This talk was given 26 October 2010
The text here may not be identical to the spoken text
THE
END OF FINAL SALARY PENSIONS
What is killing final salary pension schemes?
CONTRIBUTION HOLIDAYS
As
you may know the unions at the BBC are currently balloting on strike action over
planned cuts in the BBC pension scheme. As a freelance I am an interested
bystander in this. I am not in the BBC scheme and every penny in my own pension
I put in myself. Which is why I shall be working for many years yet!
But
one big complaint made by BBC colleagues was that the BBC had taken a
contribution holiday not paid into the scheme for 15 years. If it hadn’t done
that, the unions believe, it would not be in this mess now. It’s a common view.
Is it true?
Now
I don’t have to tell you that contribution holidays were not a voluntary
activity – although employers embraced them gladly they were actually imposed by
the Government of the day. Specifically by Nigel Lawson. When he was Chancellor
of the Exchequer he was very concerned that companies were using pension funds
as a means of salting money away tax free and then taking it back out later. So
he introduced a rule that if a pension scheme had funds which were worth more
than 105% of what the actuaries said it needed to meet its pension promises,
then that surplus could be taxed. So companies scrambled to reduce the surplus
in their scheme. The most popular means of doing that was to reduce the amount
they paid in. What we now call a contributions holiday. But there were other
techniques. You could enhance the benefits paid to scheme members or you could
cut the contributions paid by those Here are the total amounts employers took
out – or stopped paying into – their pension funds from 1987 to 2006.
Over those 19 years employers took about £20 billion out of pension schemes,
employees benefited from cuts in their contributions worth about £1 billion and
were treated to enhanced benefits to the tune of around £9bn. So £21bn taken out
and £9bn of future commitments added. Though as you can see the benefits were
shared with two thirds in favour of employers, and almost all the contribution
cuts were by the employer.
But
these are historic cash figures. Between 1987 and 2000 the value of shares rose
as part of the golden quarter century. The FTSE 100 index – and I use that as a
proxy for investment growth to illustrate my point – grew by a compound rate of
8.84% from 1987 when the surpluses were first reduced to the year 2000 and 4.55%
a year from 1987 to now.
Most of these surpluses were taken out in the early years. And a rough
calculation indicates that if those holidays had never been taken and those
benefits had never been enhanced it would mean an extra £48 billion in pension
funds today.
And
don’t ignore those enhanced benefits. £9 billion worth. They mean more costs
further down the track. So not only was less going in but future commitments
were piling up. So contribution holidays and benefit enhancements – all
consequences of Lawson’s Law – have played a big part in the problems final
salary schemes face today.
I
will pass more quickly over the more familiar pensions raid by Gordon Brown. In
1997 the modernising Chancellor of the new Labour Government decided that the
way companies were taxed was so complex it reduced their incentives to invest.
So he changed the way dividends paid on shares were taxed. That had the effect
of taking away the tax refunds on dividends which pension funds enjoyed. Brown
insisted it was not the purpose of the change, and if companies saved money as a
result they could put it back into their pension funds if they had to. And later
he introduced the Pensions Regulator to make them do just that.
But
the total cost to pension funds and others of the change to the tax on dividends
was £5.4 billion in the first year. However, estimates by the Pension Policy
Institute calculated that the true cost to pension funds was much less – between
£2.5 and £3.5 billion a year, and that figure reduces over time. Today so many
other changes have happened that it is impossible to put the clock back and see
what if it had never happened. But it was certainly less than the potential
shortfall in those funds caused by Lawson’s Law. And between them? Maybe £60 -
£100bn off the current value of pension funds. I know that’s a bit vague – and
I’m not even an actuary.
One
final word on ‘contribution holidays’. It is easy to blame politicians. And fun.
And we know from those official figures that around £30 billion was withheld
from funds because of Lawson’s Law. But before that law began, some companies,
being told by actuaries that their pensions were over-funded, took contribution
holidays without being forced by Lawson’s Law. No-one counted them. So we do not
know how much it was or how much it added to current deficits.
FAIRNESS
Next candidate for what is killing final salary schemes is fairness.
The
mid 1970s on to the end of the 20th century is seen as the Golden Age
of Pensions. Good company schemes were affordable, reliable and secure. But it
was also the quarter century when the seeds of the destruction of final salary
schemes were sown. And one key part of that is often ignored – final salary
pension schemes stole money from people who left before they retired.
