This talk was given 15 March 2011
The text here may not be identical to the spoken text
FAIR AND ADEQUATE PENSIONS
I’m Paul Lewis. I am a freelance financial journalist. I present Money Box and Money Box Live on Radio 4. And I do spots on Saturday and Thursday on Breakfast on BBC1.
The BBC is just one of my clients. I also write two columns a month for Saga Magazine which some of you may see – I know, at your mum’s or at the doctor’s. And I have just written my first piece for The Oldie. Ageing is a sad business.
As a freelance journalist, writer and broadcaster, I am not here representing any of my clients and in particular, because they get very antsy about it, not representing Money Box or, God forbid, the BBC.
So any views I express are mine and mine alone. You can read a selection of them and what I do on my website. And now you can keep up with them 24 hours a day through my twitter @paullewismoney – and see what I look like some years ago. Well it was the only photograph I had to hand. Olympics ticketing problems is the trending topic today
I eventually decided to call my talk to you today FAIR AND ADEQUATE PENSIONS. I toyed with the idea of a question mark after it but I hate that kind of hedging your bets.
So what is a fair and adequate pension? And how do we achieve one?
Final salary schemes have always been held up as the example of fair and adequate pensions. They are certainly seen as fair by employees but many of them do not consider them adequate judging by the emails I have been getting recently from people in public sector schemes. The median pension is less than £5,600, about the same as the state pension, so not huge.
But the real reason they are so liked is because they give three simple things. A known level of contributions. A guaranteed level of pension. And at a known age.
So you pay in your 5.5-7.5% or 6.4% of your monthly pay – before tax – and for every year you pay into the scheme you get 1/80th or 1/60th of your salary at retirement. So if you devote your working life to public service you can retire on half or two thirds of your pay when you retire, for the rest of your life, and protected fully against inflation.
Who wouldn’t want a pension like that?
The problem is that what happens between those monthly contributions in work and that monthly pension in retirement was just a black box, surrounded by mist, and filled with magic.
Arthur C Clarke said in 1973 that any sufficiently advanced technology is indistinguishable from magic. Just as we use our mobile phone but haven’t got a clue how it works so no-one really wondered how their pension worked. It did. We ignored the mechanism that drove our pension plan.
And all the time that such pensions were the standard in the private sector – where a pension existed at all – and while it was accepted that people in the public sector earned less than those in the private sector – then these good public sector pensions were accepted and rumbled on without much comment. Even the details of how they worked, the level of contributions, the benefits earned were actually quite difficult to find.
But now that private sector pensions are being closed down at a record rate – 17pc now shut even to existing members. Now that fewer and fewer people have access to them outside the public sector. All the details are being pored over for an advantage or disadvantage here or there the same pressures that are causing the flight from final salary in the private sector are being mapped across to the public sector.
Affordability is the first of these pressures. When Lord Hutton’s report came out on Thursday I was asked on BBC Breakfast if it was true that we couldn’t afford public sector pensions. I said ‘No, it’s not. We can afford them. We are choosing not to’.
Remember that there have already been many changes to public sector pensions. Between 2005-2008 all the main schemes that Hutton was concerned with have changed including the teacher’s Pension Scheme and the Local Government Pension Scheme paid in colleges. Contributions went up, pension age went up, though accrual rates got better for new members.
Then in the Budget last June the Chancellor announced that he would change the indexation from RPI to CPI. A huge change that will save billions every year – nearly £6bn in 2014-15 – mostly from those on state benefits but about £1.3bn of that from public sector pensions.
So after that can we afford them? So I turned to the Hutton report and there it is on p.22
“the Commission asked the Government Actuary’s
So now they cost us 1.9% of GDP of our national income. And over the next fifty years that cost will fall steadily and reach 1.4% in 2059/60.
When I asked Lord Hutton about that on Money Box on Saturday he said that such projections were ‘difficult to model’ and don’t ‘bet your shirt’ on them being right – be prudent.
But that prediction was made by the Government Actuary – no less – and took this uncertainty into account.
Here is his graph – from Hutton – reflecting that uncertainty. It shows that even the most pessimistic assumptions give a cost in 2059/60 which is less than it is now as a percentage of our national income.
And this graph was done before the Government decided to raise the contributions paid by members by around three percentage points.
I take the simple view that if we can afford the cost now we can afford it in the future. And that’s not just my view. It was confirmed in a conversation I had with the new Director of the Institute for Fiscal Studies Paul Johnson last week. In an email he said to me
“Yes these pensions are “affordable” … if that’s what government decided it wanted to spend its money on.
So it is not about affordability at all. It is about what we choose to spend our money on. And it comes down to the fairness issue that I mentioned earlier. If final salary schemes are disappearing throughout the private sector, if the Government is compelling employers through auto-enrolment to introduce a scheme with low contributions and no guarantees, is it fair to give final salary to people in the public sector when the cost and the risk is borne by taxpayers?
So that leads to the question – why are final salary pensions disappearing in the private sector?
My belief is they never could work as people believed they worked. And that as soon as the mechanism was looked at, it was fiddled with and that stopped it working.
Let’s look first at what the politicians did to wreck them.
