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.
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
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.