This is a guest post on pensions from regular commentator Clive Parry, who has had a long career in financial services-related issues. In it he explores some alternative thinking on pension provision:
Pensions are complicated. At a micro level it makes sense to accumulate assets today that can be exchanged for the services we will need (healthcare, personal care etc.) when we get old. But this fails if the assets we accumulate cannot be exchanged for what we will need and at a macro level, this is a real risk. With ever growing numbers of elderly will there be sufficient workers prepared to labour in the care industry to look after them all - however much “wealth” the older folk have accumulated? Yes, but only if the investments made today are delivering the right things – real things…. not just shuffling paper in a huge Ponzi scheme.
So, this is the BIG challenge that we face on pensions and Richard has written extensively about this. Fundamentally it is about mobilizing resources productively and whether it's directing “tax advantaged” savings to useful investment or debunking the “we can't afford it” myth it is all about doing the things that we can and need to do today so that we and our children can survive/prosper tomorrow.
What follows has has more modest aims. How can we offer ordinary people a safe and secure income in old age.
Let's consider 3 groups.
- Many folk will never accumulate savings or significant pension entitlements over their lives. Either they are in low paid work or do not work at all. For this group the answer is simple – a decent State Pension.
- Some folk are sufficiently wealthy that they can save a lot and take a risk with a large chunk of their savings. For them it is about passing wealth to children and the luxuries of life. This group will always save and the tax relief offered could be better deployed elsewhere.
- In the middle there is a huge group who see the State Pension as inadequate and can make provision. Their objectives are to achieve a reasonable standard of living in old age with a high degree of certainty.
The first thing to say is that a decent State Pension would make this middle income group much less worried about providing for their old age. It would (probably) mean higher taxes for them but this would be offset by lower private pension contributions.
Next, this group splits into 2 sub groups. Those with Defined Benefit (DB) Pension schemes and those in defined contribution (DC) schemes.
Those in DB schemes know that they can expect a decent steady income in retirement linked to their salary and the number of years worked… which is great. The problems with this are
- The risk your company goes bust and can't pay the pension
- It's complicated if you move jobs quite a bit….. and impossible if you are self employed.
- The company delivering the pension is exposed to huge investment risks…
So, by and large, the only employer that can offer a DB scheme these days is the Government.
DC schemes hold no risk to the employers, employees have their own pension “pot” so are not exposed to the employer going bust…. which is great. But (crucially) they are exposed to investment risk – will their portfolio of assets deliver a secure and decent pension?
This group of people are fortunate enough to be able to save but, in the absence of a more generous State Pension, are worried about what their savings might deliver. There is plenty of advice out there but none of it offers any certainty and it is rarely impartial.
One answer is to allow people to purchase today an inflation-linked forward starting annuity. Allow a (say) 30 year old to invest £1 today to receive a real terms, guaranteed income when they reach 67. What £1 will buy you will depend (mainly) on index-linked gilt yields and mortality rates but the calculation is relatively straight forward (if you are an actuary). It will vary as market interest rates vary and as the 25 year old ages but at any point in time the theoretical income is known. Now, there are issues related to early death, partners/dependents etc. but are no worse than we currently see. The real problem with offering this product is that hedging the risk is fiendishly complicated and expensive for insurance companies…. so they do not offer it.
However, the Government is uniquely well placed to take this risk – indeed, from a risk perspective it is little different that the risk associated with issuing Index linked gilts. Periodically they could issue a table that would specify by age what income could be purchased based upon market interest rates. As a matter of policy Government could choose to enhance this to encourage savings or “smooth” things during volatile periods. The infrastructure to deliver this product is available via NEST and (possibly) NS&I and it would be at very low cost (which might annoy City Fund Managers).
I think this idea would offer low cost, safe incomes in retirement for many and could be implemented quite easily. It could run alongside existing options for savers so no compulsion.... just a safe cheap way to save for old age.
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Sounds a little like SERPS which the government got rid of.
In many ways it does look a bit like SERPS – you pay extra for a bit extra pension. And, I suspect, for many people this was what want… so the fact this looks a bit like SERPS is, perhaps, a good thing.
However, the extra you paid and the extra you got were not very closely linked. You might say that SERPS looked like a hybrid between NI and what I am suggesting.
I have suggested something similar already, as Richard has pointed out we could abolish all pension tax reliefs and increase the basic state pension by about £5000pa – I also suggest that we should also make a portion of the basic state pension hereditable to a spouse or partner.
Then we might be on to something.
Again as already suggested Clive’s idea sounds like SERPS. Now if we were all contributing via National Insurance that makes the administration very cheap and nobody falls through the net due to poverty, ignorance, misfortune or whatever.
The forward sterling bit of the annuity is easy.. the Inflation linking bit, i think, is horrendously expensive. Do you have some calculations clive?
First, assume that you collect your annuity for about 20 years (life expectancy for a 67 year old man is 18, a woman is 20 years).
Second, today’s real yield curve is quite weirdly shaped. For 10 years it is 1.5%, 20 years 2.0%, 30 years 1.25%, 40 years 0.5% (eyeballing from the BoE website). For ease of calculation, I assume a real rate of 1.5% across the curve.
