The Government is considering proposals which could leave millions of pensioners worse off.
One of the key benefits of a pension used to be its predictability. It was ‘an income for the rest of your life’ and you knew what that income was going to be. Either your company was going to pay you a pension – they gave you a gold watch and a ‘statement of pension benefits’ as you left – or you used your private pension to buy an annuity.
But that certainty appears to be disappearing. First of all previous Chancellor George Osborne radically overhauled the rules for private pensions, allowing pension holders to ‘draw down’ from their accumulated pension pots. This gave pension holders far greater flexibility – but removed the certainty of an ‘income for life.’
And now it appears that the Government could be contemplating changes to occupational (or company) pensions which could remove the certainty from those arrangements as well – and leave millions of pensioners worse off.
First of all, though, let’s briefly look at the two main types of pension scheme.
What is a ‘Defined Contribution’ pension scheme?
Most people today will be in defined contribution (DC) pension scheme. Contributions to the pension are made by the employer and the employee, both contributing a percentage of the employee’s pay. Returns – and hence eventual pension benefits – are dependent on how much money goes into the pension scheme, and how well that money performs while it is invested in the scheme.
What is a ‘Defined Benefits’ pension scheme?
A defined benefits (DB) scheme works the other way round – your eventual benefits are determined by your final salary and your length of service. So if you’ve worked for a company for 40 years and they give 1/80th of your final salary for each year of service, then you’ll retire with a pension of 40/80ths – equal to a half – of your final salary. Both employers and employees both make a contribution to a DB scheme, but the employer’s contribution can be open-ended: the company may need to make extra contributions to fund the pension benefits due to be paid out. This is what gives rise to talk of companies having ‘pension deficits’ – and therefore the Government’s green paper.
Pension Deficits and the Government’s Green Paper
‘FTSE-100 firms’ pensions deficit soars’ was a headline last August. Pensions expert LCP put the deficit – the difference between what was in the pension funds and what was needed to pay benefits – at £46bn. They then promptly revised the figure to £63bn once the UK voted to leave the EU and bond yields (which determine a significant proportion of the income of occupational schemes) fell.
The Government’s green paper is a discussion paper on the future of Defined Benefit pensions – and it has said that ‘financially stressed’ companies might be allowed to ‘water down’ previous pension commitments. Around 11m people are members of defined benefits schemes, so this suggestion could have far-reaching implications.
In particular, some companies may be allowed to adjust the way they increase pensions to take account of inflation, using the Consumer Price Index (CPI) instead of the Retail Price Index (RPI).
What is the difference between CPI and RPI?
RPI – which was first calculated in 1947 – measures the cost of a range of goods and services. From time to time items in the ‘basket’ are added or deleted depending on changing tastes and buying habits. The CPI is a more recent measure and is broadly intended to do the same job as the RPI: significantly, though, the CPI doesn’t include council tax payments, mortgage interest payments and other property related costs – which means that it is generally lower than the RPI figure (and that differential may well increase if the rumoured increases in council tax happen).
The Government moved to CPI, rather than RPI, as the basis for paying some benefits with effect from April 2011. At the time there was a widespread outcry, with campaigners arguing that benefits would fall in real terms – and it now looks as though the same could happen with pensions.
Steve Webb – who was a pensions minister in the Coalition Government – said that such a change would be worrying:
“There is a significant risk that relaxing standards on inflation protection could be exploited and lead to millions of retired people being at risk of real cuts in their living standards.”
If we do some simple maths then we can see what he means. If someone’s real income falls by 2% in a year that’s bad enough: but if it falls by 2% for five years then compound interest means that it’s fallen by 11% in real terms. With people living longer – life expectancy is now approaching 90 in some countries – this type of compounding over the long term could have disastrous implications.
Even more alarming is the suggestion in the green paper that companies could completely suspend indexing if pension schemes are in ‘serious trouble.’ This raises a moral question: could companies deliberately weaken their balance sheet or their profit and loss account to avoid costly pension scheme obligations?
The majority of companies could clear their pensions deficits if they wanted to – and despite earlier alarms, it appears that overall pensions deficits are coming down. As the Government green paper commented; “our modelling suggests that these deficits are likely to shrink for the majority of schemes if employers continue to pay into schemes at current/proposed levels.”
Should you take any action?
Defined benefit schemes have declined over the years as employers have switched to more affordable defined contribution schemes, where they know their exact liabilities. Today, the vast majority of people in DB schemes are likely to be in the public sector – and they are not going to change jobs because of pension scheme worries when the Government is their employer.
Even so, workers need to remain vigilant.
Increasing life expectancy costs the country a huge amount of money, placing an ever increasing burden on the NHS and social care. The Government has to find the money from somewhere – so the answer is to keep a close eye on your financial planning and make sure your future security is not wholly dependent on your pension.
But it’s not all bad news…
Let me finish with some good news: rest assured that for this small group of people the glass is very much half-full. I was chatting to an independent financial adviser the other day. “What is the most generous final salary scheme you have ever seen?” I asked him.
“No question about it,” she said. “The pension scheme for MPs beats all the others hands down. Far and away the most generous I have ever seen.” Well, well, whoever would have expected that…