The Future Of UK Pensions
by Martin Dolphin
The coalition government has made two major statements in 2014 about the future of UK pensions. In his March budget George Osborne announced that from April 2015 retirees would no longer be required to buy an annuity with the pension pot that they had accumulated over their working lives. In the Queen’s speech in early June it was announced that a change will be made to the pension laws to allow Dutch style collective pension funds. These two proposals, if enacted, will make a significant change to the pension landscape in the UK. Yet the strange thing about them is that they are contradictory and therefore, as a single policy, incoherent.
The proposal by Osborne to remove the requirement to buy an annuity addresses the problem that annuities were seen as poor value. £100,000 at age 65 would buy you an inflation proofed annuity of less than £4,000 per annum in today’s market and about £6,000 without inflation proofing. It was perceived that one of the reasons that annuity rates were so low is that the financial institutions had a captive market. Pensioners had to use their pension pots to buy an annuity. So the financial institutions were in a strong position to minimise their risks and maximize their returns from annuity sales. Hence annuity sales were one of the most profitable areas of the life insurance financial institutions.
Stephen Webb, the Liberal-Democrat pension minister, had been negotiating with the financial institutions to get them to reduce their costs in both the accumulation phase (when you build up your pension pot) and the decummulation phase (when you buy an annuity) of a pension. But progress was slow. The financial institutions were resisting at every turn. Osborne effectively cut the Gordion knot. He removed the legal requirement to buy an annuity. It is now up to the financial institutions to provide better value annuities if they want to continue selling them and to take the consequent reduction in their profits. This may seem like a good move but in fact Osborne’s proposal is a continuation of the bad approach to pensions initiated in the Thatcher administrations of the 1980s.
In the 1980s the Thatcher government promoted the idea that everyone should have their own personal pension pot which they manage over their working lives. They encouraged individuals and companies to opt out of the State Earning Related Pension System (SERPS) put in place in 1978 by Labour which aimed to give the worker on an average wage a pension in retirment equal to about 50% of his pre-retirment income. SERPS may have had some design problems but it was a move in the right direction and should have been further developed and built on. But the Thatcher administation did quite the opposite by creating private pensions, legalizing the right of individuals and companies to opt out of SERPS (John Major was the junior minister who put the legislation in place) and actively encouraging opting out with financial incentives. Instead of your pension contributions going into a pot with those of millions of others, everyone had their own private pot. Each pot had to be managed separately with consequent costs and what you got back depended on the behaviour of the stock market. Unlike SERPS where the pension was directly calculated from what you had put in. It is accepted now that opting out of SERPS has made pensioners poorer in retirement.
The accumulation phase of a pension when the pension pot is built up had become personalized. However the decummulation phase did not become personalized since the financial institutions that sell annuities base their annuity on the average life expectancy which is about 85 years. The pension pots of those who die early are used to pay the annuities of those who die later. However if you don’t buy an annuity then you take on completely the risk of running out of money in retirement if you have a longer than average life. So at one level it is highly advisable to buy an annuity but because they are currently such poor value it makes sense not to buy one. The pensioner is caught between a rock and a hard place. Osborne tapped into public dissatisfaction with annuities by no longer making it a legal requirement to buy one. He would probably argue that removing the legal requirement will force the life insurers to offer better annuity rates. That remains to be seen. But the idea of an annuity makes sense since it removes the concern over future income in retirement. What Osborne should have addressed was the level of annuity rates rather than allowing people not to buy annuities.
In contrast with Osborne, Stephen Webb, the Liberal-Democrat pension spokesman, is trying to address the level of annuity rates with his proposal in the Queen’s speech to legalize Collective Defined Contribution (CDC) schemes. His proposals would reverse much of the personalization of the pension system introduced under the Thatcher administrations. Under CDC rules employees would pay their pension contributions into the same fund as thousands, possibly tens of thousands of other workers. The cost of managing these funds would be shared over all the contributors. In Holland where CDCs play a large part in the pension system pension management costs are much less than those in the UK. It is generally accepted that these reduced costs will lead to a dramatic increase in pensions. In July 2012 the RSA made the following claim:
“If a typical young Dutch person and a typical young British person were both to save the same amount for their pension, if they were to retire on the same day, and die at the same age, the Dutch person is likely to get a pension which is at least 50% higher… [one reason is]…that in Holland
pension saving is typically done collectively.” Collective Pensions in the UK, RSA, July 2012
In their White Paper “The Case for Collective DC” the global insurance company Aon Hewitt report:
Modelling by the (UK) Government Actuaries department concluded: “CDC plans do appear to exhibit superior performance on average when compared to conventional DC plans. In theory this improvement is in the order of 20 to 25 per cent, but in the simulation it is as high as 39 per cent for some members.” (p. 17)
I said that Stephen Webb was trying to address the level of annuity rates with CDCs. This is slightly inaccurate because with CDCs annuities are replaced by target incomes that depend on the performance of the fund of which you are a member with thousands of other workers. So with a CDC you have a future income stream but its exact value is not guaranteed.
The British financial institutions are desperate to stop CDCs since they would remove the easy profits they have been making from pension provision and have latched onto this fact that CDCs provide only target pensions and not guaranteed pensions. They point to the fact that some Dutch pensioners have seen their pensions reduced because of the 2008 financial crash while the pensions of British pensioners have remained unchanged.
This argument has a grain of truth in it but is essentially weak. It is true that some Dutch CDCs have reduced the level of pensions. But as argued by Aon (p. 21):
“One quarter of Dutch CDC plans reported having to cut pensions by an average of 1.9% in 2012 to restore their funding level.
These benefit cuts will have priority for restoration, if and when financial conditions improve.
In the UK, by contrast, the cost of buying an annuity increased by 29% over the three years 2009-12. Those persons retiring from a DC plan in 2012 and buying an annuity would have seen a permanent drop in their retirement income of 29% compared with their 2009 colleagues – with no prospect of subsequent review or readjustment.” (p. 21)
Furthermore even if all Dutch pension funds had had to reduce pensions the argument would still be weak because in a CDC scheme a worker would, on average, have built up a considerably bigger pension pot than one in a UK style straight DC scheme because of lower costs in managing the CDC scheme. So even after a reduction in the Dutch pensioner’s pension he would still be substantially better off than the British pensioner.
In short a move to legalize CDC pension schemes should be supported. They will improve the pension of British workers. But it is wrong to suppose that they will dramatically improve those pensions without two other changes. Contributions to pension funds should be made mandatory as they are in all major European countries and the amount of the contribution should be raised to something approaching 20% to be shared between the worker and employer. Mandatory contributions of the order of 20% shared between worker and employer are typical in Germany, France, Holland, Denmark and Sweden. Only then will British workers really enjoy a decent standard of living in retirement.
Some excellent articles on CDC pensions can be found here:
Nigel Stanley from TUC: http://touchstoneblog.org.uk/2014/06/what-are-cdc-pensions-and-why-are-they-a-good-thing/
On the opting out of SERPS fiasco: