Pay more, work longer for pensions

3 August 2003



Finding a strategy for pensions could mean changing our whole attitude to retirement and the way we save for it, an overhaul of the employment culture and higher costs. Robin Rhodes explains


Any resolution to the crisis in the pensions market seems likely to involve working longer, greater regulation and higher costs all round - for employer, for employee and for the state.

The public is losing confidence in personal investment. Investing in the home and for our old age were once the prudent choices, but such investments are now increasingly insecure.

Increasingly, endowment policies are failing to repay mortgages. The experts are beginning to advise a move away from substantial pensions investment and so the feel-good factor is fading, despite historically low levels of unemployment and inflation.

Regulations have been visibly ineffective in controlling the mis-selling of pensions, and failed to protect pension funds when companies go bust and to prevent situations such as that of Equitable Life from occurring.

These events have resulted in financial disaster for a wide range of people and few of them have any realistic opportunity to recover from the failure of investments that appeared wise when they were made.

Fund solvency savaged

But it is by no means just regulation which is the problem. A long and deep downturn in global equity markets has savaged the solvency of many pension funds which over the last two decades have become heavily invested in these markets.

Figures from some of the UK's largest companies provide quite shocking examples; the 2002 pension fund deficit for BAe Systems was £2.3billion: the BT Group shortfall was between £2billion and £2.5billion; and most recently the Royal Mail announced a deficit of £4.6billion.

A recent survey shows that 91 of the FTSE 100 companies had a combined deficit of £77bn, equivalent to 93% of their operating profits in 2002. The deficits have been magnified by changes in accounting regulations, not least the need to meet new Minimum Funding Requirements, and the removal of tax credits from share dividends.

Whether any of those factors will be modified or withdrawn is yet to be seen, but shortfalls of this magnitude will require many years of substantial additional investment to repair.

This necessity to provide huge "top-up" contributions to reinforce pension funds, and the volatile effects of those contributions on company accounts, have speeded the switch from final-salary pension schemes (or "defined-benefit" DB schemes) to money-purchase schemes (or "defined-contribution" DC schemes).

Final salary schemes closing

The number of companies closing their final-salary schemes to new members doubled in 2002, and that rate of closure is rising even more rapidly in 2003.

Many employees, and their trade unions, are unhappy about these changes which almost by definition lead to much smaller pensions, but the National Association of Pension Funds identifies the simple logic of these moves. It quotes the average employer contribution into a final-salary scheme as 12% of salary, compared with just 6% into a money-purchase scheme. Further, the risk of any poor investment performance in money purchase falls on the employee.

Even those lucky enough still to be members of a final-salary scheme will find that the cost of their contributions will almost certainly rise.

Demographics may be the most important factor affecting the funding of pensions. One of the 20th century's greatest legacies in the western economies was the lengthening of life expectancy by 25 years. But this means that by 2010 more than 40% of the UK's population will be over 45 and soon after that half the population will be over 50.

Living longer

Whilst reflecting a quite remarkable improvement in longevity those numbers place an enormous burden on both state and private pension schemes. The problem is apparrent too in other European economies, many of whom have less well-funded pension schemes than we do.

The attempt by the French government to increase the state pension age from 55 to 60 has lead to widespread street protests, but the economic imperative to make such changes is unavoidable.

It is clear that longer life expectancies present two major economic and social problems which are inextricably linked. The first is the funding of pension schemes, an inexorable problem with an ageing population, and the second is the reassessment of pension and retirement ages.

Fewer and fewer people will be able to contemplate early retirement as, apart from any other consideration, the reduction in pension for such early retirements will prove prohibitive in many cases.

Pension deferred

Deferring a pension will have huge attractions, but that will place more emphasis on the ability to earn a reasonable income later in life. This has inevitably become a big consideration in the government's plans for the introduction of age discrimination laws, which must be in place by 2006 to meet the requirements of the EU Directive.

Presently, only 9% of us work beyond 65, but it is inevitable that that figure will have to rise significantly. That requires a substantial change in our culture though, if the American and Australian experience with recently-introduced age discrimination laws is a guide, it can be successfully achieved.

In addition to the cultural change, a massive increase in spending on state pensions will be necessary as will large increases in pension contributions from both employers and employees (almost certainly with an element of compulsion). Equally important will be creating an economy in which most people work beyond the age of 65.

Kick started

The Secretary of State for Trade and Industry, Patricia Hewitt, has kick started the consultation and debate on the structure and content of our new age discrimination laws (Equality and Diversity: Age Matters - July 2 2003 available on www.dti.gov.uk). These regulations will become a crucial component in resolving the crisis over pensions.

For the government this is a complex matter. For example, its initiative to introduce Stakeholder pensions less than two years ago has floundered. Although 330,000 of the 350,000 eligible employers have set up such a scheme, 90% of them are empty shells with no members at all. Further, only 9% of employers make contributions to a Stakeholder scheme. Neither employers nor employees are yet convinced of the need to make substantially larger contributions to pension funding and that inevitably means that many will be faced with not only a longer working life but also with substantially reduced retirement income.

Expect the government to act because that scenario can only mean a greater reliance on state pension provision, and that will require a massive reallocation of funds compared to present.

The government has not been slow on setting up bodies to review and report on the pension problem.

In July 2002 the Pickering Review reported on simplifying the regulation of occupational pensions schemes. (The cost of pensions was bad enough, but additionally the regulatory regime was so complex as to be both a real disincentive and a substantial cost.)

The Sandler Review has been looking at the retail savings market, pensions' tax regimes and the impact of red-tape on the whole process.

Not to be outdone, an Inland Revenue review has been looking at personal pensions policy in the round to find ways of encouraging savings for retirement.

In June this year an Employer Task Force on Pensions was set up to develop employer pension provision and to examine incentives for employees to save via the pensions medium. A new Pensions Protection Fund was announced to cure the worst examples of the problems faced by pensioners when their employer goes into receivership, and a new Regulator to ensure increased member security.

A Green Paper on pension reform was published in December 2002 and the new pensions minister from the recent re-shuffle, Malcolm Wicks, has announced an independent commission to review the merits of compulsory pensions - until 1988 employers could make membership of an occupational pension scheme a contractual obligation, and that idea is being revisited.

Activity almost frantic

By any measure there is a fair amount of activity, some of it appearing almost frantic. However, the state pension is declining in real terms and government spending plans on health, education and transport already look too ambitious to allow much room for increased pension funding.

But private pensions have a massive task in reconciling affordable contributions with increasing longevity.

The two major investments that most people have are their mortgage and their pension, often with more money invested in the latter than in the former.

By definition, both investments are strategic. However, moving the UK housing market to longer term fixed-rate mortgages appears to be a very simple task compared to generating adequate and secure pension funding for an ageing population.

The other real difference between the two is that fixed-rate mortgages are an attractive proposition for a culture so enamoured of bricks and mortar, whereas pension funding is complex, hard to understand, and the delay between investment and reward is so long that many are deterred, particularly at the most beneficial younger ages.

Perhaps the real concern is that pensions are going to bear out the old adage of "live now, pay later".



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