End of the line for state pensions?

Pensions have hit the headlines. The Government’s plans to abolish SERPS and replace it with compulsory private pension contributions, if ever implemented, will be the biggest change to the UK’s social security system since the war. The proposal, as well as promoting the Government’s idea of personal financial responsibility, seeks to suppress the growth in the DSS’s budget – currently #90bn a year – and tackle the question of where the money will come from to pay for future pensions.

The issue is made more pressing by the existence of the so-called demographic time bomb, the predicted surge in pension provision brought about as a growing population of state pensioners soaks up an increasing share of the working population’s earnings. Even today, the basic state pension alone accounts for nearly #30bn a year of Government spending.

Government estimates show that between 1981 and 1992 the number of people of state pension age grew from 9.9 million to 10.4 million (5%). The worst-case predictions are that this trend will see greater longevity causing the pensionable population to grow at a faster rate. This would place an intolerable burden on taxpayers where pensioners rely only or mainly on unfunded state pension schemes. In the UK, these are the State Retirement Pension and the State Earnings Related Pension Scheme (SERPS), an extra payment for those who made additional contributions from their higher income.

Funded or unfunded pensions

The problem hinges on whether pension plans are funded or unfunded and whether the demographic time bomb really is explosive or no more than a loudly ticking alarm clock. In funded schemes (personal and occupational), individuals make their own provision through contributions to a fund, the income and capital from which will provide retirement income. Sometimes employers also contribute to occupational pensions. The state’s unfunded schemes, on the other hand, rely on today’s national insurance contributors to pay today’s pension commitments. There is no fund. The money simply passes from contributors to recipients. Where the state predominates in pensions provision, demographics becomes an issue.

Despite predictions, this may not be a problem for the UK which has a thriving funded sector (at u600bn invested, more than all other EU states together). Professor David Simpson, economic adviser to major pensions manager Standard Life, explains the UK’s position: ‘The dependency ratio (demographic time bomb) is not going to deteriorate catastrophically but will worsen slowly over 20 to 30 years and then level out or improve.

For countries like Germany, France and Italy the problem will be worse because high pension expectations are based on unfunded provision.’

There is a school of thought which feels the enthusiasm for a single European currency may, in part, be enthusiasm to involve countries with less unfunded commitments in bailing out those with greater responsibilities.

Certainly, the Organisation for Economic Co-operation and Development has calculated that the UK would be the only member state to avoid the mounting cost of unfunded pension provision. Gabriel Stein, economist with City analysts Lombard Street Research, has pointed out that, in 1994, whereas the UK’s unfunded pensions amounted to just 7% of economic output, the equivalent liabilities for Germany were 110%. Despite further Treasury assurances to the contrary, Stein believes that, while we may not specifically be asked to bail out our more profligate partners, monetary union could lead to a pooling of resources to meet combined liabilities under the control of a joint fiscal authority.

Another major concern has been the handling of surplus pension funds by companies for whose workforce they are held. In an atmosphere coloured by fears of a growing elderly population, any moves which appear to undermine guaranteed pensions in the long term are bound to attract mistrust.

The case of the Maxwell group highlights a deeper concern over who may have access to pension funds. Because there is a limit to what benefits may be paid, a period of particularly successful investment may leave a fund with more value than is strictly required to cover liabilities on normal actuarial projections.

In these circumstances, trustees or the company which has made the contributions may improve benefits, take the surplus as a capital transfer back to the company or (more usually) take a contribution holiday for the company.

There have been several major cases of this occurring, most notoriously, the Government absorbing the #130m surplus in the National Bus Company scheme before privatisation. The Transport & General Workers Union is currently campaigning to have the money restored for the benefit of pensioners.

Although actuarial calculations of fund surpluses are undoubtedly conservative, trade unions and others argue the surpluses belong to scheme members and should be directed to improve benefits or provide against future investment downturns.

The political response

Nobody is seriously suggesting basic state pensions should be abolished but neither is anyone proposing to raise the pension above subsistence level. However, the three main parties have put particular thought into the means by which people might be encouraged and assisted to make funded provision for anything in excess of the basic pension.

The Conservatives’ focus is on self-reliance. In other words, to encourage funded pensions. In practice, about two-thirds of UK pensioners already receive benefits from occupational pension schemes.