Remember that at the start of the Golden Age if there was a pension scheme you
had to join it. So everyone who worked for one of these top companies was
automatically enrolled in the pension scheme willy nilly, however long they
planned to work for the company and whatever their personal circumstances.
Until 1975 if you left the company you also left the pension scheme and you got
nothing. Or almost. The contributions you had made were refunded – minus tax
because you had made them out of tax-free income so the Revenue took that back.
But the fund kept the growth on those contributions. And it kept the
contributions paid in by your employer – which were always more than you had put
in. And it kept the growth on those too. So those who stayed in the scheme took
most of the contributions and all of the growth from those early leavers.
Over the next three decades that unfairness was removed piece by piece.
From April 1975 if you left the job you could leave your contributions in the
pension fund and draw your pension when you finally reached the scheme’s pension
age. Your pension would be based on your salary
in cash terms when you left, so
still a huge gain to the fund when you eventually retired and you were given a
pension based on, for example, a 20 year old salary.
From 1986 anyone who left with at least five years in a fund could take the
value of their pension rights with them and transfer that value into another
pension scheme.
A
couple of years later, in April 1988, the five year period was cut to two years.
And at the same time the compulsion to join your company pension scheme was
ended. And those who were not committed to long term employment were no longer
in the scheme to be milked.
Then in April 2006 that was cut to six months if you asked for it.
At
the same time as your rights to get your pension out were enhanced, so was the
value of what you took out.
When you got nothing then it was still worth nothing when you retired.
Then in April 1978 the bit relating to SERPS was inflation proofed – like SERPS
with RPI but with a cap to make it not an open-ended commitment – only
Governments make those!
On
1 January 1985 all contributions made from that date had to be inflation proofed
– rising with prices measured by the RPI not earnings, and capped at 5% a year.
Then in 1991 inflation proofing of preserved rights was extended to the whole
pension whenever you paid in.
Then on A Day, April 2006, the tide turned with the first example of reducing
the rights in a final salary pension scheme – the cap on inflation proofing was
cut from 5% to 2.5%.
And
from April 2011 that cap will remain at 2.5% but the chance of ever reaching it
will be reduced as the measure of inflation will be changed to the Consumer
Prices Index. And the maths of the CPI, the formula used, means it is about 0.5%
to 0.75% lower than the RPI given the same price data. So another cut in rights.
Your scheme may offer more than that – but my view is there will be a new law to
let you abrogate those contract terms – prediction not information!
Before these changes final salary pensions were particularly unfair to women. In
many companies women could not join the scheme.
The
Equal Pay Act of 1970 – Barbara Castle where are you now! – celebrated in the
wonderful film Made in Dagenham, did
not include pensions. It took years of campaigning and court cases to get the
European Union to declare that pensions were a form of deferred pay and so
extend the Equal Pay Act to mean equal access and contributions to pensions.
Discrimination on grounds of sex was not illegal until 1975. Even when women
were allowed to join a pension scheme, if a woman married she often had to leave
her job – and lose her pension. She became an early leaver to be robbed.
So
ending the practice of stealing from early leavers – many of them women – has
played a major part in making salary related schemes unaffordable.
So,
yes there was a golden age – for some. If you were with the right employer,
worked there for 40 years, and were a man. But not otherwise.
STRUCTURE
And
there is another unfair aspect of final salary schemes which was brought to
light by John Hutton – Lord Hutton of Furness as he now is –John Hutton, in his
interim report of the Independent Public Service Pension Commission, compared
final salary schemes with schemes where the pension is based on career average
earnings. And noted that high-flyers can get double the pension benefit from
their pension contributions than those who are not high flyers.
This analysis was not original. It used a paper from 2007 by Charles Sutcliffe
of the ICMA centre at Reading University. He found that a high flyer whose pay
rose by 3.5% a year in real terms over a 40 year career would end up with pay of
just over double that of a low flying colleague who stayed in the same job for
40 years and gained no real rise in pay.
But
because the pension was related to final salary, the pension earned by that pay
was not 2.02 times higher but 3.83 times higher. And that means that for each
pound he pays in, High Flying Henry earned nearly twice the pension that Low
Flying Louise earns for each pound she puts in.
Each £1000 of contributions Henry pays in buys him a pension of £178.24. Each
£1000 Louise pays in buys her just £94.18. That is a ratio of 1:1.89 – not quite
half as Hutton said but not far off. And you can devise scenarios which are even
worse.
