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Pensions Challenges and Choices
The First Report of the Pensions Commission - October 2004
On 12 October the Pensions Commission, chaired by Adair Turner, published its first report on its analysis of the UK pensions and retirement savings system. The report describes the current position of the UK system and the challenges to be met in the future. This newsletter discusses some of the findings. The full report can be downloaded from the Pensions Commission website (www.pensionscommission.org.uk).
Background
The Pensions Commission was set up by the Government following the Pensions Green Paper in December 2002. Its remit, as set out in the Green Paper was:
"To keep under review the regime for UK private pensions and long-term savings, and to make recommendations to the Secretary of State for Work and Pensions on whether there is a case for moving beyond the current voluntarist approach."
Its first report sets out the current pensions situation in the UK following some detailed research by the Commission with the aim of stimulating an informed debate on possible solutions to the problems highlighted. A second report is set to follow in Autumn 2005 following a period of consultation which will set out specific policy recommendations to the Government.
Barnett Waddingham LLP initial reaction
The report reinforces much of what we already know about the state of pension provision in the UK and we welcome the acknowledgement of these issues.
In our experience, employers are willing to provide affordable pension benefits, and to help their employees to manage the risks, but recent legislative changes have made that harder and harder to achieve. The Government needs to take decisive action to simplify the State pension benefits, and to help employers provide worthwhile pension benefits.
We look forward to participating in the debate to follow. We will be submitting a response to the Commission which will be available on our website in due course.
The report covers eight main topics and each of these is discussed in turn below:-
1. The demographic challenge and unavoidable choices
Increasing life expectancy and a reduced birth rate in future are predicted to lead to a dramatic increase in the dependency ratio (calculated as the ratio of the number of over-65s to the number of 20-64 year-olds) over the next 30 years. The ratio today is 27% which is projected to rise to 48% in 2050 with most of the increase in the next 30 years.
The Commission identifies four possible options for society in relation to retirement benefits:
- pensioners become poorer relative to society as a whole
- taxes must rise to fund higher State pensions
- savings must rise to fund higher private pensions
- people must work longer and retire later
These are the only options available. It is noted that option a) is undesirable and the solution is likely to consist of a combination of b), c) and d). Taking each option in isolation shows the extent of the problem:
- If no action is taken, pensioners will be 30% worse off relative to the rest of the population by 2035.
- Raising taxes or National Insurance contributions by £57bn a year would keep pensioners as well off on average as they are now.
- Raising private pension contributions by the same amount would have the same effect.
- Raising the average retirement age of males from the current 63.8 to 69.8, and raising the average female retirement age to the same level as males, would maintain today's level of income for pensioners, relative to average net incomes.
2. Average retirement ages: Past and possible future trends
The Commission proposes that a rise in retirement ages should be considered, but that this should not be the only change made.
Although people often think of "standard" retirement ages being 60 for females and 65 for males, in fact, only 53% of females remain in employment at age 59 and only 42% of men at age 64. The Commission found that people are generally living in good health longer which should allow people to work later. However, they note the wide differences amongst socio-economic groups, which might reduce the possibility of raising retirement ages for everyone. It is suggested therefore that this policy will only work if it is implemented in tandem with higher taxes and higher savings.
Raising retirement age does not necessarily mean changing the State Pension Age (SPA), and can be achieved by getting more people to work beyond SPA and fewer people retiring early. The report also promotes the use of more flexible approaches to retirement, including stepping down from full-time work to part-time work to full retirement over a period of time.
Some of these issues are already being addressed through the tax simplification changes. For example, under the new rules the minimum age of retirement will increase from 50 to 55 and it will be easier to semi-retire whilst continuing to work in a part-time capacity.
3. The UK pensions system: Position and trends
The UK system has worked well in the past. State benefits have been lower on average than in other developed countries (preventing pensioner poverty rather than providing a replacement income in retirement) but a highly developed private pension system has meant that overall the pensions provided have been comparable to other countries calculated in terms of the percentage of GDP. Indeed, this set-up has been seen as beneficial because it should ensure that the State system is sustainable from a fiscal point of view.
However State pensions are set to become less valuable in future and with company pensions becoming less generous as well there is set to be an overall decline in pension provision. Defined Contribution (DC) schemes are becoming more popular with employers than Defined Benefit (DB) schemes.
One problem with this is that on average employers' contributions are much lower to DC schemes than to DB schemes. The report gives some figures (which are 4 years out of date but which illustrate the point) showing that DB contributions are broadly in the 16-20% range (11-14% employer and 5-6% employee), while total DC contributions are around 7-11% (4-7% employer and 3-4% employee).
Another consequence of the shift to DC schemes is that many of the risks associated with pensions (in particular the investment risk, but also the longevity risk) are transferred to individuals who often are not in a position to deal with them effectively. This means that the problem is more complicated than suggested above - looking at the average contributions going in gives information about the average level of benefit coming out of schemes. While DB benefits are not linked to market conditions DC benefits are, and so employees retiring at the wrong time will receive lower than average benefits.
The fact that more people will need to buy annuities at retirement (because they are in DC schemes) raises questions about the capacity of the insurance industry and of the appropriate investment markets, for example in long-dated gilts and index-linked gilts. There have been suggestions that the State should actually offer a way of taking on the longevity risk after retirement, by issuing mortality-linked bonds for example. This will be an area that the Commission will consider in its second report.
The Commission also hopes to receive views on the best way to share longevity and investment risks between employers, individuals and the State in future. Hybrid DB/DC schemes and cash balance schemes are given as examples of how these risks can be shared.
4. Looking forward: Pension adequacy if trends unchanged
The report examines what would be considered an "adequate" amount of pension. The conclusion is that it should be defined in terms of a percentage of salary before retirement. Their suggested benchmark is 80% of gross earnings for lowest earners, declining to 67% for median earners and 50% for top earners.
It is estimated that 75% of members of DC pension schemes have contributions below what they need in order to provide adequate pensions. However, pension provision is increasingly unequal with some members of open DB schemes and public sector schemes, along with many senior executives, being well catered for whereas most other groups are likely to receive inadequate pensions. The inadequacy and inequality of pensions is likely to become a serious issue in 20 to 25 years, the Commission suggests, if no carefully planned action is taken to deal with these problems. The hardest-hit group is likely to be middle-income earners with private pensions, because low earners are protected by the pensions credit, whilst higher earners and public sector workers in DB schemes are likely to continue to enjoy generous benefits.
5. Non-pensions saving and housing
Pensions are not the only form of saving for retirement and the Commission recognises this in the report. Funded private pensions are estimated to be worth £1,300bn and unfunded public sector provision is worth about £500bn, but in addition individuals own around £1,150bn of other financial assets. However these are again distributed very unevenly and probably will not help to supplement retirement incomes significantly for the most needy.
Housing assets (worth £2,250bn) are distributed more evenly and may be used in some cases to supplement retirement income, especially if houses are inherited or through buy-to-let arrangements. However, the Commission does not feel that houses provide a meaningful solution to the problems faced. This is mainly because it will not benefit everybody, there are likely to be other claims on the value of houses such as the cost of long-term care, and the fact that it is relatively difficult to release the value of houses and turn it into cash.
6. Barriers to a voluntarist solution
There are many problems in getting people to make long-term savings. The Commission looked at behavioural economics and found that people will put off making a decision until they are pushed into making one (for example by the State, an employer, or a salesperson). It cites the experience in the US where employer pension schemes which automatically enrol employees unless they make a conscious decision to opt out leads to much higher participation rates than schemes which require individuals to fill in a form to opt in.
It is also noted that the cost of the advice that is needed when deciding on the appropriate savings to make reduces the returns on those savings. Pension providers also find it very difficult to be profitable when providing to low-income groups. The Commission asks whether a voluntary market for pensions can ever work for those on low incomes (who therefore make low contributions).
These problems have been compounded in the past by the complexity of the State and private pension systems in the UK. Means-testing, in particular, is singled out as being complicated and reducing the incentive to save through private pensions.
7. Revitalised voluntarism, changes to the State system, or increased compulsion?
These three options are put forward in order to achieve adequate pensions in future. The report puts forward some suggestions and background to each of them and this is the area that the second report will focus on next year.
A shake-up of the current voluntary system would need to involve some or all of the following: an increase in the percentage of firms making employer contributions, changes to tax relief, lower selling and administration costs, less means-testing and increasing the level of customer understanding of pensions-related and other financial issues.
A change to the State system would be likely to have to involve a reduction in means-testing and a higher basic state pension, and a reduction in complexity would be necessary.
Compulsion is a difficult issue and experience in other countries is not conclusive as to whether or not it has the desired effect of increasing aggregate savings.
8. Women and pensions
It is noted that women pensioners are significantly worse off than men in the UK today. The State system in particular has features which were designed when family structures were different, so that most women gained pension income via their husbands. The Commission recognises that this should be rectified if we are to have an effective pension system in the future.
Consultation
One of the aims of this report is to stimulate debate and the Commission has invited comments on the report during a consultation period which lasts up until the end of January 2005. In particular they are looking for comments on whether they have got any of their facts wrong in the report, whether their predictions for the future are over-optimistic or over-pessimistic, and on the role the State has to play in ensuring adequate pension provision.
Please speak to your usual Barnett Waddingham LLP contact if you wish to discuss any of the issues above.
Barnett Waddingham, October 2004.