The death of the DB scheme, auto-enrollment, the introduction of the Pensions Accounts and a tougher tax regime moving inexorably from the mass affluent to middle income earners– are we headed for the perfect storm for pensions providers and policy holders alike? Chris Read, Chairman of pensions administration software provider Dunstan Thomas investigates.
The turn of the year and indeed the decade that came to be known as the ‘noughties’ is a good moment to look back a few years and then forwards at the implications for imminent developments in pensions and where it is all leading us. Is retirement provision, for at least one generation of pensioners, headed towards the rocks or is the light house going to switch on at the last minute and direct us all towards a safe harbour in retirement?
Demise of DB
For those of us in Defined Benefits (DB) schemes those rocks look fairly close at hand even if we cannot see them yet. Aon Consulting revealed that the combined deficit of the UK’s 200 leading DB pension schemes increased to £73 billion during the second quarter of 2009 and is now escalating inexorably as a result of increased longevity – the much vaunted ‘demographic time bomb’.
At the same time, funds have lost value during the recession and larger provisions have had to be set aside to prop them up. So understandably, there is not a CEO in the land that is not looking hard at how to reduce the rising debt burden created by their failing DB schemes.
One study of UK company pension schemes published by leading employer benefits consultancy Watson Wyatt in August 2009, suggested that half of all DB schemes will close within the next three years. Price Waterhouse Coopers supported this by claiming in a separate study that 96% of UK businesses with DB schemes believed their schemes were unsustainable.
Indeed, the majority of the UK’s DB schemes are already closed (75%) to new members and firms are increasingly opting to exclude existing members as well. According to Watson Wyatt, 9% of companies have shut schemes to existing members, but the figure could rise to 50% by 2012.
If the DB demise happens as predicted by these experts, more than one million members of DB schemes will be transferring to Defined Contribution (DC) arrangements in the next three years. The transfer of so many employees into personal or group DC schemes is definitely a concern for DB scheme members who until recently would have been looking at very secure retirement future with a pension based normally on a healthy percentage of their final salary and were once all index linked so they were not undermined by inflation. It now looks highly likely that none of these schemes will be available to Generation Y and only those operating in the public sector and retiring in the next few years or so seem likely to get the full benefit of DB offerings.
Government response – Auto Enrollment & Personal Accounts
Everyone also knows that once pensions contributions start to become voluntary (as is currently the case with all DC schemes) then contribution levels fall inexorably as people find more immediate things to do with their money. Government studies show that the recommended levels of contribution to live a comfortable life in retirement is 20% of salary throughout your working life. But average DC contributions are well below this, perhaps as low as 3%, generating an average pension investment value of little more than £20,000 in total, generating an annual income which is probably less than £1,000!
The Pensions Commission has put some figures around the level of retirement under funding going on in the UK today. They estimate that up to 12 million people are under saving based on the benchmarks they set out. In order to counteract this, the Government is introducing a national pension savings scheme known as Personal Accounts which now plans to auto enroll at least 12 million people into the Government-managed scheme by 2013 (yes it’s just slipped by a year in the latest Pre-Budget Report).
Under the new system, all employees will be automatically included in a personal account pension scheme unless their employer already offers a suitable alternative pension. Importantly, employees will be compelled to contribute 4% of band earnings and employers will have to contribute 3%. A further 1% will be paid in the form of tax relief creating a total contribution of 8% of band earnings which will be paid into a personal accounts pension scheme from April 2013. 8% is commonly believed to be the minimum level that we need to be contributing today to avoid living below the poverty line when we retire, assuming we have no other income in retirement. The 8% contribution will have to rise as longevity continues to go up.
But the Government is already back sliding on the original 2012 target recognising that auto enrollment will hit cash strapped small businesses very hard and that it needs to avoid accelerating the resulting tax relief burden too quickly because of the current parlous state of our public finances. It will also be difficult and expensive to police them (through the already established Personal Account Development Authority) so it looks like the requirement will fall to less than 8% initially and will work up to this level by 2014 or later. Larger firms will be targeted for personal account implementation first and smaller firms at the end of the process, according to industry insiders.
The recent Pre-Budget Report (PBR) provided more detail. Alastair Darling announced plans to cap public sector pension contributions from the state by 2012, to save around £1bn a year from 2012-13 and “at least twice this amount over the long-term”. The PBR noted that cost increases below the cap would be shared equally between employers and employees, while those cost increases above the cap would be met solely by employees. It also stated public sector workers earning the highest salaries will be expected to pay a greater contribution towards their pension.
Other pension issues raised in the announcement included confirmation that employer pension contributions would be included in the calculation of employees’ income to see whether they reach the £150,000 cap for higher rate tax relief, effectively lowering the cap to £130,000.
Increasing taxes for the mass affluent
The fact that people earning more than £150,000 including pensions contributions, will not get high rate tax relief on contributions is indicative of a wider trend to tax the mass affluent harder. Many predict that this £150,000 cap (or £130,000 in reality now) will fall further in future budgets if Labour remains in power. It is quite conceivable that the 40% tax band will also rise and this will leave less and less left over to stimulate higher levels of saving for retirement.
Pensions Account vision for greater flexibility
With all these things it is important to plan for a possible change of government in 2010. The Tories have trumpeted a different solution to the looming pensions crisis. It is has somewhat confusingly being labeled the Pensions Account. The idea behind the Pensions Account is to make pensions a much more flexible and therefore attractive savings vehicle. No longer will you be locked out of your pension pot until some pre-specified and merely notional retirement date. We may all remember starting our first pension in our first full time when we stated we would retire at 55 years old or even 50. Today if we are asked the question we are more likely to say 65 or ‘never’.
The Tories argue that there is real concern about tying up large amount of savings in inflexible schemes which leads them to believe that there is a need to have a pension which policyholders can access in case of life changing events like the death of a spouse, loss of a job or onset of a long-term illness requiring additional care. The Tories are also prepared to back auto enrollment and even start it earlier than 2012 by offering voluntary entry to the scheme earlier. They will also do away with any new disincentives to long term saving that Labour is planning to introduce including reasserting tax relief on pension contributions for those taking home £150,000 or more in salary and contributions.
It is certainly clear that a change of attitude towards saving for retirement is much needed if we are to ward off the very real ‘triple whammy’ threat posed by the demographic time bomb; current parlous levels of savings in DC schemes and the imminent demise of DB schemes. It is perhaps the second largest challenge of the next government in office; second only to beginning the tough work of paying down the national debt which is set to rise past £1 trillion within two years if we don’t get to grips with it fast. The deficit laid out in the latest PBR estimates that we will add to the national debt by a further £178 billion in the next 12-months. It’s clearly not going in the right direction yet!
For pensions providers there will be real opportunities for innovation in the creation of more flexible, more diverse yet transparently charging DC pensions schemes to stimulate a percentage of the predicted one million DB scheme members that will exit into DC schemes in the next three years. Group SIPPs for example are likely to see boom times previously seen in personal SIPP and SSAS schemes. And if the Tories do get in – expect a further wave of innovation around Pensions Account introduction. Products geared for drawdown are well placed to morph into Pensions Account offering down the line and the flexibility of these schemes definitely stands to drive more money into these long-term savings vehicles which will be further bolstered by some level of auto enrollment come what may. It is inevitable that stand of living in retirement and therefore pensions will become a more high profile issue as the extent of under saving becomes more apparent and this inevitably creates an environment in which innovative pensions product providers and high quality retirement planning advisers can look forward to a bright future in the next decade and beyond.