This article was originally commissioned and published in February 2013 for Investment Life & Pensions Moneyfacts publication. Tom Murray, Head of Product Strategy at Exaxe, explores the need to re-create pensions for the 21st century and argues that the Government's latest White Paper is a great start in simplifying pensions
The ‘Part 1’ of the title of this article is considered. Not only does it refer to the fact that the article will run across two issues, with a Part 2 following next month but also that the reforms by the current government have been extensive but cannot be regarded as completed yet; they have more to do.
The recent publishing of a whitepaper on state pension reform by the DWP office is not just an opportune time to look forward to the changes that are proposed and how they will affect the pension landscape but also to look back to see whether we are achieving the original aims for pensions or whether we have got lost in the incremental changes of direction that have been made over the decades. Those of us involved in the pensions industry are often too caught up in the daily issues of providing advice and products for the pension market or busy trying to predict what the pension requirements of the population will be in the future. Rarely do you go to any conference which stops to reflect on the past; to examine progress against those goals and whether or not they should be changed.
For the majority of the population pensions are a relatively new concept and therefore cannot be regarded as being sufficiently tested for us to be absolutely sure that we are truly solving the problems that caused them to be introduced at the start.
Pensions for all
Popular pensions in the UK can be reasonably said to have begun with the introduction of the 1908 Old-Age Pensions Act, introduced a mere 105 years ago. The purpose of the act, which was the cause of fierce debate across the nation, was to provide a basic living existence to those over the age of 70 so that they would not be faced with the ‘Poor-Law’ approach of the workhouse, with all its Dickensian connotations. The initial old-age pension was for 5 shillings a week, means tested, and was set deliberately low so that people would be encouraged to save for their old age themselves.
Over the years since this initial pension was introduced, the scope of pensions has spectacularly increased as society’s views on the role of government have altered. A noticeably more paternalistic approach was assumed by intervening governments, whereby it was generally accepted that citizens had a right to retirement and that employers and the state would play a major part in contributing to the support of citizens in their old age. As a result, people stopped fearing old age and lived with the comfortable assumption that they would always be provided for. Almost all large employers provided defined benefit pension plans as did the public service and lots of medium and smaller employers. It was the golden age for the silver-haired brigade.
But this approach to retirement differed from the original plans of Lloyd George in his 1908 pension act in one significant aspect; it didn’t focus on encouraging people to provide for themselves in their later years by deferring spending from their younger years and putting the money thereby saved into a pension fund. Instead, in a time of growing prosperity, contributions from employees were set low or were non-existent and a disconnect arose in the minds of the population between the receipt of a pension and the earlier phase of accumulating the cash to pay for them.
For many decades this didn’t matter as longevity was growing relatively slowly among the population at large. The number of people who made it to retirement age was low and the number of years they lived in retirement was also low. However, from the 1980s onwards, actuarial projections started to show that the rise in longevity was becoming steeper and accordingly both the number of people who would claim pensions and the length of time they would claim them for began to grow exponentially. The unaffordability of pensions both state and company in their current format was becoming apparent. Initially, little was said as the message was politically unpopular and the ‘grey’ vote was significant and growing stronger in most western democracies. This prevented the governments from acting. Meanwhile, in the absence of popular acceptance of the problem, the large companies found that it was not possible to take action.
Eventually as succeeding reports showed the situation was worsening year by year, the corporates started to crack. As longevity raised the amount needed to provide for each individual retiree and the number of retirees increased with the approach of the baby-boomers to the retirement age, the strain on corporate balance sheets of liabilities to their defined benefit schemes became unbearable. One by one they started to close their schemes to new employees, offering those employees a defined contribution scheme instead. This move transferred the longevity and investment risk from the company to the employee. As the larger corporates moved, the smaller ones quickly followed suit and soon the only significant employer left shouldering the risks was the government.
Rising governments’ deficits worldwide finally brought home to governments the sheer cost of providing for the older members of society and this was going to be made worse by the lack of personal saving being undertaken by the current generation. In terms of attitude, it appears in the space of 100 years, the population had moved from one that feared the workhouse and poverty in their old age into one which never gave it a thought until a few years before their retirement because they assumed that either the government or their employer or both would guarantee them a comfortable retirement.
