Workers and employers pay a fortune into pension schemes. Yet they put up with a system that delivers very poor value for money, explains John Read.
Pension schemes face serious challenges – an ageing society and poor investment returns following the ‘Great Recession’ are just two of them. In short, pension systems have not moved into the 21st Century. They have been left behind by modern trends of demographic change, the restructuring of work and the age of austerity.
Pension schemes are no longer economically efficient. They have not been for some time, but it is now more obvious and troublesome. If the pensions industry were to publish a league table, it would highlight the disgracefully poor returns available across most types of schemes.
Defined benefits pensions schemes – of which there are very few left open to new employees – provide the best returns. They pay 50% of average pay in retirement, based on a contribution of 18 to 20% of pay. An ‘unfunded’ public sector scheme provides 25 to 30% of average pay, based on a 20% contribution. A defined contributions scheme pays just 15% of average pay, with a contribution of 8% of pay. And the state’s basic pension pays 22% of average pay, from an 18% contribution.
Superficially, these returns may not seem as awful as they actually are. But if fund performance and contributions were maintained at the rate of inflation, they should provide a return of three times’ contributions over the term of a working life. None of these scheme types provide anything like that. Annuities provide just half this level of return.
What this means in real terms is that all the various types of schemes are making a loss. From workers’ perspectives, the economic return would be much higher if part of their money was spent reducing mortgage and other debt whilst in work. The impact of the tax free lump sum, for example, increases contributions by a third.
Part of the problem is that the population mix is no longer static. It is changing dynamically, with increased longevity causing a large increase in those retiring at 65. This leads to more people surviving at older ages, too.
Meanwhile, investment returns have been hit by a financial ‘perfect storm’. Banks and other financial institutions collapsed, returns on corporate bonds have been hit by weak profits and those of gilts by quantitative easing. The once stable base for pension investment has been destroyed, with the stock market characterised as a speculative gambling casino that can be, and has been, manipulated. These events require a culture change not just in investment management, but also in the raising of awareness that these funds are a form of personal savings that need to be protected and managed effectively, efficiently and safely.
A more stable return on investments in the UK could be achieved through a greater focus on core infrastructure, such as housing, schools, hospitals, energy, transport and telecommunications. That this can provide a more reliable base is demonstrated by our continued reliance on the Victorian legacy. If infrastructure investment benefited from the state basic, public and private sector annual contributions of more than £130bn, then
The state pension system as it currently operates is a farce. It is run as a contributory scheme with eligibility checks on the National Insurance contributions paid and their duration. Yet these contributions are spent before they are received, preventing them from accumulating and growing into members’ funds. Pension payments are then treated separately as welfare, passing the financial burden onto future working generations – with the single tier pension becoming the ultimate in wealth redistribution (from the diligent and young to the old and indolent).
The cost pressures from the ageing population will make the existing system unaffordable. Recent cost cutting measures do not address the underlying problems and so are ineffective. The Chancellor claims that £3bn a year can be saved by delaying workforce retirement, but the Government could save £30bn by moving to a better, funded, state scheme.
The viable economic solution is to change to a group funded scheme in which benefit is earned, risk is shared and spread over the whole adult life cycle from 18 to 100, with retirement lifespan and sustainable pension payments accurately determined using the latest mortality rate trends. This would generate substantial gains and stability.
The trend towards the use of individual schemes with defined contributions, under which ownership is retained by the individual and with dependents having inheritance rights, requires investment risks to be kept low. There is a high level of uncertainty about how much payments will be, when they will be paid and for how long. Payments could be spread across anything between one and 35 years – depending on longevity after retirement. This uncertainty causes major performance loss and a consequent, inefficient, rise in contributions by a factor of at least two.
Part of the problem with pensions is the lack of performance accountability. At the mention of pensions, the mind goes blank, with fears generated by the complexity and the unknown. Yet the basic mechanics are no different to mortgages and savings: the complication comes from investment returns and uncertain life expectancy.
Pensions need to be based on self-sufficiency and earned benefit, taking out what workers have industriously put in. Welfare and wealth redistribution should be restricted to the disabled and those who have fallen on bad times. The indolent should be supported on the lowest minimum level and made to work. We need a pension system that discriminates in favour of those who diligently, prudently and with enterprise build-up their pension pots. Our current system is failing them – and society as a whole.
