The opdu Report - Issue 22, May 2007

Comment
The Pensions Dilemma
Robin Ellison

Celebrations are usually a good thing; time to meet people, have a drink, reminisce about the old days (and how good they were) and complain about the present and the future (and how bad they will be). In pensions, that’s about par for the course. But it may just be possible that the usual comparison of old good and new-bad is inappropriate in the pensions scene.

Let’s just rehearse the story of the past and present. At its peak, the defined benefit pensions movement served around half the UK workforce, which is even better than it sounds because of number of the unpensioned were either better off unpensioned (because they were such low earners that their needs if not aspirations were picked up by social security) or because they were a second-wage earner and pensions was not at that time a priority. Social security pensions were offering around a fifth of average earnings, not great, but acceptable, and the prospects were that most pension systems, in fits and starts, were improving their benefits and funding levels. The growth had been based over the years on the back of a neutral tax policy (since 1921), a growth in major workforces (steel, coal, shipbuilding) following largely on from nationalisation for which occupational pension schemes seemed ideally suited, and a high inflation scenario, in which historic defined contribution systems suffered unduly. The benefit of the system to the UK was truly immense; in particular it meant much lower pressures on the social security system, and the creation of a capital market that was the wonder of Europe and even today underlies the extraordinary success of the City. The UK pension system was the envy of many of our colleagues and competitors, and awed visitors were taken on incomprehensible tours of UK pensions associations and managers.

Then from roughly 1985 to roughly 1995 a succession of events occurred that dealt a collective blow to the system. First was an understandable drive by legislators to protect pensions against inflation. Then there was an equally understandable campaign to ensure that pensions were contractual and not gratuitous. There were very proper judgments that pension systems should not discriminate. Employment patterns apparently changed. Group pensions were seen as a socialist enterprise at a time when free markets became more attractive. Employees were given the freedom not to join their employer’s scheme, and make their own provision – and freedom included the freedom to make no provision at all. In the meantime there were insidious improvements to longevity expectations and changes in the paternalistic nature of employment. And finally the long-standing fiscal-neutrality of pension schemes was attacked by the Treasury in a thoughtless and short-sighted campaign lasting over many years. It is extraordinary, some observers conclude, that company-backed pensions lasted as long as they did.

But more important to the decline of the system than even the early legislative changes, or the economic and social changes, was the Maxwell Affair. The Maxwell Affair even at the time
was much misunderstood, and the misunderstanding has increased with the excrescences of legend. In simple terms the Maxwell Affair was a fraud by an asset manager, not of pension fund. And the extraordinary irony was that the fraud took place in a regulated entity (a company called Bishopsgate Asset Management) and not in the pension fund (although it was of course of pension fund money). Furthermore, even in the days before a pensions protection fund, in the biggest loss a pension fund had ever suffered, most of the scheme members in most cases got most of their money.
The problem with the Maxwell Affair was not the fraud, but the aftermath. Because Maxwell himself was high profile, the response was high profile. And despite the fact that pension funds had with a few exceptions delivered a product and service of exceptional quality over seventy years without eight thousand pages of legislation, no solvency requirements at all, and no investment controls, no requirement for trustee training. The system had worked in good times and bad, through a world war, and through one of the worst stock market collapses of the century. With all its failings, and there were several, it worked.

Then came the Goode Report and 222 recommendations for reform, a Pensions Act 1995, a Welfare Reform and Pensions Act 1999, and then a stream of minor changes until the Pensions Act 2004 (when it was found the Pensions Act 1995 had not worked) – and the Finance Act 2004.

If it is possible to crystallise the overwhelming pressures on pension schemes in two main areas, it would not be the social and economic and longevity changes, it would not be the markets, it would not in itself with the crude and destructive accounting rules; it would be a combination of the Goode Report and the Finance Act 2004.

The Goode Report, like all such reports, could not bring itself to say that something bad had happened, but that the cost of ensuring it could not happen again would be counter-productive and anyway could not work. It was the product of a time in the affairs of man that believed that regulation could fix things. Now of course we know it usually cannot, – and certainly eight thousand pages of regulation is oppressive. It was, with hindsight (and even at the time) a serious mistake.

