This talk was given 12 May 2011
The text here may not be identical to the spoken text
THE DEATH OF FINAL SALARY PENSIONS
Any views I express are mine and mine alone.
The death of final salary pension schemes and what caused it.
Because they are dead. Don’t take my word for it. I looked into this a couple of weeks ago for Radio 4. And I tried to get – and expected – different views. Dead, dying, on life support, not very healthy, soon be home with their family. But no. Everyone I spoke to said – they are dead.
But in their Twilight – as is fashionable – the undead zombies are all around us making our lives difficult. But their life is limited and the more light you shine on them the quicker they go.
The programme did shine that light and you can hear it on iPlayer or download it or read a transcript.
Let me take you through the chronology of the death of final salary schemes. At one time they seemed to be just what every one of us would want. At work we pay an affordable, known contribution. And at a known age we retire on an adequate pension for life.
So what went wrong?
The first thing that killed final salary schemes was fairness. It’s an odd thing to say. But it is true.
The mid 1970s to the end of the 20th century is seen as the Golden Age of Pensions. Good company schemes were affordable, reliable and secure. But one key part of how they worked had long been hidden – 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 in a company with a pension scheme was automatically enrolled in it willy nilly, however long they planned to work there 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 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.
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. And that period was cut to two years and then six months.
Also from April 1988 the compulsion to join your company pension scheme was ended, so those who were not committed to long term employment were no longer in the scheme to be milked.
Ending that unfairness exposed another. In 1975 your pension would be based on your salary in cash terms when you left, so that was 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. So inflation was the next unfairness to be tackled.
That began in April 1978 when the bit relating to SERPS was inflation proofed – like SERPS – with RPI
On 1 January 1986 all contributions made from that January 1985 had to be inflation proofed
And in 1991 inflation proofing of preserved rights was extended to the whole pension whenever you paid in.
Then we get to a complicated bit – and all this is simplified – when pensions in payment were also revalued.
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 1 ppt lower than the RPI given the same price data. So another cut in rights.
Your scheme may offer more than that – but many will change to CPI despite Government chickening out on giving power to change trust deed.
So these two sets of changes stopped schemes stealing off members who left. And just as well because in many cases that meant men stealing from women. Because final salary pensions used to be particularly unfair to women. In many companies women could not join the scheme. Even when they were allowed to, a woman who married 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, got promotion, and were a man. But not otherwise.
I’ll put some numbers on the cost of that quarter century of introducing fairness later. But next Nigel Lawson. When he was Chancellor of the Exchequer he was very concerned that pension schemes which had built up tax-free were showing huge surpluses – they had more money than actuaries of the time said they needed to pay the pensions they had promised. And firms wanted this money back.
So Nigel Lawson decided to regulate this process and introduced Lawson’s Law. Every pension scheme had to cut its surplus to 105% of what the actuaries said it needed to meet its pension promises – in other words they had a margin of just 5% above that cost.
The firms could take the surplus back – but it would be taxed. Far more efficient was to reduce the amount they paid in. What we now call a contributions holiday. And most firms embraced that solution with glee. 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.
And here they are again split between contribution reductions and benefit enhancements. The total is a fraction short of £30bn. But these are historic cash figures. The cost today to funds of starving them of that money as long ago as 1986 is a lot more.
And for my Radio 4 programme Britain’s top actuary – Ronnie Bowie President of the Institute and Faculty of Actuaries – put the value of that now at around £50bn.
And Ronnie Bowie went further than just that figure. Here is how he referred to contribution holidays and how they affect pension funds now
they’ve fallen behind also because of greed - because many companies plundered the schemes for benefit augmentations - for contribution holidays, and so they’ve really… put shackles round the assets that couldn’t grow because they were being plundered in that way.”
Plundered. Top actuary Ronnie Bowie’s word for contribution holidays.
But if you ask people which Chancellor is to blame for problems with pension schemes it is not Nigel Lawson who crops up.
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 Gordon Brown changed the way dividends paid on shares were taxed. That had the effect of taking away the tax refunds on dividends which pension funds and others 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 – perhaps end their contribution holidays! And some years later when they didn’t do it he introduced the Pensions Regulator to make them do just that.
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 Pensions Policy Institute indicate 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. So the cost today?
Again Ronnie Bowie has put a figure on it and he said it was also about £50bn. So between Lawson’s Law and Brown’s pension tax grab maybe £100bn off the current value of pension funds.
After these perhaps surprising causes of pension scheme decline we have to add on the more familiar things.
Longevity – when final salary pensions were at their height in the mid 60s people could expect to live 12 years in retirement. Now that figure is almost twice as big 22 years. And it is still growing. Indeed by the end of this talk you will have gained about 4 minutes of extra life.
Actuaries, who had observed the rise in life expectancy for many years, used to say it can’t last – there will be an end. 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.
Investment returns have not been – and never will be – what they were in the last quarter of the last century when the return on shares – after inflation – was 8% a year for 25 years (Barclays Equity Gilt Study 2011).
And then we have to add in of course changes to regulations – accounting policies FRS17 which said companies have to declare their pension liabilities in their annual accounts. Minimum Funding Requirement, and now Scheme Specific Funding Requirement – those formulae which replace the best guesses which were used to allow contribution holidays – and which are now enforced by the Pensions Regulator. The total effect of those costs is not completely known. Here is what I have got so far
The Pensions Regulator tells me that over the last five financial years – up to April 2010 – firms have paid in a total of £90bn specifically to reduce deficits in agreement with the Regulator. In addition there is another £8bn paid in just in two quarters at the end of 2009 and start of 2010 in ‘special contributions’. So without even counting last year or some other contributions – and ignoring all the normal contributions paid in which have grown by £16bn a year between 2008 and 2010 – without those things we know of a total of around £100bn being put into schemes to cut the deficits. Which by coincidence is the total net effect of Lawson’s Law and Brown’s Grab – I leave it at that!
And the total effect of these changes was to turn final salary schemes from being cheap for employers and certain for their employees to being very expensive for employers and rather less certain for their employees.
Here is top actuary Ronnie Bowie’s analysis.
In those golden days before fairness, inflation, Lawson, longevity, Brown and regulation
The cost began around 5% for the employee and 6% for the employer. Early leavers added 2% Inflation protection added another 7% - that’s 9% for fairness - Brown’s grab added another 2% us all living longer another 8% and finally regulation added 10% - and that includes investment performance and contribution holidays. So now it is still 5% for the employee but 35% - neaerly six times as expensive – for the employer.
And one final thought – I leave you with it because I am out of time and it may point the way forward. There is another great unfairness at the heart of final salary schemes. They reward high flyers and penalise low flyers. I won’t go into the details – Lord Hutton does that and you can find other talks of mine that summarise them.
But because a final salary scheme pays a pension related to final salary and because contributions are a percentage of your salary year by year it is inevitable that someone who moves up the ranks and earns more year by year will get more per contribution than someone who stays on the same grade throughout their career. The admin assistant who becomes chief executive may be paying contributions based on an admin assistant’s pay for a third of their career – but those contributions will be buying a pension which is a percentage of chief exec’s salary.
In fact high flyers can quite easily get double the pension per pound paid in than the low flyer. So this unfairness is built in. The way to avoid that of course is to base the pension on average pay throughout the career. That deals with the final unfairness of final salary schemes. But whether moving to that will be enough to save what are called defined benefit schemes and the risks they impose on employers is not at all clear.
Finally let me leave you with a quip – courtesy of Tom McPhail of Hargreaves Lansdowne.
What’s the difference, he asked me, between final salary schemes and Bin Laden? Some people still believe Bin Laden isn't dead.