PENSIONSANDSAVINGS.COM

7 November 2013

• Government trying to offset decline of Defined Benefit pensions with Defined Ambition
• DA aims to be a more flexible half-way house between DB and DC – but with hard guarantees
• Government trying to find ways to offset falling state pensions
• But guaranteed pensions in private sector are still risky – while public sector remains protected

Demise of private sector final salary schemes reduces future private sector pensions:  The UK once had a private pension saving system that was the envy of the world.  For a number of years, it seemed as if the UK pension future was all sorted out.  Sadly, that turned out to be an illusion.

Final salary pensions forced employers to take on social welfare costs they could not afford:  Part of the reason that final salary pensions have almost died out in the private sector is that employers cannot cope with the costs and the risks of open-ended pension provision.  Successive Governments tried to force employers to take on social welfare responsibilities in their pension schemes, by enshrining additional requirements in law and removing any flexibility they might otherwise have had to adjust the benefits as people’s lives changed.  By requiring final salary schemes to always provide partners’ pensions, inflation linking and revaluation of leavers’ benefits, employers were asked to assume a role that normally only the state would fulfil.  It was believed that the equity  market returns would always be sufficient to offset the rising costs of pensions, even if people continued to live ever longer and to meet the costs or rising salary and price inflation as well.  Of course, this turned out to be unsustainable.  Rather than ensuring schemes would be sufficiently funded to cater for the rising future costs, the Government decided to tax what it believed were ‘surpluses’, thereby discouraging employers from building up buffers against bad markets or future demographic and economic change.  When the schemes were building up, the majority of members were not retired, were contributing to the schemes and few members were withdrawing pensions.  Rather than ensuring the schemes put money by in the good times, they were encouraged to rely on forecasts of strong stock markets to provide future pensions.

If we had allowed DB to be more flexible, many schemes would still be open today:  We have made the best the enemy of the good.  Of course it is in members’ interests if the employer can shoulder all the risks of pension provision and can guarantee good pensions.  However, most employers will not manage to meet the costs of those guarantees, as corporate performance and market conditions are bound to change during the fifty or more years that a pension needs to last for each person.  By refusing to allow employers from ever reducing pension payments or from adjusting to rising life expectancy and periods of poor markets, regulations have made the best the enemy of the good, and employers have simply had to close their schemes.  Defined Ambition is a chance to start again and design a more flexible pension system that allows more leeway for change over time.

Investment returns cannot be guaranteed, so pension schemes need more flexibility:  We must not make the same mistakes again.   Any Defined Ambition pension must be far more flexible than our current arrangements.

Pensions are about people, not just about money – people’s lives change, pensions also need to:  Pension saving must be able to adapt to people’s lives and, as lives are not homogeneous, far more flexible benefit structures, with provision to be able to change the payouts over time, will be essential.

Defined Ambition tries to get employers to pick up some of the risks of pension provision again:  So far, the demise of DB has resulted in the risks and costs of pensions being transferred almost entirely away from employers and onto each individual.  DA is the Government’s attempt to move some of the risk back onto the employer, so that the risks are shared, rather than shouldered by one party only.  Employers used to have to bear the entire risks of pension provision.  These included:

– Salary inflation risk
– Price inflation risk
– Interest rate risk
– Longevity risk
– Financial market risk (equities or other assets)
– Regulatory risk (additional costs of regulation and compliance)
– Annuity risk
– Partner’s pension risk
– Revaluation of deferred benefit risk

In a DC scheme, the members themselves shoulder all those risks and responsibilities themselves.   Employers do not have to take responsibility for any of these pension risks if they choose not to do so.  They simply need to pay money in each month and then the actual pension which the money provides is up to the member.

State pension is being cut, so Government wants to find other ways of increasing pension income: Auto-enrolment relies on DC pensions but it is clear that they are placing too much risk on individual workers and the Government wants to improve the position in future in order to avoid millions of people at risk of later life poverty despite auto-enrolment.  It is therefore trying to identify ways to place more risk and responsibility for pensions onto employers.  It is likely that larger employers might be willing to take on these responsibilities, but most smaller firms will shy away from them.

Private employers cannot be relied on to offer guarantees – guarantees in pensions are not guaranteed: Ulitmately, private sector employers cannot be relied on to ensure pensions will be paid out over many decades.  Average corporate lifespans are only 10-20 years, so other guarantors are also required.  Insurance companies can help, but the main point is that guarantees in pensions are not guaranteed!  If the employer fails, or investment markets perform very poorly, workers need to know that their future pensions are at risk.  That is why pension planning needs to include working longer as part of the mix.  If people realise that they might have to work longer to get a better later life income, it will not come as such a shock to them.  If, however, they are always told their pension is guaranteed, they will not be expecting the possibility of disappointment.

Public sector pensions are still guaranteed though:  As the Government is proposing to water down the benefits offered by private sector employers in defined benefit schemes – proposing that future benefits need not cover partners, nor offer inflation linking, nor have a fixed pension age – the arrangements for the public sector are set for the next 25 years.  Taxpayers are still going to guarantee the pensions for public sector workers for many years ahead and I do hope public sector workers will value and appreciate just how generous their pension arrangements are, both in absolute and relative terms.