Hutton gives the high flyer a woman’s name. And the low flyer a man’s. But that
isn’t the reality is it? We know that despite 40 years of equal pay laws women
earn less than men. We know that women have a lower chance of promotion than
men. And we know that women get lower pensions than men. And those facts are all
related. So I have stuck with the sexist reality not embarked on the political
spin of women out-performing men – some do of course; but men conspire to stop
them when they can.
And
of course from April 2011 when the 50% tax rate applies to taxable income above
£150,000 a year the subsidy will be even bigger. Someone on £250,000 salary who
puts the new maximum of £50,000 into a pension will find it is matched pound for
pound by a generous Treasury – yes from the taxes of those very people on
£15,000 a year who probably have no pension scheme and no personal pension
either. And just to be clear: you earn £250,000, put £50,000 into a pension
scheme out of your taxed income and George Osborne stumps up another £50,000 in
subsidy.
This slide is a bit out of date but it shows how the minority if higher rate
taxpayers get the bulk of the tax relief on pensions.
And
beyond that, Henry, being richer and living in a nicer neighbourhood is probably
going to live longer – if not than Louise because nature does take its revenge
at this point on men for their lifelong selfishness towards women – then
certainly longer than low flying Louis. The man in the back office who keeps his
low paid administrative job all his life.
So
Henry will get a bigger pension; get more per pound contributed; pay less for it
due to the bigger Treasury taxpayer subsidy; and draw it for longer than low
paid colleagues. No wonder he’s called Hooray Henry.
So
final salary schemes also work by stealing money from low flyers and giving it
to their bosses.
All
this assumes of course that Henry is promoted on merit. But you will know as
trustees that final salary pension schemes with surpluses have been used as a
way to get rid of difficult older staff, to free up the promotion ladder, or
just to give mega-rewards for friends of the directors.
Career average can end all those abuses. And that is why the civil service
pension scheme moved to it in 2008. At the moment the civil service scheme is
alone among public service pensions. But Lord Hutton seems set to recommend its
extension to all of them and Chancellor George Osborne looks ready to accept
Lord Hutton in full.
He
has already announced in the Spending Review that he would implement
Lord Hutton’s easy win of raising the contributions paid by millions of
people in public service pensions – police officers, firefighters, judges,
teachers, nurses, doctors, civil servants, local authority workers indeed all
public service pensions with the single exception of the armed forces. The rise
will be 3%, Or, more accurately, three percentage points. So for someone paying
6% now they will pay 9% from April 2012 – three percentage points is in fact a
50% rise in their contributions. It will save the government almost £2 billion a
year from 2014/15. And the Spending Review papers make clear that the cost of
exempting the armed forces – announced by George Osborne in his speech last week
to patriotic cheers – will be paid for by the rest of the pension schemes. So
the average rise will be slightly more than 3%.
LONGEVITY
Now
our next culprit – longevity.
It
is now a given that we are living longer – and longer – and longer. And that the
pension we and our employer have paid into will have to last for longer and
longer and longer. And it is inevitable that a finite pension will be worth less
and less and less when spread over more and more and more years. Final salary
pensions are a promise for life – however long that is. And as it stretches,
either we have to save more. Or we have to retire later. Or we have to change
the nature of the pension promise that is made. Or all three.
Let
me just remind you of the scale of it. Each October the Office for National
Statistics tells us how long we can expect to live. And it is always good news.
Last year using the tables I was due to die on 26 December 2029 at the age of
81. But when the tables were published for this year my date of death had
shifted by three months to 27 March 2030. A year on and I get three months more
life. These figures represent the age at which half those alive today will have
died and half will not. Some of that rise is due to the fact that I have
survived another year. But not much.
If
we take a man who was aged 65, a year ago he could expect 17 years and 135 days
of life. A man aged 65 this year can expect of life 17 years and 219 days of
life. Another 84 days = 12 weeks or nearly three months.
And
for pension planning these life expectancies are an underestimate. Not just
because a lot of members are women who live longer – not 17 years and 135 days
as a man might but 20 years and 87 days, nearly three years more. But because
the ONS produces another set of life expectancy statistics which add almost four
years to these life expectancies. They show that a man who is 65 years old this
year can actually expect to live until he is 86 and four months and a 65 year
old woman until she is nearly 89.
