Pensions crisis, what crisis?

Even Jim Callaghan would know there is a pensions crisis. How did it come about and how to solve it?

Like any good crisis it has not just one but many causes. Over the years since the mid-1970s there have been layers of additional rights and protections for pension scheme members which inevitably have a cost.

The first key problem was probably the Social Security Act 1986 which stated that employers could no longer require employees to be members of their pension scheme. It was cheaper to provide for younger members and once they were allowed out it meant the average cost for everyone went up. This also led to a personal pensions misselling crisis which undermined confidence.

Following the Maxwell scandal the Pensions Act 1995 sought to protect pensions by a multi-front approach: improved funding methods, enhanced and expanded protections provided by trust law, and a regulator, the Occupational Pensions Regulatory Authority (OPRA). Many sectors of the pensions industry did not like these measures, but even where welcomed and acted on they inevitably had cost.

The Government’s answer to widespread closure of pension schemes – stakeholder pensions – turned out to be a cheap, but not very cheerful, personal pension scheme. The best that can be said for it is that the insurance industry was bound to keep charges at under 1% per annum. Consequently enthusiasm for it in the insurance industry is limited. Takeup has been extremely low and few could suggest that it was going to solve any of the problems of the pensions industry or the saving public.

Gloom on all fronts

To make sure no opportunity for gloom is overlooked, the Accounting Standards Board came up with a particularly terrifying method of accounting for the cost of pension schemes in Financial Reporting Standard 17, the introduction of which has now been delayed, not really because the standard was right or wrong but because its introduction would spell disaster.

As if all this added administrative burden were not enough, financial markets proved to be not the straw but the ton weight which broke the backs of most people’s camels.

Since the early 1990s annuity rates have been going from poor to extremely miserable. With public sector borrowing requirement and interest rates down (annuity providers back their liabilities with Government gilts) and people living longer, annuity rates would inevitably plummet. Furthermore, virtually all providers (many for technical reasons due to the Financial Services Authority solvency standard for annuity business) left the market so that it became uncompetitive. The slide in equity markets need hardly be mentioned. In 2002 alone the average pension fund lost 28% of its value.

All these factors have led to the crisis. The result is that employers are now scared to think about their pension liabilities. Some must be facing insolvency. To trap them further the Government have, as announced in June 2003, at last in February made the Occupational Pensions Schemes (Winding Up and Deficiency on Winding Up etc) (Amendment) Regulations 2004 (SI 2004/403). The effect of these is that if on or after 11 June 2003 an employer which is not insolvent seeks to wind up its pension scheme, it will be liable for the cost of providing annuity contracts to secure pensions. The concept of the employer being responsible for any deficit in a final salary pension scheme was originally brought into force in 1992, but that was on the basis of liabilities being assessed as transfer values that might be 50 or 60% of the cost of securing annuity contracts, which is now to be the measure of liability. This will mean that many (at least hitherto, solvent) employers will be trapped.

At present the statutory order of priority means that in many cases pensioners will get their full benefit (although without a right to future increases) and there have been cases where those awaiting a deferred pension got nothing. The Government introduced draft regulations which were intended to give more favour to long service deferreds, but has not brought these forward as yet. The Deficiency Amendment Regulations referred to above also make changes in the order of priority to ensure that any extra funds brought in go to those for whom they are intended. In each of these adjustments or proposed adjustments to the order of priority a distinction is made between benefits attributable to service which is contracted-out and that which is not. Since the Deficiency Amendment Regulations are moving an MFR (minimum funding requirement) transfer value basis to an annuity purchase basis, again that is not comparing likes because a different set of assumptions is used. Without getting any more technical than can be helped, the net effect is that the Regulations actually have the reverse effect of being more likely to favour those with shorter service. So in many cases will the proposed amendment in the draft Winding Up Amendment Regulations.

So, apart from those regulations what is the Government’s solution? This was debated on 20 January 2003 in the Commons when a Conservative motion was put forward expressing “deep concern at current arrangements for winding-up occupational pension schemes”, which leave many people receiving much less than expected for their retirement. The Government in response brought forward a green paper which the Pensions Management Institute and the National Association of Pension Funds described as limited and cosmetic. Nevertheless the Government pressed ahead with the white paper published on 11 June 2003, the first effects of which we see in the Deficit Amendment Regulations. As mentioned the other promised regulations to change the order of priority in winding up (to give more priority to those with longer service) have not been followed through.

The Pensions Bill 2004

The white paper has at last led to the Pensions Bill 2004 and yet another Government report. The main themes in the bill are:

• The Pensions Regulator
• The Pensions Protection Fund
• Scheme funding
• Planning for retirement
• Miscellaneous provisions on occupational and personal pension schemes
• State pensions

The Pensions Regulator is a new quango to replace OPRA but with additional powers, including to issue what are to be known as improvement notices, third party notices and freezing orders. The main intention is to make regulation more directed and less bureaucratic. Whether it would be possible to restrain that cultural tendency in the Civil Service remains to be seen but a non-executive committee is to be set up specifically tasked to keep the new Pensions Regulator on track.

Pensions Protection Fund

In the good times instead of trying to filter off surpluses (as was done by the Finance Act 1986), or filter off hitherto reclaimable tax credits (as was done in 1997), the Government might have thought of building up a fund for those whose scheme goes bust. Of course they did not, but now, in the bad times, that is exactly what they want to do by the setting up of the Pensions Protection Fund. It will also subsume the existing Pension Compensation Board which pays compensation to both defined benefit and money purchase schemes in cases of fraud or misappropriation of assets.