In this case,
a 27 year old making a £100 one-off contribution today will deliver a pension of about £9 per annum (in “todays money”) starting in 40 years time.
a 47 year old making a £100 one-off contribution today will deliver a pension of about £6.7 (in “todays money”) starting in 20 years time.
a 27 year old making a £100 contribution EVERY year for 40 years (assuming current rates prevail) could expect a pension of £295 per annum.
“Second, today’s real yield curve is quite weirdly shaped. For 10 years it is 1.5%, 20 years 2.0%, 30 years 1.25%, 40 years 0.5% (eyeballing from the BoE website). For ease of calculation, I assume a real rate of 1.5% across the curve.”
These are CPI not RPI and real yields could change in a heartbeat. For the most part over the last 10yrs there were negative real yields in index linked gilts so real yields are a very recent and in all probability a short dated phenomena… you absolutely cannot base a policy around todays pricing.
What would you base them around then?
Andy, you are right, they could change. But savers are not obliged to buy; each year they could take a view…. equally, the government is not locked in to offering subsidised returns.
You rightly say that real yields have been negative for the last decade or so but this is a result of QE. Over a longer sweep of history one might consider 1 to 2% the norm. The last decade was distorted by QE with gilt yields (real and nominal) being driven to absurdly low levels in the vain hope that this would encourage borrowing to invest in the real economy and prevent recession. It did not – it required fiscal policy; it seems that Keynes observation about “pushing on string” had been forgotten.
I have long criticised QE for the “Q” (ie a fixed quantity at any price). what should have happened is for Base Rate to go to (almost zero) with long gilt yields targeted using intervention as required. The ball would then have been seen to be squarely where it was – in the fiscal policy court.
With this approach to monetary policy it would then be far more likely that long term real yields would be much more stable which would make this product better. Indeed, the government could mandate a real rate (other than the market rate) if they so chose in extreme conditions (as, for example, Singapore does).
As a footnote, it does make the cost of making contributions for missing years in one’s NI record look extremely cheap.
(NB All the usual disclaimers apply – take proper advice, it depends on so many things!).
A very good introduction to pensions policy from Mr Parry, Thank you.
The reference to actuaries is interesting. In the days of mutual funds, when the pension investor was the sole focus of the fund, and the management company’s shareholder did not exist, actuaries (mathematically proficient to a high level, and who understood life expectancy and pensions ‘inside-out’) had, I think a far more central role in fund management.
On indexing, I confess to general reservations about index-linked Gilts.
You don’t need to be an actuary (although I am one), to realise that locking in (relatively low) government bond yields for up to 40 years (before retirement) and for a further 20-30 years in retirement is likely to be horrendously expensive.
It would also be very difficult for consumers to understand as each ‘premium’ paid would purchase a different amount of pension and would have to change on a regular basis.
Very roughly, a 20-year old would be paying about £7 for a payment of £1 (increasing with inflation) starting in 40 years time, from age 60. For a 50-year old the payment would need to be at least 3 times as much.
In practice, the cost is likely to be higher than that, given the potential for inflation to exceed target.
This is the exact reason that private sector DB schemes are few and far between – they just don’t make sense given current longevity, government bond yields and inflation etc
So, tell me your answer.
Details please.
No negatives, just solutions.
Richard,
Unfortunately the solutions are not economically viable – final salary pensions made sense when people would work for 40 years and live for 5-10 years in retirement. Now (on average) people live for 20-25 years and the level of contributions that would be required to fund such pensions, would be unaffordable, even taking account of long-term equity outperformance (whilst still leaving significant investment risk for someone to pick up).
If you actually insist these contributions need to be invested to lock-in government bond returns then the contribution rates become even more ridiculous.
No matter how clever actuaries are, they can’t make money out of thin air!
That is not a reply.
All you are saying is that you and your profession have given up.
How would you supply pensions? Why not address the question?
Expensive? Well it depends what you think other assets will return over the long run… and with what risk. Conventional wisdom is that youngsters should invest in equity as it “always” outperforms in the long run. Now, that has been the case for a long time but I would suggest that this very fact makes it less likely to be the case in the future. Bond market returns are clearly mean reverting – falling yields means high returns today but the certainty of lower returns tomorrow; the best estimator for future returns is today’s yield, not last year’s returns. By extension, future equity returns are best estimated by today’s profitability and I am not sure that this is very encouraging for equity investors.
But, in any case, whether cheap or expensive it is a pretty simple product for government to offer and people will make their own choices as to what to buy.
A 20 year old might buy equity but as a 50 year old that might not be appealing. The point is that with this plan workers are not locked into any particular scheme for life and always have the option of purchasing a guaranteed income in old age.
Putting a clear (if expensive) price on a guaranteed income might encourage people to look at the underlying assumptions when they get “projected pension” estimates each year. It might make us realise that high investment returns of the last 20 or 30 years mean that very few are really putting enough away in the pension under realistic returns assumptions.