This was a drastic shift in the perceptions of people and as the new millennium dawned, it shone a ray of light into the collective mind-set of the government. They realised that they would have to take action or there would be a significant problem in the medium term. In a mere 50 years there would only be 2 taxpayers to support every pensioner compared to 4 for each one now. Thus the burden would become almost impossible for the working population to bear, resulting inevitably in a cut in pensions of such severity that it would cause a drastic drop in the living standards of the pensioners, which would result in popular strife and discontent.
Pensions Time Bomb
Pension reform became the rallying cry across the western democracies and the phrase “Pensions Time Bomb” quickly became a cliché as commentators discussed it endlessly in the media. This background gave the government the opportunity to start the process of resolving the issue. There were two sides to the problem; the public pensions paid to all qualifying citizens and the pensions paid to government employees, whether in the civil or public service. Given the immediate difficulties that would face the government in fundamentally restructuring the pensions of the public sector and the risk of unionised disruption to the day-to-day work of the government, the government so far has focused on the state pension paid to all citizens.
Make them save
The government quickly set about researching the way forward and reverted to Lloyd George’s original approach of encouraging people to save for their own retirement. Thus was born the idea of auto-enrolment, currently being rolled out across the UK in a five-year programme. Auto-enrolment is designed to encourage saving by exploiting inertia. By automatically putting people into pension schemes while permitting them to actively opt out, the assumption is that the majority will remain in and therefore automatically start saving for their own retirement.
The idea is good and will undoubtedly significantly increase the number of people saving for their own retirement. However a number of flaws quickly became evident. In particular, there was a likelihood that with so many of the new savers coming from the low-earners in society, the only effect of their savings would be to decrease the amount of top-up benefits they would get essentially leaving them no better off than those who had opted out and were relying on the state to provide for everything in their retirement. The other big issue was that in that event, the employer could be deemed to be liable for their loss as they had automatically auto-enrolled the individual into a pension scheme whose implications the employee did not necessarily understand. The result is a savings trap, whereby those who don’t earn enough to save much are actually better off not saving at all and employers who are supposed to encourage pension saving are wary of doing so.
Levelling the platform
Another consultation had to be undertaken to deal with the perceived flaws in the auto-enrolment approach. As a result the government have just published a new whitepaper entitled “The single-tier pension: a simple foundation for saving” on pension reform. This latest reform whitepaper introduces a flat rate basic state pension (BSP). This is a huge enhancement to the state pension system as it is going to give a flat rate pension to all citizens who have 35 qualifying years of an amount equivalent to £144 in today’s money. This rate will move almost all people above the level where they would qualify for top-up, means-tested benefits and therefore take the vast majority of the population out of the savings trap created by auto-enrolment. It will become much easier to persuade people to save for their future when there is practically no chance that they will lose out because of that saving.
This is a return to the fundamentals of the pension scheme envisaged by Lloyd George where the state provided a minimum level in order to prevent absolute poverty but the quality of peoples’ lifestyles in retirement above that minimum depended upon their own efforts. This approach will provide support to the auto-enrolment process and will relieve employers of their particular concern.
This is all very well but it will not in itself solve the looming pension crisis because significant numbers of people will still opt out of saving. The government have shied away from being blunt with the population. Until the average citizen is woken up from his or her daydream and starts to worry about their future seriously, then there will be no significant drop in the government’s obligations, which will snowball into a huge problem awaiting the taxpayer around the middle of this century – in pension terms not a long way away.
Well begun is half done
This latest whitepaper is a great start in simplifying pensions and bringing people back to taking responsibility and even an interest in providing for their own future. Much more, however needs to be done. Next month I will take a look at further reforms which are necessary to give us a pension system that is sustainable and fair and that engages the population so that we can give everyone the opportunity to have sufficient income to enjoy a decent and dignified retirement.
Part two of this article is now available on the Exaxe blog: http://www.exaxe.com/moneyfacts-pension-reform-part2.
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