund’s lifetime).
Having said that, Stakeholder
pensions are still money purchase pensions with no defined benefit on
retirement, though you will search in vain in all the Government literature on
them to find any mention of this fundamental unknown about them.
Individuals trying to decide
rationally about taking out a Stakeholder pension are faced with two unknowns:
(1) what is the gap going to be between the basic pension and Minimum Income
Guarantee from retirement onwards and (2) how much needs to be contributed for
how long in order to bridge that gap throughout retirement – plus a lot more to
make it worthwhile? In the face of
these unknowns, the sensible thing to do is not to take out a Stakeholder
pension.
Happily, it appears that by and
large people in the Government’s target group have done the sensible thing and
not bought Stakeholder pensions in their first year of operation.
The Second State Pension
The
above discussion does not take into account the Second State Pension, formerly
known as SERPS. Most people retiring
now will have a SERPS earnings related addition to their basic pension, but for
many of them, particularly for women, the addition will be small, and will not
bridge the gap between the basic pension and the Minimum Income Guarantee.
As
we said above, the Government’s plan is to force everybody on an income above
£10,500 a year out of the Second State Pension and into a private pension with
no defined benefit on retirement.
For
people with an income of less than £10,500, the Second State Pension is to
provide a flat rate pension (set at twice the level of a SERPS pension for
someone on £10,500). This may seem to
be quite generous, and redistributive.
However, it will be 40 years before recipients get the full benefit of
it, and when they do it is by no means clear that even then their two state
pensions will amount to more than the Minimum Income Guarantee, assuming the
latter continues to be uprated in line with earnings.
People
with this level of income are unlikely to have much money available for saving,
but if they have they would be foolish to put it into a private pension, which
is a very inflexible form of savings.
The Government is aware that the
present system discourages saving because it penalises people with modest
savings or a modest additional pension.
They have attempted to address the problem by introducing a new benefit
for pensioners called the Pension Credit from April next.
This is an extraordinarily
complicated benefit, the introduction of which will result in a massive
extension of means testing for pensioners.
It is estimated that from next April (2003) around 50% of all
pensioners, that is, nearly 6 million, could receive Pension Credit, assuming
they all apply and go through a means test (which they won’t). It is expected that this percentage will
rise in future, assuming the guaranteed level of income rises in line with
earnings, with perhaps 70% of pensioners eligible for means-tested benefit in
2050.
The Pension Credit is basically
the Minimum Income Guarantee plus a credit of 60p in the £1 on income, other
than income from the basic pension, up to a certain limit. The idea is to reward pensioners a little
for having the foresight to save or take out an additional pension (but it also
applies to any SERPS income, even though SERPS was not a voluntary
option). The maximum reward for a
single pensioner from next April will be £13.80 – it will go to those who have
just bridged the gap between the basic pension and the Minimum Income Guarantee
with income from other sources.
Readers who wish to fully
appreciate the complexity of the Pension Credit should study the simple example
in Annex A below. It is inconceivable
that this fiendishly complicated system will lessen the disincentive to saving
that is inherent in using the Income Support system to top up the basic
pension. For any incentive to be
effective, it has to be understood. It
will be hard enough to explain to today’s pensioners how it will affect them,
let alone trying to convince someone who is 20 years from retirement that its
introduction is going to make it worthwhile to pay into a stakeholder pension
for the next 20 years (which it won’t).
It’s a fair bet that it won’t be around in 20 years time.
People on low incomes know that
they their basic pension will be topped up with Income Support when they
retire. They also know that having
savings or another pension merely reduces the amount of Income Support they can
get. There is therefore no incentive to
save or take out a private pension, even if they have sufficient disposable
income to do so. The introduction of
the Pension Credit will not change that.
There is a straightforward
alternative to this complex morass, which would encourage people to save for
their retirement. The fundamental
principle of it is that people retiring after a full working life have a state
pension above the Minimum Income Guarantee, and that this pension be earnings
related, so that pensioner incomes keep pace with the earnings in the rest of
the society.