I fear the nest scandal will be along the lines of the Mortgage Endowment mis-selling – the “pot” does not grow as projected and whatever pot there is does buy what was hoped.
This is a great idea.
Only the state can offer completely risk-free assets (I/L gilts), and at the moment it doesn’t offer them at long enough maturities to meet potential full-lifetime needs. This means that insurance companies can’t offer their own versions, because they simply can’t hedge the rate risk (there are issues about longevity risk too of course).
Evidence of the hunger for such assets is already in the market. Market yields on I/L gilts peak for those at approx 27 year maturities at 1.35% real per year. Longer maturities have lower yields, reflecting their scarcity: the longest I/L with a 50 year maturity has a real yield of just 0.97%.
A first step towards Clive’s suggestion would simply be for the DMO to start issuing I/L gilts with 60, 70 and 80 year maturities: the market is already showing that it is hungry for them. It would then at least be possible for insurance companies to think about offering something like Clive’s product idea.
Yes, the shape of the real and conventional yield curves do suggest unsatisfied demand for long duration real and conventional gilts. The DMO should meet this demand – it satisfies investors and cost the government less.
It also suggests that there might be demand for the product I suggest.
I think more fundamental change is required if we want to provide a decent level of pensions whilst investing pension fund savings in productive activity. I have commented on Richard’s blog in the past to advocate the establishment of a National Pension Fund as the key element in addressing these two aspects.
DB pensions are virtually extinct in the private sector. Restoring them is key to providing a basis for a decent income in retirement. A NPF is the means to do that as it removes investment risk from employers and if people who are in DC schemes are permitted to transfer their accrued “pension pot” into the NPF (earning a credit towards a DB pension by doing so) then a NPF provides an opportunity for people to shed the investment risks that DC pensions impose on them.
A NPF can be designed to deliver a pension of 50% of pre-retirement earnings after 40 years of contributory employment, That can be supplemented by a state earnings related top up pension and/or a flat rate state pension. How the NPF and state pension components are integrated would depend on what level of pension relative to earnings is the desired policy objective.
The contribution rate for the NPF can be designed such that on a rolling annual basis contributions cover the pension payments.
The first stage in forming the NPF is to enrol all new workers joining the workforce at a specified age (say 20). None of this cohort will make a claim on the fund for 40 years and so their contributions will quickly build a large fund. That fund can be invested productively.
The fund can also be grown further by accepting transfers in of people who wish to transfer their DC pension pots in and start to earn DB pension rights.
Contribution income pays the pension benefits but the growing fund would also act as a “buffer fund” to provide liquidity if necessary whenever pension costs exceed contribution income. We know that NICs do not pay the state pension but in a funded pension scheme contributions do help pay the pension benefits. The NPF will be a “currency user” not a “currency issuer”.
Workers and their employers would pay NPF contributions but NICs can be abolished. Contributions into the NPF can be used as a measure of entitlement to the state pension (earnings related and/or flat rate) as well as an NPF pension.
It is possible that folk in DB pension schemes might also transfer in and/or their employer may decide to transfer the whole scheme in. DB pension fund consolidation is already happening as many employers have closed their DB schemes and eventually achieved “buy out” by pension insurers. We already have a de facto DB consolidation process ongoing, and big finance companies are increasing in size as a result with more and more financial assets being concentrated in fewer hands. Is that what we want?
The NPF will quickly become a large fund held in trust for citizens. It can be applied like a Sovereign Wealth Fund but the important distinction is that the NPF would not be owned by the state.
The size of the fund will enable greater risk to be taken in investments, including greater capacity for providing venture capital. The required level of investment return may very well be low too, especially if pension contributions are adequate to meet pension payments on an ongoing basis. A NPF may well reduce the cost of capital in the economy.
There is a wide range of issues to consider here and it is not possible to cover them all in a short comment piece. A NPF may not be the answer but if we are calling for “new ideas” then I firmly believe the concept deserves further and more detailed examination.
Jim,
I think you are missing the point – it’s not difficult to design the system, it’s just paying for it that’s the problem. And it’s a very big problem.
The suggestion that many private individuals can afford to put 30%+ of their salaries into a pension is just fanciful (on top of the amounts they are already paying towards the state pension).
This article highlights the huge costs of DB pensions – we are all paying this towards public sector pensions:
https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=&ved=2ahUKEwjQ2dOlruSCAxVk87sIHZW7BFkQFnoECDIQAQ&url=https%3A%2F%2Fwww.ft.com%2Fcontent%2F9d9b03d0-55ff-4e2a-8ec7-2caab0a89381&usg=AOvVaw3tzBoS2vo1G4HgvbaouuX0&opi=89978449
So what is the systemn that works.
Do you spend your whole life not answering questions?
Stuart,
Providing DB pensions via a NPF will cost a lot less than providing them via a fragmented system of thousands of separate employer sponsored schemes. I think that a pension of 50% of earnings could be delivered by a NPF based on annual contributions of around 18-20% split between employer and employee contributions (maybe a 12% – 6% split). NICs don’t pay for the UK state pension whatever illusions you may be under. The money spent by the state to provide a flat rate and/or earnings related top up can be recovered if necessary by a range of taxes which can be determined within a broad tax policy framework.
