Future's grey

This summer the UK government will publish its long awaited white paper on the way forward for UK pensions. After three reports from Lord Turner’s Pensions Commission and a series of contradictory messages from government, primarily from the Chancellor Gordon Brown, it is hard to find any pensions expert who feels that they can predict the contents of that white paper with any confidence.

Will the government favour the introduction of compulsory contributions from employees and employers? Possibly. Will it be able to solve the complicated juggling act required to introduce compulsion without disrupting, and even destroying, existing occupational pension schemes? Probably not. Is the UK in better shape than our continental neighbours? Very probably. Does that mean we’re in good shape? Not exactly.

The government can either opt for Lord Turner’s National Pension Savings Plan or try to fudge some compromise with the now thoroughly discredited Stakeholder scheme. If it goes for some such ‘national’ scheme, it is not clear if the government will give it to the pensions industry to run, or render the industry largely superfluous by opting to run it itself.

There are enormous factors at play in the UK pensions market. The game could hardly be more serious. At stake is the health and well being of millions of retired people for decades to come, plus there is the small matter of the implications for the tax burden on those in work.

The problem the government is trying to grapple with is not just the savings gap – the difference between what we should be saving to have a reasonable old age and the amount we are actually saving. Government also has to somehow defuse the demographic time bomb.

Time bomb

The demographic time bomb has two major components. First, since the state pension is paid out of current tax revenues, rather than out of some carefully set aside national pensions pot, one runs into the issue of the imbalance between those in work and those out of work. As more people live longer, the number of retired people climbs relative to the number of people in work. At a certain point the arithmetic breaks down and taxes would have to become unrealistically high to keep supporting a growing aged population that is increasingly long lived, to a reasonable standard out of current tax revenues.

Second, there is also the politically dangerous possibility that the ageing population, being numerically significant, will organise themselves to become an ever more potent political force. As such, they could well frustrate future government attempts, in a parliamentary democracy, to somehow limit their pension entitlement in order to rectify the imbalance between those in work and those out of work.

To see this scenario at work, just look at the drubbing the government has already received at the hands of public sector workers in its recent attempt to try to restore some kind of parity between private and public sector pensions. These are not easy issues for politicians to “tweak”. Proclaiming policy is one thing, making it stick at street level is something else entirely.

Arthur Zegleman, managing consultant for Watson Wyatt in Scotland is not optimistic that the white paper will contain breathtaking solutions to these issues. “Most governments find it very difficult to grasp long-term issues,” he says.

“So far, the government has consulted and consulted, without making decisions. This is all about an inter-generational shift in both political clout and wealth,” says Zegleman. He points out that we are coming to the end of the baby boomer generation, a particularly fortunate generation which, by and large, has enjoyed better pensions than anyone is likely to be granted in future.

This generation went through a period where it was expected that every generation would be better off than the previous one, so providing a reasonable retirement pension became relatively easier. However, we are now in an era of low returns for investments and record levels of individual indebtedness. Saving for a pension today is not easy for anyone who is not already rich enough not to need a pension.

Government actions over the past few years have done a great deal to make things even more stable, as far as pension rights are concerned, for this favoured generation. The introduction of mandatory indexation of pensions for final salary schemes and other protections are instances of this. “If we have promised a proportion of the national cake to one generation that is out of whack with what the next generation are prepared to pay for, how is the government going to cope with this?” he asks.

Next generation

One thing you can bet on is that the baby boomer generation is not going to vote away its privileges. At the same time, today’s young adults joining the economy are going to start with a large chunk of educational debt, so getting on the housing ladder is going to be difficult for them. Saving for a pension will not be an option for them for a long time.

As Gary Cullen, head of pensions at law firm Maclay Murray & Spens notes, when people have no money, introducing them to compulsory pension payments makes no sense.

“In 1986, the government abolished the idea that an employee joining an organisation with a final salary scheme was compelled to join or contribute to that scheme,” says Cullen. This was a big vote winner for the government of the day. It is highly unlikely that reversing direction on this and reintroducing an even stronger form of compulsion will be a vote winner today, when the resulting pension is certain to be far poorer than the pensions arising from 1986-era final salary schemes. One suspects that government ministers will figure this out and that the thought will be a powerful disincentive to decisive action.