The new fund will pay compensation in respect of loss on final salary schemes, basically at 100% of pension in payment for those over normal retirement age, and existing ill-health or survivors’ pensions, subject to certain exceptions, or 90% of the pension for deferred pensioners subject to a cap calculated using a combination of individual scheme rules and Protection Fund standardised rules. The cost of this in addition to taking over the assets of a stricken scheme is to be met by various levies on existing schemes including one levy which will eventually become risk-based.

It is unfortunate that the Government did not have the vision to try to solve two problems at once by imposing the cost of this not on the good schemes but on employers who have not made any pension provision or have not made provision to a prescribed level of adequacy.

Initially it was declared that there was no intention to backdate this compensation scheme. Political pressure was brought to bear, including MPs signing petitions to extend it for those who have already lost out. This pressure seems to have led the  Government to reconsider, but a final view has yet to be reached.

Scheme funding

Part 3 of the bill introduces reforms in scheme funding. The Government seem to be of the view that it is possible to ease the funding burden on employers while somehow making pensions more secure. Only a politician could believe this. The statutory framework is set out for the scheme funding requirements to replace the MFR, introduced by the Pensions Act 1995 for most private sector defined benefit schemes. The new framework will be required to fund on a funding measure, the objective of which is that the scheme should have sufficient and appropriate assets to cover its technical provisions, meaning the amount required, on an actuarial calculation, to provide for the scheme’s liabilities. How this is done will require a great deal more detail to be set out in regulations and actuarial practice.

Part 4 gives the Secretary of State power to promote and facilitate planning for retirement and allow him to receive the information to do so.

Inclusions and omissions

Part 5 contains miscellaneous provisions on occupational and personal pension schemes which are designed to simplify administration. These include:

• Restating but even more prescriptively the requirements for member-nominated trustees.
• Requiring trustees to be conversant with trustee rules and funding requirements, the performance of trustee functions and investments.
• Simplifying internal dispute resolution procedure, which may now be a one-stage rather than the previously required two-stage process.
• Contracting-out. While various tinkering is done it is very unfortunate that nothing has been done to simplify the pre-1997 contracting-out system of guaranteed minimum pension. These frequently cause years of holdup in occupational pension schemes particularly where they are winding up. In addition there is an unresolved problem as to whether the discriminatory pension ages of male 65 and female 60 require to be equalised. The Department for Work and Pensions, acting in league with the Occupational Pensions Regulatory Authority and the Pensions Ombudsman, has conspired to try to privatise the responsibility for this intractable problem to pension scheme trustees, who are effectively being asked to wind up schemes without it being clear how liabilities should be treated.

Clause 203 addresses the so-called TU(PE)R exclusion for occupational pension schemes. Basically the employee must be eligible for a similar sort of scheme to which the relevant contributions are made. That is still to be defined in regulations but is probably going to be up to a maximum of 6%.

The maternity leave provisions of the Social Security Act 1989, schedule 5, are to be extended to paternity and adoption leave.

There are new provisions regarding payments made by employers to personal and occupational pension schemes, in particular in relation to notice to the Regulator of default.

The cap on limited price indexation is to be reduced from 5% to 2.5%, which will not make a great deal of difference at the current rate of inflation.

Part 6 relates to the state pension scheme and makes various minor amendments in relation to national insurance contributions and deferral of drawing state retirement pension, including a lump sum award for deferring. Generally speaking however, the state pension remains ludicrously complicated.

The following matters are not addressed by the bill as originally published:

• Inland Revenue limits simplification. This is a different set of legislation and a different consultation.
• Reform of guaranteed minimum pension, as mentioned above.
• The problems imposed by the Pensions Act 1995, section 67 which prevents modification of accrued rights. This has thrown up many practical problems for lawyers and actuaries.
• Pensions Ombudsman jurisdiction which is currently an incoherent miscellany. There is a separate consultation exercise.
• Provision of transfer values for those with between three months’ and two years’ service.
• Compulsory membership. There was a suggestion that there would be automatic admission to pension schemes. How this would change the existing provisions where legal admission was automatically discretionary is not clear. It is further discussed in yet another report published in February 2004 mentioned below.

A whole section of the June 2003 white paper on simplification (from paragraph 16 onwards) has been omitted. This related to:

• Pensions Act 1995, section 67 mentioned above.
• Greater member involvement.
• Additional voluntary contributions.
• Streamlining contracting out.
• Consultation and communication.
• Simplifying pensions on divorce.

In February 2004 the DWP published yet another report entitled Simplicity, security and choice: Informed choices for working and saving. This takes further the idea of automatic admission but generally seems to think that a solution to all these problems is going to be achieved by supplying people with forecasts. On 2 March 2004 this approach was described in Parliament as “serial consultation”. At the time of writing things are in flux as the Government introduces amendments.

Work harder, and longer

What else could be done? With so many problems there can be no one solution. The key decision for the Government is: does it want to be involved in pensions? And if so, why? Clarifying this would guide what it is trying to achieve.

A healthy economic climate and economic certainty are necessary to maintain the economy and financial markets on the right track.

The Government needs to consider the annuity market. Would the Government not be better employed somehow assisting (even subsidising) the provision of annuities?

Clearly it is going to have to give more incentive for people to save for retirement. People only begin real earning about 25 and hope to retire some time after 50, with the possibility that they will live well into their 80s. That is just not sustainable on a 30 year contributing life. People need to be brought to realise that they will have to work longer or receive less in retirement. This applies both to the state and private schemes.

People must be adequately protected. More broadly based and comprehensible legislation is needed rather than the piecemeal mass of complexity which we have at the moment.

The Government could do more. Even so, we will have to work harder and longer.

Iain Talman, Partner, Biggart Baillie; Convener, Law Society of Scotland Pensions Law Subcommittee