Failure – Pulverising final salary pension funds

Once nicknamed the Rolls-Royce of pensions for savers, final salary schemes – which pay out according to your final salary and how many years you worked at the company, with the riskshouldered by your employer – have broken down and are unlikely ever to get off the hard shoulder again.

In their place have risen so-called ‘defined contribution’ pensions which put all the risk of investment on you – and offer no guarantee of a set sum at retirement. With smaller contributions from employers, pensioners are at the mercy of stock markets plunging at the wrong moment, leaving insurers to offer you a poor ‘annuity’ – or income for life – in exchange for your pension pot.

How did it all go wrong?

Back in 1988, when the stock market – then the bedrock of many pension funds – was roaring, Conservative Chancellor Nigel Lawson decided to introduce a tax on company pension fund “surpluses” (money that boosted the value of a pension fund by virtue of it having benefited from soaraway stock market prices).

However, this move had a knock-on effect: to avoid the tax, in the 1990s employers reduced their pension surpluses through “contribution holidays” – putting no money into the pension fund – while offering generous early retirement packages. Unsurprisingly, this ended up leaving very little in the kitty for a rainy day.

Fast forward to a new Government and a new Chancellor. It is 1997, and one of Labour Chancellor Gordon Brown’s earliest critical moves was to remove tax relief on dividends received by pension funds (and, later, equity ISAs). While boosting Government coffers to pay for policies, it denuded pension funds of vital cash that – over years to come – would have otherwise bolstered millions of workers’ funds.

As an example, before 1997 a pension fund could be paid £800 in dividends and earn £200 in cash from the Treasury in the form of dividend tax relief. Once Mr Brown abandoned such a savings perk, it deprived funds of vital cash – the cost of which has been estimated to be between £50bn and £100bn.

But that’s just the start of it. On top of this loss of dividend income and the taxation of scheme surpluses, other Government moves depleted your pension savings.

Regulatory burden

The Maxwell scandal – where media tycoon Robert Maxwell raided his own company pension funds to pay for his lavish lifestyle – has much to answer for.

In a perfect example of The Law of Unintended Consequences, the much-needed tightening of pension scheme regulation in the wake of the Maxwell scandal yielded the Pensions Act 2004. For you and fellow savers, it unleashed a wave of burdensome red tape whose rules and regulations on the way that pension schemes were run ratcheted up costs and discouraged employers from supporting them.

Foremost was the financial price tag for the new Pensions Protection Fund “lifeboat” which forced employers offering staff final salary schemes to pay in a levy. This would help compensate workers who faced losing part – or all – of their occupational pension because of company collapses or wind-ups.

Separately, the Act also ushered in so-called pension “scheme-specific” funding, which meant that companies with under-funded schemes had to ensure they were regularly topped up to meet liabilities.

Since these changes, an estimated 15% of schemes have seen costs rise by more than 10%, with 4% reporting cost increases in excess of 30% . As Ann Robinson, a former director-general of the National Association of Pension Funds famously said: “Occupational pension schemes are in danger of being regulated out of existence”.

To this end, the hideously multi-layered legislation made managing a pension scheme and educating its trustees a nightmare.

Employers: a new extension of the welfare state

In a fresh twist, these new layers of legislation precipitated a new shock cost: that final salary schemes be “enhanced” way beyond their original purpose of providing in old age. The changes turned employers into a de facto extension of the welfare state, a role that employers don’t have to play in other countries.

This so-called “gold-plating” of pensions included the introduction of spouses’ and children’s pensions, ill-health early retirement pensions, and fixed percentage increases to final salary pension payments each year.

Naturally, these add-ons came with a huge price tag for employers. Despite vigorous lobbying from actuarial bodies, the Government still does not allow companies to cut benefits as a means of reducing their financial obligations. As a result, the ballooning cost of pension schemes has resulted in the value of some schemes actually exceeding the value of the sponsoring company. A well-known industry quip suggests that “British Airways is a pension scheme with a small airline attached to it”. It would be worth a giant belly-laugh were the implications not so deadly serious.

The perverse effects of quantitative easing

The deadening effect of Government intervention has had a much more recent shock too. As part of Labour’s reaction to the credit crunch, it has desperately tried to encourage banks to start lending again at competitive rates to ordinary consumers as well as to small companies. It kick-started a policy known as “quantitative easing”, which has unfortunately had a nasty side effect on pension funds: further raising their costs.

How? It’s all to do with gilts, or Government bonds, giant loans given to the government by the world’s money markets which pay a fixed income for a set period, usually five, 10, 15 years or more.
As a rule, they’re bought in huge numbers by pension funds and other financial institutions that need the safety of a government-backed investment to meet regular obligations such as regular pension payouts.

In a nutshell, the “yield” – or return from these financial instruments – depends on the size of the regular income paid out from the gilt as a proportion of its price. It might sound horribly complicated but the most important part is simple: when the price of a gilt goes up, this vital yield that is crucial to pension funds falls. Today, gilts are in comparatively high demand thanks to their safety amid the credit crunch chaos, and the Government’s quantitative easing has pounded yields down even further. This has piled on further misery for the pension funds as they must now pay even more to be able to meet their financial obligations.

Longevity bonds

You might already despair at the lack of joined-up thought on pensions policy, but there is worse still; a refusal by the Government to consider so-called “longevity bonds”. Our rapid increase in life expectancy – while great for our own personal satisfaction – is another factor hampering pension schemes. Before the Second World War, workers tended to die shortly after retirement at the age of 65. Today, we are likely to enjoy a retirement span of 20-30 years.

This turnaround in our fortunes is extraordinary: last year, charity Help the Aged found that a person aged 55 now has a 50% chance of living to 90 and a one in four chance of living to 95. And with medical advances, it appears this trend will continue. According to a Cass Business School survey in 2007, a man who reaches age 65 in 2050 would be expected to live for another 26 years on average. Even more remarkably, Club Vita – a longevity comparison body for pension schemes – has calculated that life spans are improving by two years each decade, at a cost to pension schemes of £10bn a year.

How to protect against this? The Government could help pension schemes meet these long-term liabilities by issuing “longevity bonds” – essentially a financial instrument which hedges against the threat of costs posed by increased life expectancy but, to date, has adamantly refused to do so. The idea was roundly rejected in the Turner Report on pensions on the grounds that the Government has assumed enough risk in other areas and is not willing to accept risk on behalf of private sector pension schemes.