This would mean that if people
choose to save by whatever means during their working lives, they would get the
full benefit of their savings in retirement.
The uncertainty inherent in taking out private pension would remain, but
at least an individual who chose to take out a private pension would get to
keep all of it on retirement. Likewise,
for any other form of savings. There
would be no need for the monstrously complicated Pension Credit.
It may even be possible to do away
with the requirement that people must buy an annuity with their pension fund on
retirement. In order to encourage
people to provide for themselves in retirement, successive governments have
given tax relief on pension contributions, and allowed people to take 25% of
their pension fund as a tax-free lump sum on retirement. But they have insisted that people buy an
annuity with the rest, the aim being to reduce or eliminate their dependency on
state support in retirement. If the
vast majority of people retire on income above the Minimum Income Guarantee,
then the requirement to buy an annuity can be eliminated or at least greatly
relaxed.
Almost all means testing of
pensioners would be eliminated at a stroke, even if the Minimum Income
Guarantee continued to be uprated in line with earnings. Only people who have not had a full working
life would need to have their income in retirement assessed and topped up to
the Minimum Income Guarantee.
Until recently, it would have been
impossible to imagine that this obvious solution would come about. But even some of New Labour’s best friends
have come to the conclusion that the pension regime they have put in place
since coming to power is a complicated mess, and that this is going to get
dramatically worse next April with the introduction of the Pension Credit, when
the number of pensioners eligible for means-tested benefit is scheduled to
triple from 2 million to 6 million.
On 2 March, New Labour’s favourite
think tank, the Institute for Public Policy Research (IPPR), published a
booklet entitled A new contract for retirement, which came to the
following blunt conclusions about the current pension regime:
“1) With low take-up of the
Minimum Income Guarantee, and take-up certain to be an issue for the Pension
Credit, pensioner poverty is still a key problem.
“2) Incentive problems under the current settlement remain
acute. The Pension Credit does not
resolve the incentive problems of the Minimum Income Guarantee but rather
spreads them out over a larger number of people
“3) Planning is very difficult for
individuals. The pensions environment
has become much more complicated since 1997, and the new policy instruments
both increase the need for good quality advice and make such advice more
difficult to provide.
“4) Public support for the
pensions settlement is low. Many
individuals feel that means testing retirement benefits is unfair: the
settlement is not seen by the public as equitable”
They propose raising the basic
state pension to the level of the Minimum Income Guarantee by 2010 and then
indexing it in line with earnings.
They claim that if the Second State Pension was phased out, together
with all the rebates given for contracting out of the Second State Pension, and
if the retirement age was raised to 67 by 2030, then this proposal is
approximately revenue neutral. In 2050,
overall state expenditure on pensions would be around 6% of GDP, which is the
Government’s prediction for the current pension regime plus the Pension
Credit. It is very low by European
standards.
Note that this is a highly
redistributive scheme with a flat rate pension being paid for by earnings
related National Insurance contributions.
Last autumn, a group chaired by
Frank Field called the Pension Reform Group made proposals for what they call a
Universal Protected Pension. This
group is interesting because it includes a wide spectrum of people, including a
Conservative MP, Howard Flight, a Liberal Democrat MP, Steve Webb (who is their
Social Security spokesman) and representatives from the CBI and from the
pensions industry.
In a booklet entitled Universal
Protected Pensions: Modernising Pensions for the Millennium the
group express broadly the same conclusions as the IPPR about the current
pension arrangements. Their solution
is a flat rate pension indexed in line with earnings about 30% higher than the
Minimum Income Guarantee, which would require an increase in employee National
Insurance contributions by about 5%.
Frank Field has always been
concerned about the impermanence of pension arrangements in Britain, that
successive governments are forever changing the arrangements put in place by
the previous government. This happened
in 1974 when the Wilson Government revoked a scheme drawn up Keith Joseph
before it came into force. Likewise, in
the 1980s the Thatcher Government destroyed the scheme put in place by Barbara
Castle in 1975.