Lord MacKay, social security minister, made clear the party’s priorities in a speech to the TUC pensions conference before last week’s SERPS announcement.

‘We must not commit future taxpayers to more than they can afford. In the UK, social security expenditure amounts to almost one-third of Government spending and 44% of total benefit expenditure. However, in the UK now over three-quarters of employees have chosen funded pensions.’

The Labour party’s policy on pensions also starts from the point that state unfunded pensions will not be sustainable as a main provider of future pensions. At the same conference, Harriet Harman, the shadow social security secretary, said that Labour’s pension policy would be guided by the following principles: ‘Establishing the right balance between the state and the individual in providing for retirement, ensuring that everyone who is able to do so makes a responsible commitment to their retirement income, and promoting public understanding of pensions so that people can plan for the future.’

Labour’s solution differs only inasmuch as, instead of personal pensions, it envisages industry-wide group pension schemes (dubbed ‘stakeholder pensions’). The Liberal Democrats would also give ‘every employee an automatic entitlement to have their employer pay into an occupational or personal pension scheme on their behalf’.

Ultimately, all three parties would run down unfunded provision but would maintain the ‘safety net’ of a basic state pension. Labour has further proposed a citizenship pension paid by those who can afford it for the benefit of those who may be unable to fund their own scheme. Any of these changes would not so much affect the costs of pensions as shift the responsibility for provision away from the state, towards individuals and employers.

Learning from abroad

There are examples of ways in which provision of earnings-related pensions can be achieved without the need for large-scale Government commitments from current account income.

In Australia, a system of industry-wide schemes has operated since 1984 when the Australian government and trade unions negotiated a wages and pensions accord establishing multi-employer pension schemes, commonly known as ‘industry super funds’. Four million Australians are now in 80 multi-employer schemes, all of which offer simple money-purchase, funded benefits. From an initial weekly contribution rate in 1984 of Aus$11, contributions have risen to Aus$50 per week for employees plus 6% of income from large employers (5% from smaller employers) scheduled to rise to 9%. The target is for 12% contributions including 3% from employees plus additional contributions from the state variable with the member’s earnings.

Another system that has recently received publicity is being tried in Chile where the only option is for all workers to take out a personal pension plan in order to provide an earnings-related, money-purchase pension.

The scheme has been beneficial for the Chilean stock market with all of the working population having to save for their future, prompting increased investment.

Both schemes have managed to hold down the cost of pensions provision by limiting the charges that fund managers and product providers may levy.

In Australia, they have achieved this by putting the management contracts for ‘industry super funds’ out to competitive tender among investment management houses.

Clearly, the consensus on future pensions provision is dominated by the need for governments to ensure that most of the population has a decent pension while avoiding any unfunded commitment for the state to underwrite the value of that pension.

Property values are also increasingly relevant to the pensions debate.

The current value of UK domestic residential property is estimated to be u1.2 thousand billion. The current outstanding mortgage book is #400bn so there is some #800bn of free equity (unmortgaged property value). Such a sum would make a significant contribution to the funding of pension schemes. There is, however, a reluctance on the part of many homeowners to trade the family’s inheritance for a useful pension.

That concern may be addressed by some newer mortgage products, tailor-made for this market. Bank of Scotland Centrebank, for example, has launched the Shared Appreciation Mortgage which may be used, according to the lender’s own publicity, ‘for a variety of options such as: funding pension or long-term care contributions’. Interest rates are low and fixed.

Moreover, as long as the property appreciates in value, at death or redemption the original equity is retained by the owner while any appreciation will be shared with the bank in proportions according to the interest rate selected. Such a plan should make it easier for homeowners to utilise the value in their property while ensuring there is still something to bequeath. Given that all pension funding must come from whatever value there is in the economy, this currently unused value may become a significant source in the future.

Come what may, more people will, in the future, be depending on well-run pension funds for retirement security and those funds will need to be properly controlled and monitored. Good and safe pensions will rely on well-run schemes which will require strong financial management, control systems and skills. Pensions may well be at a crossroads but, with unfunded schemes more or less ruled out, it will fall to personal, occupational or industry-wide schemes to provide for the future.