The other cost saving by running a NPF is lower regulatory costs – the complexity of the current “Pillar 2” DB/DC landscape has spawned a vast and very costly regulatory regime. The legal framework around a NPF can also address the inadequacies of the law relating to “fiduciary duty” – the NPF will have a duty to act in the best interests of all citizens, not separate groups of “beneficiaries” .
I agree, any system will fail unless there is enough put in – on that, at least I am sure we can agree. I think we would also agree that current contribution rates are far too low for the expectations that existing workers expect.
Should people keep paying in too little on the hope that real equity/asset returns will deliver a decent pension? (Most projections use about 7% which I suspect is wholly unrealistic).
You might be correct in suggesting that nobody will buy. They might prefer the prospect of 5% real returns in Equity instead of 2% in index linked gilts…. but that would be a risk. At 25 years old I might risk it; At 60 I might gradually buy into an annuity over the next 7 years to reduce the risk that you identify – that “rates can change in a heartbeat”.
I can understand that this is not for everyone but I can’t understand why you are so set against offering people a choice.
Also, assume 40 years paying in, 20 paying out, 2% real returns and 18% contribution rate. This gives about 55% of salary (assuming constant real salary) so Jim is not a million miles away with his contribution rates. (yes, this is very rough and does probably underestimate the contribution required a bit).
I think the 30% contribution rates you are saying are needed are to reflect the fact that historic contributions have been too low.
My real concern is that a 2% real return assumption might be too high. If you use 1% then things look worse with contributions of 22-24% required.
I suspect if the actuaries see a real problem, then to paraphrase a famous understatement: “We have a problem….”
At the same time I think we do need actuarial insight here; but it would be fair to ask of the actuaries, for future pensioners looking 40 years ahead; if we have a problem, what do we do?
Mr Parry, I think believes in a basic, State pension that is sufficient to offer some level of comfort and decency in living standards. The alternative, I submit – will (and does) prove far, far more expensive, in the costly consequences to all of poverty or ill health. The point to note, however is that the State has not set up a fund to pay the State Pension for which it accepts responsibility (although it has considered a funding model, it has never effectively implemented it); hypothecation has never worked well in Britain’s single bucket State, and is typically illusory. Only the State has the capacity to not to fund pensions; but it underscores the nature of the problem, for everyone.
John,
At no point have I disagreed with Mr Parry’s desire for a basic state pension offering a ‘decent’ standard of living.
I’ve just explained the cost of that pension and what must be given up in order to fund that, and some people don’t like the answer.
Mr Caldwell,
I wan’t challenging you; I was only crystallising my understanding of Mr Parry, partly for myself. I think I understand the general problem; I wondered what viable solutions you may consider worth future generations considering in pension planning? I have written a comment that pointed to the pensioner’s house as part of the modern pension pot for those who have paid off mortgages; and for many people that has produced a good IRR.
I’m afraid that no-one has ‘given up’, but the experts have recognised the limitations of what can be achieved, given basic economics.
The short answer is that people will have to consume (much) less when working AND be happy with (much) lower income in retirement, in order to make the sums work.
That’s not a message that the majority of the population are wanting to hear – particularly when the majority (lowest earners) are already being subsidised by the minority (highest earners) for things like the State pension etc.
So, are you saying we need a totally different system?
Or that pensions as sold now should carry a health warning saying ‘This product will not meet your needs’, or what?
I am asking you to take a positive approach. Is that unreasonable?
Pensions already do include a variety of health warnings, including confirmation that future benefits will depend on the investment returns achieved on the underlying investments.
Unless you are in a public sector DB scheme, then there are no guarantees.
As in the FT article I linked to, pretending that it is affordablen for individuals to spend 60% of their salary on their pension, as required for some public sector DB pensions recently, is not credible.
So why do you bother to work in a sector that has no apparent purpose because it cannot meet need?
@ Jim Osborne.
Your ’6% + 12%’ calculations are not credible, you only have to look at the contribution rates on private sector DB schemes to see that. And given that most private businesses are paying much less than 6% currently, then how affordable would it be for the majority of business to have their costs increased to that level.
Of course I understand that NIC doesn’t directly fund the state pension, but there is a link, given that if you don’t pay the required amount of NIc then you don’t qualify for a full pension.
@ Clive Parry
I am not against giving anyone a choice – but look what happening when compulsory pension annuitisation was removed – the number of people purchasing annuities fell of a cliff!
It doesn’t suggest that there will be huge take up for the type of product that you are proposing, assuming it was available at ‘fair’ price.
The only way take up would be significant is if, like public sector DB schemes there is a huge subsidy’ from someone else, which can only be from other taxpayers.
Why is the state subsidised by everyone else?
Is that a statement you can justify? Or is it just prejudice?
It’s just basic maths.
No it isn’t.
It’s politics.
Confusing the two is always an error.
Yes, they did. First annuity providers offered poor rates because they had a cartel and a captive client base. Second, market rates were low historically speaking when compulsion was lifted. Third, every IFA was peddling something that sounded better – well better for the IFA that earned fees.
We have moved on since then and at current rates there is a case for a product like this.
Agreed
‘So why do you bother to work in a sector that has no apparent purpose because it cannot meet need?’
At no point did I say I worked in the Pensions sector. I just explained that I am an actuary and as such have the technical expertise to do the sort of modelling that is required to work out the sorts of contributions that would be required to fund a pension of the type being proposed.
As actuaries we work in the real world, building models that take in a variety of assumptions to provide useful information on product design.
To this end, the pensions sector does what it can to invest money to target long-term returns to give people better options when they get to retirement.
What it can not do (nor can anyone else) is to create money out of nothing.
So, you are not willing to design a product that might work is how I read that.
Actuaries ‘make financial sense of the future’, they do not ‘construct products that disobey basic laws of mathematics, economics and demographics so they can pretend to achieve a desirable outcome’.
Nor do accountants
But we do try to find solutions
The government takes money in and pay money out. You only have to compare who pays what in and who pays what out to identify there is a massive amount of cross subsidy that takes place.
I can’t believe that anyone would dispute that cross subsidy takes place, neither that it is necessary and desirable for such cross subsidy to exist.
That’s a conception of government I do not share.
Perhaps we are not looking at this ‘in the round’, at least for significant numbers of private pension investors. Many people, i surmise, with a DC pension plan do not just have a pension plan; in substantive terms they have their (again typically) mortgaged home, which they will be planning to pay off. The assumed equity enhancement built in to this economic profile (broadly guaranteed by the subsidy to house values provided by the under-provision of new homes, combined with a growing population through immigration, and reduced per capita household occupancy); suggests that the house is overall perhaps almost as significant as the pension plan itself (more in return on investment terms). Of course everyone needs a home, but surplus equity in the home may be turned into cash when the mortgage is paid, and children have decamped, through ‘downsizing’; providing a windfall gain able to generate an investable contemporary return with the period of retirement, and at least a wider dimension to pension thinking and solutions – not for all – but for many.
Trying to find solutions does not mean ignoring economic reality – maybe that’s the difference between actuaries and political economists.
And why one group are in huge demand by all sorts of institutions globally and command top quartile salaries.
🙂
When did you have the charm bypass?
Perhaps you need to re-read your own comments first?
I did
I simply asked you to answer a question and all I get back is that there is no answer.
Thankfully, I live in world where we try to solve problems. You clearly don’t. Which is a shame.
Richard began with a title: “Pensions: is new thinking needed?”
There has been a frank exchange of views. I have great sympathy for Mr Parry’s general objective, but at the same time (and before everyone retreats into pre-prepared positions), I do not know if Mr Caldwell represents general actuarial opinion, but I am not sure where the pensions industry goes, without the actuaries. I am looking for constructive conciliation here. After all, I do think everyone is engaged here; and Mr Caldwell has kept contributing to the discussion. I would hope to keep the door open, because Richard is right; we need some fresh, workable and saleable thinking.
Of course I don’t speak for the actuarial profession, but you’d be hard-pressed to find many actuaries who would dispute my comments above, emphasizing the basic economics of pensions, and that the required contribution rates to fund the sort of pension that was being proposed, just isn’t viable in the real world.
But as I note elsewhere, your comments on money suggest you have not a clue how the real world works.
In the real world, you can’t create money out of nothing, without consequence, Richard. That’s the reality.
That’s why actuaries work in real businesses that deal with real economics in real markets with real constraints.
You really need to learn about money.
All money is made out of nothing. Every single penny of it. It’s all based on promises, including an inter-generational one. And there is literally no limit to its amount.
So much of what you have said here is so wrong.
I really don’t think you understand finance or economics at all. The maths, I am sure you do. The real world, maybe not much at all.
It’s like looking at a non-overlapping Venn diagram
Of course Richard, you’ve solved everything – money can be made out of nothing without consequence, so we can just offer everyone a £100k retirement pension for a contribution of just 6% of their salary p.a. and just create the money to pay for it.
What could possibly go wrong?
To become an actuary you need to pass exams in economics and finance, as well as a variety of other subjects. Qualifications that you clearly don’t have.
Can you remind me which ‘real world’ business are knocking on your door, desperate for your amazing knowledge and understanding of finance, economics and ‘real world’ solutions?
So, we are reduced to trolling.
I have a degree in economics.
To be a chartered accountant you have to be qualified in finance.
And for my work in political economy I have been elected a Fellow of the Academy of Social Sciences.
And what I did not say is we can make unlimited money.
What I did say is literally every penny we have is made up, or created out of thin air. Read the Bank of England on the issue in the first Quarterly Review of 2014.
It would seem you passed an exam on an archaic syllabus in economics but the continuing professional education might be lacking. It is obvious you do not understand economics as it is now understood.
Frankly, I now doubt you are an actuary. You could not read my cv on this blog and made up ludicrous claims instead. As I said, pure trolling.
Richard, I’m sorry to have to tell you this:
You do not have a degree in Economics, you have a degree in Business Economics and Accountancy – that is far from being the same thing.
You are a qualified accountant – most people (and the available evidence) would suggest that the actuarial qualification is much more onerous and rigorous than that of accountancy.
Your other ‘qualifications’ are not actual qualifications just somewhat meaningless titles that you’ve been awarded, but which have no relevance to the world of finance / business. That’s why you don’t work in a ‘real world’ finance role.
Quite amusing really because I just realised you commented under two names on this issue. You changed name after your first comment. You might like to write nonsense about my qualifications, but you are not what you claim to be. And you are now banned for trolling.
I am old enough to remember the 1980’s when a number of companies had to make significant contributions to their DB pension schemes and nobody thought that this wasnt something they should do.
Similarly in WW2 my late father continued to have his salary paid by his employers, the Midland Bank when he was serving in the army. It wasnt just the middle classes who benefitted from such largess either, in his autobiography, Percy Parsons, who started his Railway Career as a porter with the Somerset and Dorset Joint Committee at the Clapham Junction of the Somerset Levels, Edington Junction also continued to be paid during his service in WW2 despite the generally dire financial position the railways were in.
So if these sort of things could be afforded in the past why not now?
Looking at the cost of higher pensions in purely financial terms is not the only frame of reference that can be applied, and IMHO it is perhaps the least helpful frame available. To qualify that claim: if you are a private company who is closing down a DB pension scheme and aiming to offload your remaining future liabilities, then it *is* the right frame to use. But that’s not what we’re talking about here: we’re talking about public policy for pensions. There are two frames of reference that are more relevant in this case.
First: while it is generally correct than somebody will have to be spending less if pensioners on low-to-middling incomes are to spend more, the State’s power to tax can be used to reduce spending wherever it is deemed appropriate. So it is not just a question of increasing pension contributions; both higher pensions contributions and higher taxes, or of course a mixture, are possible approaches. If doing it all with higher pension contributions looks difficult because they’d have to be very high, that doesn’t mean it’s impossible; rather, it’s an argument to use higher taxes instead. This is where Richard’s “taxing wealth” series could come in.
Second: there is the perspective that we need real investment to generate the future wealth that can pay for future pensions. Tax is a way of reassigning the use of some of the wealth that exists in any part of the economy, but it is only possible to reassign such wealth as actually exists. Health and infrastructure are the usual areas of real investment that tend to give a high rate of return; the latter now needs to be focused on mitigating climate catastrophe, because the latter carries a real risk that we will collectively be a lot poorer in the future.
These real investments could be made by pension funds, but the essential point is just that they are made.
(Circling back to private companies with DB schemes … as I said, if they are closing the scheme down, their liability has to be looked at in financial terms. But what if the mistake is the decision to close the scheme? If they kept it open, perhaps they should mainly worry about whether current contributions are sufficient to pay current pensions. If they are, perhaps they should be less concerned about theoretical deficit/surplus figures for the scheme – figures which tend to highly volatile, depending on market movements. I appreciate that this “mistake” may be one they are forced to make because of the views of regulators.)
It seems to me obvious that ‘subsidy’ by Government, one way of another of pensions, biased toward the lowest paid, and tapering off as income increases, is unexceptionable in a society that aspires to common decency. I say one way or another, because if we take the BoE interventions in the LDI crisis end 2022/early 2023; the buying back of Gilts by the BoE was followed by the Gilts being sold back in a “timely but orderly way”; but nobody dwells overlong on the shortfalls left to the BoE through these transactions to shore up the Pension Fund industry.
I am still trying to understand why we find ourselves in a world where pension funds (pension funds!) are found to be (routinely?) doing LDI business, and paint themselves into precisely the corner the pensions industry – of all people in the whole world should NEVER be – the liquidity crisis “dash for cash”; after all, the investors they are protecting are not investing in a deposit account at call, and likely turn up in a disorderly queue to retrieve their cash in a crisis, but are invested long term in (say) a future, 40 year annuity, with limited or no immediate access to their money.
I completely agree; at a fundamental level pensions are not about money. I hope my opening paragraph made that point and that my suggestion is not a “solution” to the question of how do we invest productively, merely a product that might deliver what current pension savers want – certainty of purchasing power in old age. The BIG issue is how we invest today in the real stuff that we need tomorrow which will allow tomorrows workers to be sufficiently productive to look after the old folk AND have a decent life for themselves.
There has been a lot of back and forth on the subject but I think we can agree on some things.
First, a better State Pension solves a lot of issues (but creates others in terms of redistribution of resources between different people today AND between today’s generation and future generations).
Second, buying a forward starting annuity is a lovely idea… but the issue is cost. (Cost to the individual AND government if it chooses to offer high real rates)
Third, Expectations of living standards in old age exceed what is likely to be delivered because not enough resources are being “put in” today.
All three things have a common theme – getting old is not cheap and as a society we have failed to address this. Why? because our politicians will not be honest about what it means – lower consumption, higher investment.
The Dilnot report (aiming to address part of the aging issue – care) is over a decade old without anything happening; what chance of a serious discussion on pensions?
