Back to basics

From Pensions World
Geoff Ashton, Head of Retirement Practice

Pension provision is currently unattractive to employers and individuals alike. A recent survey by the SPC found that virtually half (46%) of the working population is not saving towards their retirement. Reasons include:

• Decent pension provision appears to be too expensive and uncertain
• An overly complex legal structure and excessive government involvement
• A chronic lack of knowledge and understanding

The rapid demise of private sector Defined Benefit (DB) schemes is a result of employers losing confidence in being able to cover the liabilities. Many employers have closed their DB schemes and fled to fixed Defined Contribution (DC) arrangements. This leaves the challenge of financing an adequate level of benefits in the hands of the member.

To get a reasonable DC pension the member needs to pay high contributions, have access to exceptional financial/investment skills and probably enjoy a lot of luck in the markets. If we are honest with ourselves even the best expertise in the markets has struggled to perform to adequately fund DB schemes and to deal with the technical aspects. How can we expect an individual to do any better on their own? Unlike trustees of DB Schemes, they cannot afford the best advice in each area, nor share the many funding risks (e.g. investment conditions, longevity) associated with pension provision.

Yet pension provision is a very simple concept - you save today to provide for tomorrow when you are unable, or simply do not wish, to work. There are three main parties involved: The State + you the beneficiary + your employer

The extent of each party’s involvement in each of the areas of provision is different and reflects the overall complexity of the system; proposed changes will increase complexity. Let’s consider how each of the proposed main areas of provision shapes up.

Solid foundation

The UK needs a State pension that provides a solid foundation for all and which is easy to understand. Very few people have a clear idea of their expected State pension. The basic pension and, to a greater extent, the State Second Pension (S2P) and its predecessors are cumbersome and difficult to understand. This has been recognised and the system is being amended (albeit at a snail’s pace) and by 2030 S2P will provide an additional basic flat rate pension. This will involve a series of changes that will still retain much of the past complexity.

A braver Government would take an early sledgehammer to the current system and provide one basic retirement pension for all UK citizens of, say, 30 years’ standing. This should not depend on the ridiculously complicated system of totting up years of national insurance credits when most qualify anyway.

Those who have fewer than 30 years’ citizenship could buy into the State pension on cost neutral terms to the tax payer. The new basic pension should exceed the current Pension Credit level removing further complexity. A simpler system would enable a significant portion of the administration costs to be channelled into better benefits. There would some winners and losers but for most the differences would not be significant. Being cynical, who would know how they were personally affected anyway?

Compulsory

If the State pension exceeds Pension Credit level then PA benefits will always be on top. This would remove a concern that PA benefits would only fund a gap between the Pension Credit and the State pension. To provide for all people PAs need to be compulsory for those in employment earning enough to pay income tax. Auto-enrolment simply allows people to opt-out of something that is a fundamentally a requirement - the State pension alone would not be enough for most to live on. It would also avoid the disproportionate costs of administering small levels of benefit. Under auto-enrolment many people will opt-out after a few months’ contributions because they simply want to spend the money elsewhere.

With the State and PAs providing a base level of benefits any further provision should remain voluntary. The ability to contract out of both State and PA provision should only be possible under high quality employer schemes. To avoid a dumbing down to the State plus PA level private provision needs to become more attractive by:

• Removing much of the current prescription, particularly for DB schemes
• Educating people on realistic retirement expectations as well as the many benefits of private provision.

More work needed

The A Day legislation has brought much simplification and is good in terms of the broad principles. The legislators though were over zealous in relation to some of the detail which often adds little for the Government or the consumer. An example of this is what are now dubbed ‘unauthorised payments’, for step children and overpaid pensions, which give rise to disproportionate bureaucracy in relation to what they achieve.

There are amendments being considered for the treatment of overpaid pension and the conditions for commutation of trivial pensions. However, these are slow coming through and the cost of the bureaucracy that will remain is still not justified; more work here is needed.

Simplification

This has been debated thoroughly elsewhere and the proposals put forward would simplify the requirements. However, in the main the legislators appear to be reluctant to rise to the challenge. Anything that provides legitimate retirement and death benefits on top of the State and the PAs should be encouraged by the Government. The design and generosity of a scheme should be for the employer to decide.

Areas to address for DB plans would include the removal of obligatory pension increases including those in respect of deferred entitlements. There is a current proposal that would enable a scheme to withhold an increase until the scheme funding can afford it. This is a step forward but why force any increases when a less generous employer need not provide any provision on top of PAs?

Disproportionate sums are spent in the UK managing relatively small benefits. Many schemes have a complex history and have accommodated many changes in benefit designs due to legal needs, benefit reviews or scheme mergers over the years. Many schemes would benefit from some streamlining by reshaping past accrual into a single easy to administer design. The relaxation in the Section 67 amendment requirements and the possibility of simplifying Guaranteed Minimum Pensions does not appear to have prompted much interest. Nevertheless, this is an area worth reviewing as the one-off costs of a change are often more than compensated by the benefits of simplification.

Education

So far most material concentrates on education of design features and, for DC members, the important aspects of contribution selection and investment choice. Most people are going to find that surviving on their retirement funds alone will not be tenable unless they defer full retirement until a later age. Therefore, they need to think about how long they need or want to remain in their current occupation and what they are going to do when this ends. This will probably involve a new occupation perhaps on a part-time basis. The ability to take some of their benefits until they can afford to fully retire will be important and something they need to factor into their thinking.

The cost of a given pension is significantly influenced by the age from which it is taken. Below are some examples of current level retirement annuities at different ages (with no dependant provision) based on a fund of £100,000 at age 60 increasing by 5% pa going forward:

Retirement Age	Male pensions pa	Female pensions pa
60	£7,015	£6,670
65	£9,998	£9,380
70	£14,678	£13,575
75	£22,443	£20,359

The above pensions exclude any further contributions to the fund beyond age 60, which would improve the level. To balance this it also ignores the impact of future improvements in mortality or exposure to poor investment conditions.

It can be seen that the annual pension is over twice the level at age 70 compared to age 60 and over three times more at age 75. The education needs to focus on identifying an age when the pension is sufficient to retire on and earning other income to live on until that time. This is a realistic approach given the longer, and healthier, life expectations we will enjoy compared to our parents and grandparents.

In a Nutshell

• Retirement planning needs a solid foundation, provided by a simpler universal State benefit above the current Pension Credit level, topped up by compulsory Personal Account membership
• Private provision needs less red tape and more encouragement
• Everyone needs help to plan for a retirement which may not be until age 70 or over.