PENSIONS REVIEW - Workers can't have their cake and eat it.

The next few months will be confusing and irritating for the pensions companies. As Paul Greenwood, head of retirement research at William M Mercer points out, all that anyone in the industry can do during that time is wait for the government to publish the rest of its promised batch of consultative documents on stakeholder pensions. The first green paper, on charges, appeared in January. Others are promised in the coming weeks. “There is a letter from the DSS to the joint working group members which lists the as yet unpublished consultative papers as bearing on advice, taxation and rebate, and governance,” Greenwood says. And obviously, the industry needs to see government thinking in the round before it will be sure of where things are headed. “The government is committed to publishing all these papers by September or October and until they do, a number of elements remain unclear,” he notes. The consensus of opinion right now, Greenwood points out, is that despite the rhetoric about helping low-income groups, stakeholder pensions look as if they can be thought of as a simple rebadging of personal pensions, with a cap on charges (the rebadging is seen as a necessary consequence of the mis-selling scandal of recent years). What is new and different, though, is the deliberate effort to target low-paid employees. But the key unknown is the extent to which the government is prepared to subsidise pensions for the low-paid. “When we see the consultation document on taxation and rebates, that might give more of an idea as to how deeply the government is prepared to dip into the public purse to make these schemes viable,” Greenwood says. This aside, capping charges at a reasonable level is, most industry experts agree, no bad thing. A good personal pension right now, Greenwood points out, charges between three quarters of a percent to one percent on contributions to the fund, though in the worst case some funds can levy a one-off start-up charge of 6%. The justification for the higher charges is that they represent the cost of both management and “best advice”. The theory behind the government’s scheme at present, he suggests, seems to be that if stakeholder pensions can be separated out and specifically targeted at the £10,000 to £18,000p.a, or possibly even the under £21,000 income bracket, then it may be possible to drop some of the “best advice” requirements. Funds could be simplified by making them index trackers, for example, thus lowering management and administration costs. “The government is hoping that these schemes will be set up on an industry-wide scale. If they get the detail right, stakeholder pensions could end up being a very big idea. However, if they get it wrong, it’s not going to amount to much at all,” Greenwood says. One of the difficulties with low contribution pension plans of any sort is that there are really only two ways of increasing the size of the final stake available to buy an annuity on retirement. You have to increase either the level of risk or the level of contribution. “There is no way around the hard fact that decent pensions are expensive. Inflation can disguise this unpleasant fact for a bit, but people have to get used to the idea that if they really want to plan for their future, then they need to bite the bullet,” he says. David Segal, a partner in consulting actuaries Punter Southall & Co, points out that employers could find some real difficulties with the administration of stakeholder pensions. “It seems likely that employers are going to have to offer a stakeholder pension for every employee who is not eligible for the company’s occupational scheme,” he says. This could well include people on six-month probationary contracts, for example. But the mechanism for getting people to agree to transfer out of the stakeholder scheme and into the occupational scheme, when they become eligible, seems to pose problems. As Segal puts it, “There are bound to be some individuals who will come to feel that they have been misadvised after transferring from the one to the other.” Some of the basic rules that have been set out governing stakeholder pensions are quite interesting by comparison with run-of-the-mill personal pension plans, Segal says. For example, employees who fall within the earnings ceiling for this type of pension will be able to invest a maximum of 15% of gross pensionable earnings (which includes bonus payments as well as salary). They will also be able to pay into their partner’s fund as well as into their own. This last point means that a husband will be able to contribute to his wife’s plan while she is on maternity leave. Individuals will also be able to pay into their schemes for up to five years after leaving employment – although precisely how someone on the dole will be able to achieve this remains to be seen. But there are many areas where the detail remains unclear. “One of the big unknowns about stakeholder pensions has to do with how future administrations view them,” Segal says. “Even with SERPS, where there was broad cross-party consensus, we have seen an enormous amount of tinkering from government to government, so there is no way of knowing how this concept will run over the course of the next 50 years.” In common with many actuaries, Segal is satisfied that even for the relatively low-paid, a stakeholder pension that is funded at near the limit of 15% for 30 or 40 years, would generate a reasonable level of retirement benefit. However, he points out that this is the ideal case and experience with higher earning employees does not hold out much hope that people will in fact contribute on the scale that the government might like. The plain fact is that the statistics show that most employees, whatever their salary level, do not think seriously about funding their pension until they are in their 40s. Left this late, the cost of a pension can seem too steep for many to contemplate. “One of the beauties of the final salary scheme, as it has been conducted over the past 30 years, is that by and large a good level of provision