Terry Arthur: The failure of the British pensions system

Terry Arthur is a Fellow of the Institute of Actuaries and is co-author, with Corin Taylor, of The UK Pensions Crisis, which was published this week by the TaxPayers' Alliance.

The objective for any pension scheme must be to fund the continuation of living standards (appropriately adjusted) available prior to retirement at an acceptable cost.  The UK’s pension system, managed by politicians with short time horizons, has lamentably failed to achieve this.

In December 1942, at the request of the Government, Sir William Beveridge produced his report proposing that all people of working age should pay weekly contributions; in return, benefits would be paid to those who were retired, sick, unemployed or widowed.  He argued that this system would produce a minimum living standard “below which no-one should be allowed to fall”.

Almost 70 years later, nobody would argue that anything remotely resembling Beveridge’s claim has been achieved, although it would have been much nearer had his relatively limited recommendations been followed rather than escalated.  Since then the state system has been reformed and reneged on many times. For example the Basic State Pension is at least 20 per cent down from its 1950 level relative to earnings.  (The link with earnings was broken in 1980, for both past and future years of service.) 

At the same time, the reduction and then abolition of advance corporation tax relief has helped to destroy Britain’s private sector occupational pension system, which was once regarded as one of the best in the world.  This infamous retrospective tax raid has cost pension funds a cumulative £150-£225 billion, through lower-than-otherwise dividends and growth.  This was before the recent financial turmoil, and has been a major factor in the 43 per cent fall in the number of active members of private sector defined benefit schemes.

Unlike state and private pensions, public sector pension arrangements remain extremely generous.  Freedom of Information requests from the TaxPayers’ Alliance have revealed that there are over 17,000 retired public sector employees in receipt of an annual pension (net of lump sum) of at least £33,000, which implies total retirement benefits of at least £1 million.  Unsurprisingly, unfunded public sector pension liabilities have been estimated, by former Bank of England economist Neil Record for the IEA, to exceed £1 trillion, over 70 per cent of GDP.

In 2012, the default National Pensions Savings Scheme (NPSS) will be introduced.  It is immediately apparent that it could lead to lawsuits on a massive scale.  The possibility that contributions may prove to have been worthless because they end up disqualifying the individual from pension credits or other benefits is just the tip of the iceberg. For many young people and their families, it is simply not sensible nor, indeed, feasible to devote scarce resources to future retirement. 

Much of private sector saving, such as ISA saving, is flexible in terms of duration – for a rainy day which cannot be predicted.  Often there are many more pressing items than inflexible savings for retirement. For example, the fast repayment of a mortgage is saving which could easily be better value than pension savings.  Nor is it necessarily sensible to save at all until much later than one’s early twenties; this depends on family situations, the rearing of children, the likelihood and extent of a rising earnings stream, and so on.

Aside from rising life expectancy (where we should note that the so-called “dependency ratio” is a major issue only for unfunded schemes) there are many reasons for the failure of the British pensions system, nearly all due to government. Not least is the problem of time horizons – measured in decades for those affected, alongside a few years or even months for ministers.  Government changes have continually offended the cardinal principle of accrual, in which a year of work becomes a year of eventual pension benefits according to rules in the year in question.  Gordon Brown’s 1997 tax-grab from pension schemes via abolition of ACT relief on then existing assets (a process started by the previous Conservative government) was a straightforward theft which left accrued liabilities uncovered.  If ever one needs proof of the time-horizon gap, here it is.

It is highly unfair, though unfortunately not surprising, that occupational schemes for MPs and others in the public sector have been largely free of the hugely damaging meddling suffered by their counterparts in the private sector. 

There is no easy solution to the pensions crisis.  Reform will be difficult and unpopular.  Other countries have, however, undertaken sustainable reforms to their pension arrangements.  The reforms in Australia and Chile point to a more practical solution in the UK.  (But for the reasons of flexibility referred to above such arrangements should not be compulsory – certainly not before the age of 40). The kernel could be private pension pots (PPPs) modelled on ISAs, with larger tax-free contribution limits and a light regulatory touch.

There is a pressing need for major and immediate reforms to cut the shameful and unsustainable costs of public sector schemes, often supported by taxpayers who have watched their own schemes disappear or decline, usually at the hands of government.  Despite regular government abuse of the accrual system, accrued rights should not be reduced.  But future service benefits in public sector schemes must be sharply reduced.

More generally, final salary schemes, as opposed to salary-related schemes, were an error.  They originated in the public sector and were reproduced elsewhere under the belief that the main feature was a simple link with inflation.  In fact, it has turned out that there is no such simple link; the movements of individual salaries can be highly diverse (with some being manipulated in the last few years before retirement) and any equity is hard to see.  Salary-related schemes, with a common method of adjustment for price inflation, would be much more equitable and would provide a more predictable and controllable cost pattern at a lower cost.