These higher figures are called ‘cohort life expectancy’ rather than ‘period
life expectancy’. Period life expectancy assumes that today’s life expectancy
will stay constant. Whereas in fact it won’t. Cohort life expectancy does take
some account of the increase in life expectancy. It
reflects the
fact that not only is life getting longer, every time actuaries look at what it
might be in future, it has grown again. And even though they build that error
into today’s prediction, next time they look it is longer still. Actuaries
who had observed the rise in life expectancy for many years always used to say
it can’t last. And tail it off in their future calculations. But in
October 2005 the
Government Actuary, Chris Daykin, announced that he had stopped assuming that
the length of life had some ultimate biological limit. In other words, the age
we live to really could go on increasing forever. Or as he put it in
actuary-speak ‘Previous projections have assumed that rates of mortality would
gradually diminish in the long term… However… the previous long-term assumptions
have been too pessimistic. Thus… the rates of improvement after 2029 are now
assumed to remain constant.’
‘now
assumed to remain constant.’
It is one of the
most important pronouncements of actuaries ever since their profession began in
the 18th century when men walked round graveyards and noted down birth and death
dates and working out a theory of life expectancy.
But back to my
life. When I first did this slide in 2004 the figures were these. I was
expecting to die in 2027. And in 1985 when I took out the first of my inadequate
pensions the arithmetic for how much was needed to pay me assumed I would die in
2024. So over that time I have gained six and a quarter years of life. And from
65 my life has grown by 58%. And so has the cost of providing me with a defined
benefit pension. Shame I haven’t got one!
There is an easy
answer of course – raise pension age, And with the state pension age rising to
66 by 2020 and then to 67 and 68 and probably more, occupational schemes will
have to raise their age too. Again legislation would be needed to make that
retrospective
INVESTMENT PERFORMANCE
Next is investment performance and the financial services industry
I
have missed out for time reasons the bit about the charges the financial
services industry levies. For an individual a quarter of their lifetime
contributions can go in charges. And any growth in the fund can easily be shared
50:50 with the fund manager. These charges are of course entirely unrelated to
the actual performance of the investment. They are levied whether the fund meets
its objectives or not.
The
industry says of course that the charges are worth it because you get better
performance. And the industry still believes in its maxim – if you want a bigger
reward you have to take a risk. But think about it – a risk doesn’t guarantee a
bigger reward. If it did it wouldn’t be a risk.
The
three largest public sector pension schemes in Canada lost 19% or C$72 billion
off their C$385 billion assets in 2008 because their active managers prefer to
put the money at risk in shares rather than keep it in safer bonds. Defending
this approach Jim Leech, the CEO of the Ontario Teachers’ Pension Plan which
lost C$20 billion, said ‘The fact of the matter is we have to take on risk to
meet our pension promise.’ Oh Jim! If taking a risk guaranteed those extra
returns you need so badly it wouldn't be a risk would it? The risk is you may
lose another C$20 billion. Perhaps he should have listened to Toronto teacher
Kelly Alles ‘A high return is great’ she told the magazine
Canadian Business in July 2008 ‘but
when it comes right down to it I'd rather have a guaranteed lower return’.
And
that is what is missing in pensions. Genuine options that allow money to be
invested in cash and other options that produces a guaranteed positive return
year after year rather than shares, property, commodities, balanced portfolios,
absolute return funds and the like – none of which do. My risk reward balance is
this. If you never take a risk you will be certain of a small reward.
TRUSTEES
And
finally in my list of things that threaten final salary pension schemes let me
add trustees. Many of you are amateurs. But you are up against the professionals
in the financial services industry. Who want you to take a risk so they can get
a reward. And you are in many cases up against the professionals from the
sponsoring company – the finance director, the head of personnel – sorry Human
Resources Director. Who want you to close down the scheme so they can shift the
risk to the members – and cut the contributions while they are doing it.
But
trustees have a sacred duty – to act in the interests of their members. And it
is never in the interest of members to lose a defined benefit scheme. But there
are difficult choices to make to find a change in a pension scheme to make it
sustainable, to help prevent it closing down.
And
I am sorry to say that nowadays, with no stealing from early leavers; with the
evidence about high flyers taking more out of the scheme than ordinary members;
with investment returns that are modest and charges that are anything but; the
fair and sustainable way to preserve defined benefit pensions is probably going
to be a career average scheme with, of course, a later retirement date.
Better to swallow those two bitter pills than throw your members on the mercy of
the financial services industry where they take huge charges from their
contributions, give them limited choice, poor advice, and no guarantees at all
except that after a lifetime of contributing their money purchase pension will
not be enough to live on.
Thank you.