03 November 2016
Time to rob (grandpa) Peter to pay (grandson) Paul?
A huge overhaul of the pensions system is needed but has anyone the stomach for it?
by Frank O’Nomics
The UK population at large, and the financial services industry in general, has had enough of changes to the pensions system. In the last 10 years alone there have been 10 changes to the lifetime allowance and the annual allowances for tax relief on pension contributions, and any further changes could make it more impossible for people to plan for the future. Recent reviews have led the government to conclude that there is no consensus on the benefits of further change, and that there is a strong feeling that the roll out process of auto-enrollment should take precedence over further reform. However, the problem with doing nothing is that the issues young people face in ever being able to save enough for a comfortable retirement are getting worse and fundamental reform is needed to stop this getting beyond the point of no return. The Autumn Statement is just two weeks away and it is worth considering what can be done to resolve a looming pensions crisis.
First, is there a way to ease the pressure on companies which have huge pension deficits? Data this week shows that defined benefit pension scheme deficits improved by £60 billion in October (the result of rising gilt yields), but they remain over £600 billion in the red. Companies forced to set aside significant sums to ensure that their pensions schemes are solvent are unable to invest for future growth, pay dividends to investors, or increase the pay of current employees, all because of previous overly-generous promises to those who are now retired. Just how generous? Well, anyone with a pension that pays two-thirds of their final salary is deemed to have an effective pension pot equal to 20 times that pension. An individual with a final salary of £60,000, who receives a £40,000 pension therefore has a £800,000 pension pot. However, there are firms who, in efforts to reduce their pension liabilities, are prepared to buy off pensioners by paying up to 35 times an annual pension; in the case above the pot would be worth £1.3 million. The end of defined benefit pensions means that current employees are getting a deal that is much, much worse than this. Even generous schemes that pay around 8% of an individual’s income into their pension will produce a final pot that gets nowhere close to that of anyone on a defined benefit scheme. The promises made by one generation to itself are effectively leading to the impoverishment of the next generation.
A number of ways have been suggested to offset or remedy these cross-generational imbalances. For example, companies could be allowed to adjust pensions in payment according to the size of their pension fund. There are many factors that have driven the rapid increase in pension deficits, but the main ones have been a steady rise in longevity, a fall in investment returns and a fall in long-term bond yields. This last factor has been especially important recently, with the impact of Brexit leading markets to expect rates to remain lower for longer, significantly extending the fall in bond yields. Should a firm that has been, on historic grounds, both prudent and generous in contributing to its pension fund be penalised by factors like this which are beyond its control? There is surely some sense in allowing the company to moderate its pension promises, according to the size of the pot it can reasonably generate, given that this will both help future growth and avoid them falling upon the Pension Protection Fund, which would produce a greater fall in pensioner incomes.
There is an obvious difficulty here. One would not want companies who have been less prudent to escape their obligations, and reducing pension incomes would generate understandable outcry, but the alternatives could be much, much worse. A further significant reduction in the size of company pension deficits could be generated by a change in the index used to adjust pensions in payment for inflation to CPI from RPI, discussed before in these columns.
The measures so far discussed would help free companies from some of the burden of their pension responsibilities, but something more needs to be done to help those whose pension pots have currently no hope of reaching the size needed to allow them any degree of comfort in retirement. Some funding could be provided from the cash saved by reducing previous obligations, but help is needed from the government. Currently the taxation of pension contributions is still weighted towards those who earn more, even after the reductions in annual and lifetime allowances, with some savers receiving tax relief at their higher rate on up to £40,000 of contributions (falling to £10,000 for those on incomes in excess of £210,000). It does not seem fair that a high earner, who may be able to generate income from savings other than in a pension, gets relief on his contributions at 45%, while those on low pay benefit by just 20%. Further, there is a strange imbalance between a young person getting 20% tax relief on saving into a pension, when they will get 25% saving into the forthcoming lifetime ISA. An interesting suggestion has been put forward by Hargreaves Lansdown, whereby tax relief becomes age related, so that, for example: someone aged 35 would get an additional £65 from the government for each £100 they put into their pension, while someone aged 60 would get only £40. This would seem to be a very effective way of encouraging young people to save. A more likely solution is to have a single rate of tax relief for pension contributions of around 30%.
There would be a cost to increasing incentives for people who save into a pension scheme, but much of this could be offset by addressing the way in which state pensions are increased. In effect a gap between the state pension and average earnings, a “triple lock” currently ensures that pensions increase at the higher of RPI, average earnings or 2.5%. In an environment of low pay growth and very low inflation, 2.5% is very generous, and in recent years, much of the long-term lag in pensioners pay has been eroded as a result. The triple lock has cumulatively cost £18 billion so far; abandoning it, and replacing it either with indexing for inflation or, as would seem more equitable (and recommended this week by Iain Duncan Smith), just indexing to earnings, would save a great deal of money.
All of this falls well short of being a pensions manifesto, and it is very unlikely that any of these measures are being considered for inclusion in the Autumn Statement. The recent review on the state pension, conducted by John Cridland, has left the impression that there is no clear consensus on pensions reform, with a danger of adding further confusion as auto enrollment develops. For those who have built nice large retirement pots under the defined benefit scheme there is probably lots of scope to provide for their children. However, most of the millennial generation will not have the luxury of wealthy parents and the pensions system needs a thorough overhaul for their sakes.
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