Mr Parry,
I think that a good summary overview. The issue that has to be addressed most of all perhaps, is the investment required for that period forty years hence. Of course nothing we do guarantees what the world will be like in forty years; all we can do is invest as best we can understand the direction of travel, to prepare for that future. The forty years of neoliberalism has not been investment driven, but borrowing and rentier driven; squeezing out more and more profit out of – for example – old, decaying infrastructure for negligible new, productive capital investment. It has thus been a ruinous forty years of wasted time and opportunity.
Phil
the fundamental flaw in disaggregated employer sponsored DB schemes is that eventually contributions cannot cover the costs of pension benefits. The reason is quite simple – over time the number of retired pensioners and “deferred” members (who are still working but for another employer) in a scheme grows relative the the size of the contributing “active” membership. I took a look at the demographics of the Scottish LGPS funds a while ago and the ratio of contributing employees to pensioners was down to a bit over 1. All segregated DB schemes, from the smallest to the largest, follow the same trajectory from the point they are established. Initially there are no pensioners and lots of employees making contributions but once the first person retires the ratio of actives to pensioners goes into decline and, once the liquidity to pay pensions cannot be derived from contributions, investment returns become more critical, and “deficits” occur more regularly and with increasing size and volatility. The advantage of a universal NPF is that the demographics are much more stable and mirror the demographics of the nation as a whole. Whilst the “dependency ratio” changes over time as folk live longer it changes gradually and predictably so the NPF can be adjusted gradually if necessary to reflect that. There would be no need to reduce pension benefits as happens in all disaggregated employer schemes although some upward adjustment in contribution rates might be needed and/or additional support provided via the state by increasing the level of “top up” that can be designed in to the way the NPF and state elements of total pension work together. The state can also act as guarantor of the NPF and in that sense functions as a “sponsor”, but unlike private sector employers who sponsor pension schemes the state cannot go bust.
There would be relatively few deferred members in an NPF scheme since it covers all workers and all employers so everyone stays in the NPF scheme when they change employer. The only “deferred” members would be those who decide to retire early but defer taking their pension plus some temporary deferred members who take time out of work during their career (eg for education, carer roles, parental leave etc)
Jim,
You must be right that a single NPF would be much more stable than many disaggregated DB schemes.
However, I would like to probe the issues with disaggregated schemes a little more, if I may.
The ratio of contributing employees to pensioners will obviously decline for a new scheme. But won’t it level off eventually? Rises in life expectancy are now stalling. Pensionable age has been increased for many schemes. Or is part of the issue that the *number* of contributing employees is also declining?
At a point when current contributions are less than current pensions in payment, are current contributions *plus* investment income still greater than pensions in payment? Because if they are, I think perhaps schemes ought to be relatively sanguine about fluctuations in the market value of investments. (Capital values of investments are far more volatile than the income they generate.) Though perhaps the regulators don’t allow them to be?
Thank you Clive Parry (and Richard for posting this)
Thank you Jim Osborn (and some other commentators)
I was a DB Pension Fund trustee for 16 years, which has left me interested but cynical.
I try to look at the published accounts of the Universities Superannuation Scheme for some insight. A couple of years ago, using some strange assumptions, their actuary appeared to predict that a £1 contribution to USS would give a member 60p worth of pension.
In which case why bother? Was the assumption that in the future the UK economy will be 40% smaller?
My suggestion is absurdly simple.
Pension funds already invest heavily in Government bonds.
Why not create a Pension Bond, index-linked, that instead of a dividend pays an actuarially equivalent index-linked pension?
Most of the actuarial heavy lifting is already in place. Every year an actuary looks at the assets of a pension fund and the cost of its obligations.
There would be several advantages:
1) Many organisations and pension fund trustees would be delighted to offload the liabilities of their scheme. If the scheme were more generous, it would only need to hold assets to underwrite its additional liabilities.
2) If a pension scheme were less generous, members would be delighted to receive a better pension for their contributions.
3) Many DC scheme members would welcome a pension guaranteed in real terms
4) Almost all non-Government pension schemes are funded, only the Government can afford pay-as-you go. Transitioning gently to pay-as-you-go would give an immediate influx of funding to the Government to fix the NHS, schools, and broken infrastructure.
Other points:
a) Although I am the recipient of a good final salary DB pension, because Pension Bonds would cover a wide range of professions and salary scales, I don’t think final salary would be feasible. For fairness, it would have to be £1 of contribution = £1 worth of pension for everyone.
b) I thought originally that the bonds could be issued by a Development Fund and simply underwritten by the Government. I don’t now think this would work, because the benefits of a functioning NHS or better infrastructure would flow to the Government as tax, not to the Development Fund. I think they would have to be Government-issued pension bonds.
c) If a large swathe of the pension industry moved to pension bonds, it would disrupt financial markets. A transition would have to be managed.
There would be a mass of details to work out – spouse’s pensions, ill-health etc. How to make the bonds available to individuals and pension schemes.
Nevertheless, I think this would be a good way forward.
One for Clive, I think
This is (almost) exactly what I am suggesting.