has been made. By contrast, if one takes many of the money purchase schemes that are about at present, with annuity rates being as low as they are, it seems clear that these schemes are going to produce very disappointing levels of pension for many people,” Segal warns. He points out that where it is left up to employees to determine an appropriate level of contribution, experience with personal pensions and money purchase schemes suggest that few are prepared to invest as much as 10% of their income. “The reality is that most leave it to the point where the least they should be investing to avoid penury in their old age is double that, at 20%,” he says. Another difficulty with assessing stakeholder pensions at the present moment is that it is still unclear as to whether they are going to be on top of state benefits, or whether, as with today’s money purchase schemes, the monthly payment will disregard state earnings benefits, which employees can then claim on top of their money purchase pensions. As Segal notes, this continues to be an important point of distinction between money purchase schemes and final salary schemes. The latter usually start with the state benefits then top up the employee’s pension to the appropriate final salary percentage level out of the occupational fund. The return from a money purchase scheme may look low by comparison, since it excludes any consideration of the state benefit. But once this is added back in, the money purchase scheme can, under some circumstances, compare quite favourably with final salary schemes. “In principle, I believe that stakeholder pensions are a good thing,” says Segal. “The idea of moving to a capped charging structure is a good one, and it means that the government has recognised that encouraging personal pensions with unrestricted charges was a mistake. However, whether it will encourage many more individuals to invest responsibly for their own future remains to be seen.” He points out that, stakeholder pensions aside, all does not seem to be completely rosy with respect to mainstream pensions, whether of the final salary or the money purchase variety. “We are seeing more and more corporates either trying to finance final salary schemes on more optimistic assumptions, or moving to money purchase schemes with disappointingly low levels of employer contributions,” he says. At the same time, he points out, annuity prices have risen between 25% and 40% over the past few years. (The lower interest rates are, the more expensive it becomes to buy an annuity that will deliver a specific level of monthly benefit.) “Funds have been growing faster than expected, but they have not really grown fast enough to compensate for this rise in annuity costs,” Segal warns. Steve Bee, head of pensions strategy at Scottish Life, points out that research carried out by his company highlighted the fact that the average pension most low-paid workers judge to be acceptable is around £10,000 a year. “What people do not realise is that while many would list their house as their biggest asset, even this level of pension is worth three times the value of the average house,” he says. An average semi-detached house currently costs around £76,000. To get a £10,000 pension today a man aged 65 would need at least £200,000 in cash to buy an annuity. “What this means for people in even modest final salary schemes is that even a £10,000 a year pension provided by their employer is far and away their biggest and most valuable asset, and for many it dwarfs the value of their house,” he says. Bee says that the reason this point – like much else to do with pensions – is not grasped by most employees is that the UK has managed to create the most complicated pensions framework in the world over the past 30 years. “Stakeholder pensions were an opportunity for the government to introduce major reform and to give this country a pensions structure we could export to Europe. At present we have two complicated regimes: occupational and personal pension schemes. Now the government is introducing a third level. No one has ever seriously suggested that the way to drive costs down is to introduce yet another level of complexity. No one in Europe would want what we are building. It’s far too complicated,” he says. However, Bee adds that it is perhaps too early to come to a final judgement on the government’s efforts. The consultative process is still ongoing and there are some signs that the government is willing to listen to reason. “For example, we made a suggestion that we thought would be disregarded, namely that we should drop the exclusivity rule we have applied in this country since 1956. This is the rule that prevents you from having a personal plan if you are a member of an occupational scheme. We have said to the government that if it allows parallel schemes, then many of the complexities involved in introducing and maintaining stakeholder pensions will vanish. To our surprise and delight, a few weeks ago, Alastair Darling announced that parallel schemes are on the agenda.” Bee points out that one thing that the UK in general can be proud about is that the present generation of employees (through their political representatives) have not promised themselves pensions larger than they have funds for and, together with employers, have saved a total of £850bn. This, he says, is more than the pension savings of all the other EU countries combined. Complacency, however, is not in order. As the advent of money purchase schemes has shown, new regimes can erode established practices of employer contributions to employee pensions. Final salary schemes used to be funded at around 18% of payroll. Today they are funded at 12% of payroll, while money purchase schemes are funded to the tune of just 4% on average by employers. “My own concern is that the arrival of stakeholder schemes, where the employer has no financial commitment, will adversely impact the trend for employers to pay even less over time to established schemes. The addition of a zero into the equation on the employer’s side can accelerate this process dangerously,” he warns.