One keeps reading about a pension crisis. One also reads about an alarming lack of trust in pensions and the pensions industry. Could these two phenomena be related one wonders! The source of the pension crisis lies, in my opinion, in wilful ignorance on the part of the general population aided and abetted by the authorities for their own political expediency. Financial illiteracy is perhaps more common than general illiteracy and potentially more lethal. Perhaps a brief blog can alleviate this illiteracy.
State Pensions and the National Insurance Fund
The state pension is a pay-as-you-go scheme. This may not be obvious given talk of a NI fund. Surplus NI contributions are invested in gilts (loaned to the state) and used when NI contributions in any year are not sufficient to cover pensions in payment. So what happens if the fund runs out? There will be a Treasury grant to make up the shortfall. In other words, it is covered by general taxation. The state could of course increase NI contribution rates. The important point here is that the state pension is underwritten by the taxpayer. You will get whatever you are promised, though promises can change for each geneeration.
Talk of crisis in part reflects the decline in the NI fund surplus. This reflects the upgrading of the terms of pensions in payments coinciding with slow wage growth (and hence slow growth in NI contributions). The logical response is to raise NI rates. It is after all a pay-as-you-go system. Politically it has not been expedient to do so overtly. The only crisis is a political one. The government of the day does not wish to upset pensioners by downgrading the inflation adjustment of pensions in payment and thus reduce the cost. Pensioners have votes and tend to use them. It has chosen to effectively raise NI contributions by raising the age of retirement for state pension purposes. You pay the same for longer. There is no crisis. It is a pay-as-you-go system and subject to the vagaries of demographics and terms of contributions and benefits.
Public Sector Pensions
Many people work for state organisations. These typically have defined benefit contribution schemes. The state promises a retirement income based on some ratio of final salary and years of service. Employees make contributions from current salary and the state also makes some contribution as the employer. There may even be a fund accumulated from these contributions (which is loaned to the state). Whether the fund is adequate is irrelevant as the taxpayer underwrites such arrangements. The state cannot renege on liabilities. As with state pensions, public sector pensions constitute a contingent liability of the taxpayer. There is no crisis except a political crisis as this contingent liability becomes a real liability. The important point is that a promise by the state will be honoured.
Defined Benefit Private Sector Pensions
These superficially resemble public sector pensions. The employer and employee make contributions into a fund which is nominally used to meet pension promises based on final salary and years of service. The fund however is the property of the corporation. There are state regulations as to what kind of fund must exist in relation to liabilities but ultimately the promises are only as good as the corporation that makes them. Unlike the state a corporation may not honour its promises.
A pension contribution is a deferral of income. A direct deferral is made via the employee contribution normally before tax. An indirect deferral is made via the employer contribution. This could have been paid to you as part of your salary. The deferred income is loaned to the pension sponsor in exchange for promises based on final salary and years of service. Promises by the state are typically honoured. Promises by corporations may not be. Part of the problem has been that people have not grasped this latter point.
The Funding Crisis
The ‘crisis’ has in some respects been artificially created. Pension liabilities stretch a long way into the future (technically, forever). In order to get some idea of the size of the fund necessary to meet these liabilities we need to discount the future liabilities to obtain the present value. I have explained this discounting process in many previous blogs. If the discount rate is positive then a future pound is worth less than a present pound because you can earn interest on a present pound. Interestingly if interest rates are negative the opposite is true. If interest rates are zero then all pounds are the same value irrespective of when earned so the present value of liabilities is the sum of all of the future liabilities. The lower are interest rates the greater the present value of the liabilities and the bigger the fund needs to be to match liabilities. It also means the bigger the contingent liability of the state and the corporate employer.
The funding crisis emerged when the state required pension plans to present value liabilities using a discount rate based on long dated gilts and then proceeded to crush long dated gilt yields through a deliberate monetary policy. At the same time rising life expectancy increased projected liabilities. There is no basis for projecting current gilt yields indefinitely into the future. The correct discount rate should be that related to the potential return on assets. If one includes, equities, credit products, commodities, and property, this is much higher and thus the so-called pension deficits much lower. The use of the discount rate insisted on by the state effectively assumes all assets are invested in gilts.
Defined Contribution Pension Plans
In order to deal with the pension ‘crisis’ employers have been shifting as quickly as possible to defined contribution plans ( you may know these as ‘money purchase’. Basically the contributions, employer and employee, go into a personal investment pot and accumulate until retirement. The pot at retirement depends upon investment performance and contributions. At retirement one buys an annuity or invests the pot and lives off the investment income.
The annuity provides certainty of income in retirement but depends upon average life expectancy and gilt yields. Rising life expectancy and very low gilt yields have reduced annuity rates. The funding crisis has been shifted to the individual. A pot that sounded fine when you started out on your career now buys much less certain income. It may be less than you hoped. The reality is that unless you had a promise from the state, certain income in retirement was never on offer. Your employer could always default. The ‘crisis’ is as much about false expectations as funding.
Solving the Pension Crisis
The first step is to explain to all that certainty of income in retirement is an illusion unless it is underwritten by the taxpayer. Making this clear is politically dangerous but necessary. The taxpayer in the corporate sector might wonder why she is underwriting a public sector employee. It would help if a correct valuation of this contingent liability is included when comparing public and private sector pay. Other things being equal public sector employees should earn less than private sector employees by an amount equal to the value of this contingent claim.
The next step is to stop talk of ‘funds’ when a system is pay-as-you-go. The nature of the system should be made clear to all and risk assessments made public. Once again politically difficult but important to do. The state pension is pay-as-you-go and NI contributions may need to rise if demographics and pay rates require. Indexation of pensions in payment may also need adjustment. Some frankness from politicians is necessary (so don’t hold your breath).
The next step is to do away with the requirement to value liabilities using a discount factor based on gilts. If gilt yields rise in the next few years the pension deficits could disappear and move into surplus and all talk of a funding crisis will look quite Malthusian. The correct discount rate is one based on the expected return on all asset classes. Pension funds do after all invest in all asset classes.
Finally, one needs to educate the individual on investment. Instead of sitting in cash or bonds or the same high charging, low performing, managed fund for a career span, the individual should be encouraged to opt for a low-cost, diversified passive fund structure. They should be encouraged to switch providers as the industry adjusts and new possibilities open up. They should be encouraged to understand and monitor what it is they are saving into. Moreover, the regulator should force the industry to encourage individuals and to educate them as well as making switching easier. If one has saved sensibly over 40 years it might be easier to generate and cope with an uncertain income in retirement. One reason pensioners make poor decisions is because it is the first time they ever really think about the problem of generating income from a pot of capital.
Finally a word on the easy caveat, ‘take financial advice’. this is about as useful a comment as ‘gamble responsibly’ or ‘when the fun stops, stop’. Financial advisers are not all of the same quality or integrity and there is no kitemark. They are expensive and offer variable service. In my experience if you can use a financial adviser successfully then you can probably do most of it yourself. The knowledge needed to choose and interact with a financial adviser successfully is huge. They need to acquire the professionalism of solicitors and accountants before ‘take financial advice’ is a useful caveat.