Another problem for the government is that it is still apparently fixated on forcing people to buy annuities when annuity rates are getting steadily worse. Cullen points out that the latest mortality statistics from the government actuaries department have actually driven annuity rates still lower. “Today, £100,000 will buy you a pension of around £4,000 a year from an annuity provider. The government faces a potential misselling crisis if it forces people to invest in pensions when they demonstrably will not gain from such an investment,” he says.

Rachel Vahey, head of pensions development at Scottish Equitable has a neat way of summarising the UK’s position compared with the rest of Europe when it comes to the pensions crisis. “We’re all capsized, but at least the UK has some wood to cling on to,” she says. Vahey believes that there is no doubt that the grey vote is going to get ever more powerful, and she points out that this trend is being amplified by the fact that the youth vote is becoming more and more apathetic, particularly on pensions issues.

“The government has a problem with means-testing. Undoubtedly, the introduction of the pension credit has helped many retired people on low benefits. But why save as a low-salaried person if your savings are going to get means-tested out of sight?” she asks. Will the white paper produce some coherent answers on the role of means testing versus the incentive to save? Vahey certainly hopes so. “The government has to convince people that if they save then they will be in a better position than their neighbour who did not save,” she says.

One thing Gordon Brown could do, of course, is to stop raiding people’s pensions via the stealthy dividend tax. Prior to Brown’s first Budget in July 1997, pension funds holding equities did not pay tax on dividends. The Chancellor ended that ‘perk’ and the popular estimate is that his ‘raid on pensions’ now takes around £5bn a year out of UK citizens’ pension funds. “It would be nice if he put that back, but it is incredibly unlikely,” says Vahey.

Vahey expects the government white paper to introduce mandatory enrolment (with the option of opting out) in occupational pensions (as opposed to the opt in system at present). She also expects compulsory employer contributions to feature.

“The problem facing the government is how to get the six million or so people who are not currently saving, to get saving. At the same time, the government has to think through the macroeconomic consequences of what might happen if people actually do start saving instead of spending,” she says.

German lessons

Jens Witt, managing consultant in the Munich office of Watson Wyatt, has first-hand experience of just how profoundly government tinkering with people’s attitudes to pensions can have macroeconomic consequences. The German government has been making a determined effort since 2000 to get to grips with its own version of the demographic time bomb and the pensions shortfall.

It has shifted the retirement age from 65 to 67 with effect from this year, a move that met with a good deal of pubic resistance. But the key macro economic effects have come from the fact that having heard their government expound upon the horrors of the penurious old age awaiting the profligate, Germans have thought the matter through and decided, en masse, to save.

Time to spend

“We are now in deep trouble, economically, because consumer spending has fallen dramatically, while savings have shot up,” says Witt. The German government, he says, has taken fright at this and has gone all out to try to tell people to get out there and have a good time; the message is to spend. But the Germans, remembering that bit about a horrendous old age if they don’t save, have dug their heels in and are generally counting each euro several times before they consider spending it.

In 2002, the German government introduced the Riester Rente, an attempt to get Germans to move away from a state supplied pension (paid out of a combination of social security payments and taxes) to a private savings scheme. At the same time, it cranked up the employers and employees social security contribution to a combined level of 19.5% of salary (to get the revenues up to pay pensions).

However, Witt points out that the tax advantages of the Riester Rente scheme are proving so attractive to Germans that the government is having to keep the maximum contribution possible to the Riester Rente scheme at unrealistically low levels and has, in any case, not committed itself beyond 2008 regarding the scheme’s continued existence. The irony of a lifetime pension scheme with a two-year life span and a low maximum contribution rate is not lost on the Germans.

All of which goes to show that any meaningful attempt by politicians to tackle the pensions crisis is fraught with difficulty. However, the recent announcement by the government that it intends to restore the link between the State pension and earnings in 2012 perhaps shows that not every intervention by politicians needs to be disastrous for the sector. Of itself, that step will do nothing to repair the damage that cancellation of indexation has already wrought to the pensions of millions. But, if it does come to pass, it will stop the damage from getting worse. We await the UK government’s white paper with interest.