Secondly was the Finance Act 2004, which expressed a grievous misunderstanding by basing its structure on the assumption that pension schemes involve substantial tax privileges. Pensions taxation in most developed countries mostly followed OECD / EU / World Bank  guidelines, that there should be tax relief on the contributions (both employer and employee), tax relief on the growth, and then tax on the benefits,  the so-called EET system. Without that system or something like it, the provision of pensions by employers or through employers is inefficient and usually involves double taxation. In 1921 the forerunner of the NAPF persuaded the forerunner of HMRC that deductibility of pension contributions allowed pension plans to be fiscally neutral. It cost the Treasury some cash flow, but the ultimate receipts were broadly the same. There was some mild arbitrage in that some relief was at high rates of tax and the pension payments might have been at lower rates of tax, and there were of course tax free lump sums. But the broad principle was sound. Indeed without setting money aside in a kitty, and in the absence of a pensions protection fund, plan members who had worked on the understanding that their employer would put them on a payroll for life were at the mercy of a future insolvency. The arrangements in the 1920’s was that private schemes could be put on the same basis as public schemes (eg the civil service) if they wanted, although there was no minimum solvency requirement.

For over seventy years the tax structure worked pretty well. It is only in the last decade that the system has been destroyed by a Treasury that forgot the need for fiscal neutrality and coherence and saw, mistakenly, pensions as a cost to the taxpayer.

Accordingly the grand simplification plan, which was intended to dismantle 1300 pages of rules in exchange for a couple of simple constraints (breach of which would in any event have caused littler concern, because the need to purchase annuities would allow HMRC to collect its tributes in due course) failed. We now suffer over 3,500 pages of rules, very few of them actually necessary to protect the Treasury and many of them expensive to administer and many of which create some kind of apartheid between high earners and low earners so that the higher management now have less incentive to help their lower paid colleagues.

Finally the accounting rules developed over the last decade insisted that pension liabilities be valued as though the employer had gone out of business, unlike any other liability (eg its leases) that it had on the books. This bizarre conclusion, intended to tell the truth about a companies liabilities, achieved almost its reverse – and encouraged (along with the risk-averse regulators) pension schemes to invest in the wrong kinds of assets at the time in the economic cycle. It was a classic and awful example of doing harm by doing good.

But we are where we are. And while there are still major threats on the pensions horizon (EU legislation in particular, with the possibility that pension funds will have to maintain capital reserves like insurers under Solvency II) the general outlook could be benign.

First even politicians and civil servants are beginning to acknowledge that they have played a significant part in creating the problem. Recent comments by David Willetts a former opposition spokesman on pensions have lead the change of heart. Secondly, as we begin to create a cohort of badly-off pensioners, the growing cohort of the elderly will begin to demand some change. Thirdly even under the current pressures employers in particular are conscious that the least worst way of providing for old age is through the workplace - rather than the government or the insurance industry.

While the short term outlook seems unpromising, there is a growing ageing population – and it needs some kind of income in old age when they are too infirm or disinclined or needed to work and gain earned income. Some of the more enterprising may use property as their proxy, and some of the lower paid will rely on the state (although the outlook for such arrangements is uncertain. It is a brave person who will rely on the success of the NPSS for his comfort in old age). The state scheme generally is in the famous cliché unfit for purpose and getting unfitter. Not many of us, even the pensions experts, can describe what the state pension system will deliver over time. While some of the rules are being removed it is bewilderingly complicated (several classes of the basic pension, a confusing flat-rate/earnings related contracted-out/in second state pension, a means tested (both ways) third state pension and forthcoming fourth state pension dependent on a computer system that is as yet untested.

All these make it highly probable that the pressure to provide employer-linked retirement income in years to come will increase. It is unlikely its design will look the same as it does today. But experience in the US and Europe suggests that it may have some elements of salary-relation, it will more risked-shared, it will operate in a lightly regulated environment and it will be funded. And the fact that the current DC arrangements, especially personal arrangements, lack the governance arrangements of trusteed arrangements that we currently enjoy also suggest a resurgence over time of quasi trustees who may not run the risks that current trustees do, but yet offer some additional protection for the consumer.

We are slowly re-learning some of the old nostrums – that the price of absolute guarantees is too high for most of us, that regulation has a sometimes unbearable cost and may be more for the benefit of the regulators than the regulated, that employer-related systems with their drawbacks still have material advantages over the alternatives, that in the absence of tax-neutrality pensions will wither,  and that now with the opportunities under the European Pensions Directive we can choose other jurisdictions than our own overheated country to fund our retirement. In ten years time we might well be able to celebrate not only the twentieth anniversary of opdu, but its expansion across the EU, supporting pension systems which we can only hazard a guess at. And we might also have to be able to conduct the celebrations in Chinese.

Robin Ellison
Partner
Pinsent Masons
020 7667 0010
robin@pensionslaw.net
robin.ellison@pinsentmasons.com