As you may know the BBC is currently planning big cuts in the pension scheme. As a freelance I am just an interested bystander I am not allowed in the BBC scheme – which is why I’m still working. But one big complaint made by colleagues was that the BBC had taken a contribution holiday, not paid into the scheme, for 15 years. If it hadn’t enjoyed that holiday, the unions say, it would not be in this mess now. It’s a common view. Is it true?
When Nigel Lawson was Chancellor of the Exchequer in the 1980s 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 still paying in. 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 almost £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 almost all the contribution cuts benefited the employer. And the total is almost £30 billion taken out or given away in better benefits.
But these are historic cash figures. Between 1987 and 2000 the value of shares rose strongly. The FTSE 100 index – and I use that as a proxy for investment growth to illustrate my point – grew by a compound rate of 4.55% from 1987 when the surpluses were first reduced to the end of last year.
Most of these surpluses were taken out in the early years. And my latest calculation indicates that if those holidays had never been taken and those benefits had never been enhanced it would mean an extra £66 billion in pension funds today.
And those £9 billion worth of enhanced benefits mean more costs further down the track. So not only was less going in but future commitments were piling up. 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. 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? Anything up to £100bn off the current value of pension funds.
Both these raids were made because politicians saw the funds as too successful. They had too much money. The schemes can’t work well because of political interference.
There is a second unacknowledged reason why final salary schemes can’t survive in their present form.
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; investment returns were good.
And 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 stole 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. Millions were missold personal pensions instead – at a cost of £13 billion in compensation.
Then in April 2006 that 2-year period was cut to six months if you asked for it.
And 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 measure of inflation will be changed to the Consumer Prices Index. And the maths of the CPI, the formula used, means it is about 0.75% lower than the RPI given the same price data. So another cut in rights.
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 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.
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. Discrimination on grounds of sex was not illegal until 1975.
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 a man. But not otherwise.
Raids by politicians and increasing fairness to women and members who leave has led to a crisis in private sector, funded, final salary schemes.
I haven’t mentioned life expectancy which just grows and grows and grows.
Let me remind you briefly 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. And I have to cancel the funeral again!
And for pension planning these life expectancies are an underestimate. Not just because a lot of members are women who live longer, nearly three years more. But because the ONS produces another set of life expectancy statistics which add almost four years. 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’ which takes 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.
Actuaries, who had observed the rise in life expectancy for many years, always used to say it can’t last. 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 worked out the maths of life expectancy.
There is an easy answer of course – raise pension age. And as Hutton has recommended in the public sector it will rise with state pension age to 66 by 2020 and then to 67 and 68 and probably more as time passes. Though that will not necessarily apply to pensions in the private sector. Which may well then have an advantage.
And let me finally come to the main recommendation of Lord Hutton. Which tackles another fairness which few people had recognised
In his interim report Hutton 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.
The high flyer earns twice as much and therefore pays in twice as much to the pension.
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. (NB Hutton uses a female hi flyer and a male lo flyer but that is not the reality of the sexist employment world we live 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’s final report makes the difference a bit less using real public sector data.
There is another inequality which Hutton ignored. High flyers are more likely pay higher rate tax at some point in their career. So their pensions are more heavily subsidised by the taxes paid by others – including poor Louise of course. Every £1000 pound she pays in gets a Treasury contribution of £250. Every £1000 Henry pays in gets a Treasury contribution of £667. That makes a big difference and on my calculation increases the ratio of pension earned for each £1 spent out of net income from 1.89 to 2.52.
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 by giving them shorter life expectancies – then certainly longer than low flying Louis – the quiet 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. And as I am sure you know Henry will not necessarily even be more capable than Louise. Late promotion and the final salary pension promise have been used as a way to get rid of difficult older staff or to free up posts for younger people.
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 Chancellor George Osborne is likely to accept Lord Hutton’s final recommendation to extend it to all.
And I think you should embrace it. It is cheaper – but it is fairer and the way Hutton has ensured that the pension that is already paid for is protected is generous. The final salary pension earned up until the date of change – probably 2015 – will be preserved and related to final salary not at the point of change – as you would expect in the private sector – but at normal pension age.
Let me end as I began. Where are we on fair and adequate pensions?
I said at the start that all the while that pensions just worked we never looked inside the black box that converted contributions into an income for life at pension age.
And all three of those terms have now been attacked.
Contributions have risen and will rise again. Another 3% rise is planned from 2012 though how that will be shared out is not clear – except that the armed forces will not face a rise. Now that is 3 percentage points for LGPS and TPS will be around a 50% rise in their monthly contributions (3/5.5-6.5, 3/6.4). The rise is likely to be tapered – so it will be higher for the high flying Henrys and lower for the low flying Louises.
The guaranteed pension has been cut – it will be less in future though still defined.
And the fixed pension age is no more. It will be raised under Hutton’s plans automatically as state pension age and life expectancy rises.
So all three of the attractions of these pensions have been challenged. That undermines the psychological attraction of these pensions, and will lead some people to leave their public service pension. One of my twitter followers, Sue, who paid £150 a month into the LGPS told me on Money Box on Saturday
That is certainly a mistake. But understandable.
Because now that the three pillars of final salary schemes have been attacked – and for the second time in a decade – who is to say that a future government won’t come along when the last final salary scheme has disappeared from the private sector and say ‘we can’t afford this. We will only support paying into NEST at the minimum level of 3% employer and 5% employee and if you want more, see an Independent Financial Adviser.’
Now that would be the end of fair and affordable pensions.