There is no doubt that this is a
problem, which makes planning for the future impossible. If the Castle arrangements had been left in
place, the pension regime would not be in the mess it is in now. Had the basic pension remained linked to
earnings, it would now be over £100 a week for a single pensioner and above the
Minimum Income Guarantee – and there would be little means testing of
pensioners.
In an attempt to guard against
their proposal, if implemented, being overthrown by a future government, the
Pension Reform Group propose that the portion of the Universal Protected
Pension that is additional to the basic pension be funded, that contributions
be invested under the supervision of a commission independent of
government. That way, according to the
group, people would collectively have something akin to property rights over
this fund, which would make it more difficult for future governments to tinker
with it. Interestingly, the Joseph
scheme also included a funded element, but it hadn’t started before the Wilson
Government revoked it.
Conservative wit?
If the Conservatives had any wit
they would take up one of these schemes, and beat New Labour to death about the
absurd extension of pensioner means testing which begins next April. New Labour are wedded to “targeting”
benefit, which implies means testing, and they would find it very difficult to
move away from that agenda, not least because it is the strongman in the
Government, Gordon Brown, who is responsible for it. And his stubbornness is legendary.
The Conservatives have made an
alliance with the Liberal Democrats in opposition to the Pension Credit because
of the extension of means testing involved.
But the only way to reduce means testing is to raise the universal
benefit above the Income Support level.
It’s time for them to sponsor a scheme that will do just that.
Labour & Trade Union Review
July 2002
Annex A How
the Pension Credit works
Next April, the full
basic pension for a single pensioner will be £77 a week and the minimum income
under the Pension Credit will be £100 a week.
The latter is equivalent to the Minimum Income Guarantee and like the
Minimum Income Guarantee will apply from age 60.
The Pension Credit also has
savings credit element, which begins at age 65. Under it, income between £77 and £100 attracts a credit of 60p in
the £1.
Thus an individual with a full
basic pension plus £10 from another pension, that is, with an original income
of £87, receives an extra £13 to bring his income up to the guaranteed amount
of £100, but on top of that he gets £10 x 0.60 = £6 as a savings credit, making
a total of £106. Thus, whereas under
current Income Support rules his extra pension is literally worthless, it is
worth £6 under Pension Credit rules.
An individual with original
income of £100 (£77 from a basic pension plus £23 from other sources) attracts
the maximum credit of £23 x 0.60 = £13.80 and therefore has a total income of
£113.80. After that, the credit is
tapered off at the rate of 40p per £1 of additional original income, so that
someone with an original income of £101 receives £13.80 - £1 x 0.40 = £13.40,
someone with an original income of £102 receives £13.80 - £2 x 0.40 = £13.00
and so on. Someone with an original
income of £134.50 will receive nothing (since £34.50 x 0.40 = £13.80). This means that individuals with other
income of £57.50 or more, apart from the basic pension, will receive no credit.
The savings income used to
calculate Pension Credit is notional, not actual. Savings under £6,000 are ignored, as for the Minimum Income
Guarantee, but savings above £6,000 are treated as yielding 10% interest. For example, an individual with savings of
£26,000 is treated as receiving net interest of £2,000 a year or £40 a week,
which is perhaps three times actual net interest at present rates.
Thus on the one hand an
individual is assumed to have received income he hasn’t, but on the other hand
he receives a savings credit on this notional income – which can produce some
bizarre results that can hardly be said to encourage savings.
For example, an individual with
savings of £26,000 as well as a £77 basic pension is assumed to have an
original income of £77 + £40 = £117, which attracts a credit of £7. So, the individual’s total real income is
£77 + £7 plus the actual interest of, say, £13, making £97 in all – whereas, if
the individual hadn’t saved a penny, his basic pension of £77 would be topped
up to £100.
Pension Credit entitlement will
be reassessed very infrequently: initially at retirement, then at 65 and then
once every 5 years, which is strange given the Government’s obsession with
benefit fraud.