The only argument against is that people will baulk at the cost of buying a guaranteed pension but let’s offer it and see.
It might not be as expensive as it sounds because currently a lot of pension is “lost in the wash” as insurance companies transform the cashflows from bonds to annuities for pensioners (and take out profit).
The last is so true
Michael
you said…..”Many organisations and pension fund trustees would be delighted to offload the liabilities of their scheme.” They are already doing that and many have managed to achieve it – in the pensions “buy out” market. This is what my former employer and the pension trustees are now seeking to do (the “end game”). What is going on here (as I said before in my original comments) is a de facto consolidation of DB pensions by transferring the assets and liabilities to a small number of finance companies. This is concentrating huge quantities of DB pension assets into the hands of private, profit seeking financial companies who are very unlikely to invest in real productive assets rather than carry with the speculative buying and selling financial assets, which build up future financial claims on the economy without contributing anything towards creating the productive capacity to satisfy those claims.
BTW I was also a pension trustee for 7 years as well as a senior trade union rep. My motivation for becoming a trustee was to explore how my pension fund could be managed in order to help build a “better world”. Pension funds have the potential to do that but not if we carry on organising and regulating them the way we do now.
There is a better way to do this – a NPF is the ideal “consolidator” and I’m pretty sure that companies with DB pensions and the trustees of those funds would jump at the opportunity to transfer into a NPF. DC scheme members would also have a strong incentive to transfer and thereby covert a DC pension and all its attendant risks into a national DB/earnings related scheme/fund
Phil
It is mathematically inevitable that the decline in the worker/pensioner ratio (w/p) will level off over time. If the active workforce is 100 initially the w/p ratio is infinity. It falls to 100:1 at the first retirement, 50:1 with 2 retirements 33.3:1, 25:1; 20:1……..and when half the workers have retired it falls to 2:1.
At some point the pension contributions no longer cover pension payments. That point will vary from scheme to scheme….we are talking about a generic trajectory which is a feature of all disaggregated DB schemes but actual details will vary.
The ability to keep contributions adequate to meet pension payments then relies on either increases in rates of contributions by employees and employer or reductions in pension benefits or, a combination of both.
In the Scottish LGPS funds the w/p ratio has fallen to about 1.2:1. A couple of years ago the Strathclyde Pension Fund (the biggest of the 11 Scottish LGPS funds) reported that contribution income for the year was more than pension payments; however in the projections for the following years this was not the case but investment income made up the shortfall easily. The fact that contributions were enough to cover pension payments can only be the result of increases in contribution rates in recent years and reductions in benefit levels – the latter by changing from a “final salary” DB scheme to a “career average” DB scheme. Combined employer/employee contributions are over 25% of payroll – employers contribute 19.2%; employees contributions vary with salary but average out at around 6% or so.
This generic problem for disaggregated DB is exacerbated by the fact that the fund has to be maintained at a level which is capable of fulfilling all the pension promises (the “liabilities”) in the event that contributions cease. There is a basic (and realistic) assumption that employer sponsored DB schemes have a limited life span. Whilst employers may be relatively sanguine about asset values they are a lot less sanguine about the value of pension fund liabilities. The problem there is how liabilities are valued and in particular the vulnerability of liability values, and therefore the size of any “deficit”, to fluctuations in the discount rate which depends on interest rates. The reporting of funding deficits is the trigger for employers to seek to increase contributions rates and/or reduce benefits and frequently results in industrial disputes, especially in unionised workforces.
I was a senior trade union rep for 20 years and faced several stages in the life cycle trajectory of the company DB pension scheme including the first changes in benefits, changes in contribution rates, and closure of the scheme to new members. All of these changes were seriously contested and compromises achieved through negotiations. After I left the company the DB scheme was closed altogether and the trustees are now in the “end game” stage of planning for a buy out by a pension insurer. Employers are devious – the close the scheme to new members so existing members aren’t immediately affected and support for the union in resisting the closure is weak. After achieving that employers then come back later and close the scheme altogether – classic divide and rule as the new members who are in a DC scheme have no stake in fighting to keep the DB scheme going.
The levelling off of the w/p ratio in a NPF is predictable – it will level off at the ratio of working age population to retired population across the nation as a whole. There is no necessity to assume that contributions will ever cease and so there is no cause for concern about “deficits” – what matters is the annual cash flow and that allows a contribution level to be set which permits contribution income to match pension payments on a rolling annual basis; this is in effect designing the NPF as a “pay as you go” scheme as the starting point.
If the national “dependency ratio” (the w/p ratio) is 2.7 workers to every pensioner then the “pay-as-you-go” contribution rate (C) is a function of W/P and the “replacement ratio” (R). R is the chosen pension income as a percentage of pre-retirement earnings. So if W/P = 2.7 and R = 50% C=1/2.7 x 0.5 = 18.5%. If W/P is 2.5 then C = 1/2.5 x 0.5 = 20%.
This calculation does not take into account any investment returns from investments made by the fund so there is scope to discount the “PAYG contribution rate” if desired to take account of expected investment returns.