The 1995 Pensions Act which comes into force this April is a huge and complicated piece of legislation. What makes it different from predecessors sponsored by the DSS is that it first attempts to be pre-emptive and failing that matches nearly every obligation and responsibility with a penalty for breach. There are distinct resonances with the Financial Services Act, amplified by the introduction of a new regulator, the Occupational Pensions Regulatory Authority.

OPRA not only inherits some of the responsibilities of the old Occupational Pensions Board but will have even wider powers to impose penalties and other corrective measures. Chairman Michael Hayes is campaigning hard to dampen fears about his considerable authority. The prospect of burgeoning costs and administration is still causing consternation among directors battered by a decade of economic trauma. But well-run schemes have nothing to fear.

Member nominated trustees On the face of it, schemes must introduce a procedure by which members can nominate at least one-third of trustees (two is the minimum: one if there are fewer than 100 members). In fact, employees can put forward ‘alternative arrangements’ which may mean continuing with existing ones or opting out altogether. There is a catch: the membership must be consulted before such alternatives are adopted. If 10% object, it goes to a ballot.

There are a number of exemptions from the MNT rules, mainly for small schemes. What could be worrying is the requirement that if a scheme has a corporate trustee (typically a defined contribution scheme with an insurance company) then members have the right to nominate one-third of the company directors.

The trustees’ responsibility

Nothing in the act modifies the fiduciary nature of the trustee’s office.

Indeed, it reinforces it. There are also fairly specific rules which require a more formal relationship with professional advisers. Actuaries and auditors must, for instance, be given specific terms of reference by formal letter of appointment. The same goes for fund managers. Trustees are expected to seek advice from a suitably-qualified person before making decisions on investment, the day-to-day management of which they may delegate to someone appropriately qualified under the Financial Services Act.

What professional advisers should take note of is the introduction of ‘whistle-blowing’ into the regime. The act invites a number of interested parties to report to OPRA any suspected irregularities of ‘material significance’.

The invitation becomes an obligation in the case of actuaries and auditors.

This presents a clear conflict of interest but OPRA can disqualify professional advisers from acting for a scheme for breach of this statutory duty.

Minimum funding requirements The Pensions Act does much to protect the ‘expectation’ of members. The Minimum Funding Requirement (MFR) for final salary schemes broadly requires assets to match liabilities on a discontinuance basis. This demands a higher level of funding than before but is partly mitigated by allowing the valuation to assume equity returns on longer-term liabilities rather than lower yielding gilts. Where funding falls below the required level, there must be remedial action: a supervised funding schedule or, in more serious cases, an immediate reinforcement of assets either through a cash injection or an instrument such as a letter of credit. The MFR rules will be phased in by 2007.

Hand-in-hand with MFR is the requirement for a Statement of Investment Principles drafted by the trustees after consultation with the employer (whose comments they can ignore) and on the advice of a professional expert.

This will cover such matters as risk profile, expected returns, classes of investment and how the MFR rules will be observed.

Contracting out

Contracting out comes in for a radical overhaul with the severing of the link with the state scheme in respect of future accrual. Until now, a final salary scheme has had to provide a ‘guaranteed minimum pension’ (GMP), which is then deducted from the members’ SERPS entitlement in each relevant year. While the GMP roughly equals SERPS, the latter provides a small top-up – in particular inflation-proofing on GMP above 3% per annum.

From 6 April 1997, anyone who contracts out loses all entitlement to SERPS for the relevant years, GMPs are abolished and the scheme must exhibit the features (as a minimum) of a reference scheme. The reference scheme must, among other things, offer inflation proofing on the emerging pension up to 5%, making it more expensive. For money purchase schemes and personal pensions, there is a system of age-related rebates. These have been set at a level that makes contracting out unattractive unless the member has an exceptionally tolerant attitude to risk.

Rather bizarre, perhaps, is the requirement to provide inflation-linking, up to 5% a year, on pensions. Many final salary schemes have done this already (at significant cost) but the same requirement now applies to money purchase schemes which could cut the initial income by around 35%.

The act covers much more than this – from procedures to deal with disputes between member and trustee to earmarking pensions on divorce (soon to be changed) – and is a worthy piece of legislation. Inevitably, though, it tilts the balance away from final salary towards money purchase schemes.

For some small to medium-sized companies, the attractions of contracting out administration and regulation by way of personal pensions will become irresistible.