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OPDU Report 24
- May 2008
With defined benefit pension provision reducing, particularly in the
private sector, the debate on whether there are viable options to
the main alternative method of defined contribution, which passes
all the risks to the member, is gathering pace. To begin at the beginning Once upon a time well-meaning employers concluded it would be a good idea to provide pensions to former staff. Typically pensions were a fraction of the member’s salary (often dependent on the length of service). The final salary pension scheme was born. The employer had the satis-faction of providing an element of financial support in retirement. The pension supported the business too, enabling it to attract and retain staff in the good times but also making the break less painful particularly in hard times. What happened next? Over time, a whole new industry developed to support this provision of pension. A new structure arose with trustees given significant powers over the schemes which arose to deliver pensions. The well meaning employers had begun to lose control. A large raft of advisers and service providers arrived on the scene. They explained that reluctantly, they had to charge the market rate. The market rate was not cheap.
In the beginning there was no obligation to provide increases in either payment or deferment and usually no obligation to provide any pension to members who left service well before retirement. Government introduced various requirements to reduce discrimin-ation between various classes of members (specifically pensioners, deferred pensioners and active members). That was a noble aim. But it couldn’t stop at legislating through principle (allowing employers to find a sustainable solution). It thought it knew best and instead forced employers who had voluntarily introduced pensions to:
These three improvements, taken alone have probably acted to double the cost of pension provision. In addition to the above further legislation introduced to avoid discrimination on grounds of sex and age has tended to impose additional costs with actual or perceived obligations to level up to the better benefits in either case. In each of the three years from 2000 to 2002 the equity market fell. As 2000 neared its end investment consultants reassured us that these things do not happen two years running. Yet now we find ourselves in 2008 with the FTSE equity index (admittedly ignoring dividends) still well below its end 1999 level. Past returns and historically low ‘risk-free’ investment returns mean that schemes are in deficit and provision continues to be expensive. And finally there is increasing longevity. It is a measure of how punch drunk the industry has become that this is perceived as almost entirely a bad thing (with industry figures delivering an unconvincing throw-away line that it might be good for ‘people in general’ but….). Those who forget the past are condemned to repeat it The preceding catalogue (and readers will have their own additions) is included because we must learn from the past (as well as for masochistic purposes!). Many of the improvements (in particular those that eliminate discrimination) are right and proper. However it is the levelling up associated with them that is unsustainable. I believe there is now a greater acceptance that uncertainty is part of our lives. In the pensions arena this arises primarily from investment returns and longevity. In a climate of uncertainty it is not realistic to keep imposing additional burdens without the system breaking at some point. The existence of the Pension Protection Fund (PPF) is a direct acknowledgement of this point. The employers exposed to these additional costs now find their businesses are under threat in the illusory pursuit of a ‘guaranteed’ high quality benefit. Interestingly, the PPF has provisions which allow it to reduce its compensation in certain circumstances. Yet the Government denies similar flexibility to those well meaning employers wishing to provide good quality benefits. Money purchase benefits The knee-jerk reaction to the evils of the past has been the introduction of money purchase or defined contribution pension provision. The advantage of this approach (from the employer’s perspective) is that the cost of benefit provision becomes fixed giving rise to the additional benefit of simple accounting. From the member’s perspective it is a less than satisfactory solution. Put simply all the uncertainty over the cost of benefit provision is transferred from the employer to the individual. In the new spirit of individuals taking control of their own destinies DC members are expected to assess the adequacy of personal funding plans and make complex investment decisions, often with little more than the spurious comfort that their money is being invested in a default ‘cautiously invested’ fund. A minority of members can cope with this (or have sufficiently thick skin or wallet to weather the storm if it goes wrong). The vast majority are ill equipped to do so or lack the will to do so (there are many more pleasurable ways to spend time). A number have already suffered as a result of retiring at the wrong time; hit by the ‘triple whammy’ of low equity markets and low interest rates coupled with emerging awareness of increasing longevity and its adverse effect on annuity rates. The relative immaturity of DC provision coupled with the greater lobbying power of ‘corporate UK’ as opposed to ‘employee UK’ mean that adverse publicity from inadequate DC provision has yet to hit the headlines to the same extent as DB provision. But it will… Shared risk arrangements In the circumstances it seems extraordinary that no middle ground has been found between DB and DC. The failure of the recent Pensions Bill even to pave the way is particularly disappointing, but perhaps not surprising – what incentive do politicians have to address the problem? One can only speculate that removal of the excellent civil service (and the even more generous MPs’) final salary pensions, with full indexation and underwritten by taxation, might be needed before the required understanding of pensions is achieved. Certainly the high turnover of pensions ministers does not suggest the issue is regarded as important. From any perspective this seems short-sighted. With an increasingly ageing population, the Government should welcome anything that increases pensioner prosperity so harnessing the ‘grey haired’ vote and minimising potential problems from means testing in the future. The pensions industry itself has been subdued (albeit with several honour-able exceptions). This is perhaps surprising as the people within it may be amongst the biggest losers from the current demise of DB pension provision. Perhaps the older members of the industry, whilst regretting the current DB wasteland, no longer have the energy for the fight and take too much comfort from the thought that the current state of affairs will nevertheless ‘see them through’. And perhaps the younger ones have forgotten how to think at all. But of course this is primarily about employers and their employees. The current state of affairs perpetuates the position where all the risk falls on either the former (DB) or for the latter (DC). It seems a universally accepted truth that a healthy relationship should involve some ‘give and take’ yet the UK pension regime does not allow this. A solution (the Association of Consulting Actuaries model) It is probably worth starting with the solution proposed by the Association of Consulting Actuaries (whose President Ian Farr has been a vocal champion of the ‘middle way’). Their proposal involves; l a career average salary pension (this avoids the unfairness of differ ential revaluation rates implicit in final salary pensions)
This approach is essentially closer to the defined benefit model but with the proviso that increases are conditional upon affordability. It might be the natural starting point for employers currently struggling with DB provision but nervous about exposing employees to the full brunt of DC. The ACA reckons some 900,000 private sector employees continue to accrue DB benefits. Another solution (the HamishWilson model) An alternative approach which we have promoted is modelled more closely on the defined contribution regime and involves:
With the underpin of the known employer contribution, this sort of scenario is a more natural harbour for those who have already moved in that direction (the majority of the private sector) but would welcome the opportunity to improve risk sharing between members – both within and between different cohorts. Alternatives It would be possible to come up with various alternatives (and tempting to offer the ritual bottle of champagne for the best suggestion). In short, it does not matter which sort of approach is adopted; a healthy market (supported by principle driven legislation) will always have a good choice. The baggage The main objection to risk sharing is that current legislation will not permit it. This is a smokescreen from those lacking the will to consider an alternative. We do understand and respect the legislation that has built up in the past and (perhaps reluctantly) accept that it needs to be retained (but only for benefits accrued to date). For the future (if indeed the pensions industry is to have one) we need the vision and courage to shake off the chains of the past. It can be done! Conclusion I have yet to find anyone who objects absolutely to either DB or DC (the objections, such as they are, sit in a given context). In the circumstances it seems hard to understand how anyone could object to a solution that sits between them. I am forced to conclude that the lack of progress reflects an inability of MPs and legislators to engage with a problem which sits outside their own comfortable experience. The sad fact is that if action for risk sharing schemes is not taken quickly, the opportunity will be lost. It will be the next generation that are the losers and it will be our job to explain why we let them down.
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