The Annuity Boomers
Years ago, when pensions were far simpler than they are in today’s simplified tax regime, the main form of pension provision being accrued by ordinary people and fat cats alike was of the final-salary company pension scheme variety. The UK’s extremely favourable pension position today when compared to other European Union countries has been built on the foundation of the voluntary occupational pension schemes built up by employers in the 1960s and 1970s. OK, so those schemes had funny beginnings as they were largely built to get round the wage restraints that plagued those decades, but final-salary schemes grew and thrived to such a point that, years later, the incoming Labour Government in 1997 described them as one of our greatest national assets and one on which they intended to build their pension revolution.
Well, those days, like all other past days, are now over and our private sector final-salary schemes are today in terminal decline. Don’t take my word for that, ask the Pensions Commission or the National Association of Pension Funds, or the scores of other institutions and trade bodies that have investigated and reported the impending death of these modern day dinosaurs.
The rapid flight from final-salary schemes to money-purchase schemes in recent years has been well documented, as has the sharp reduction in employer generosity when sponsoring pensions for their employees. A typical final-salary scheme promising sixtieths of final earnings for each year of service would set the sponsoring employer and employees back something like 20-25%1 of payroll (with maybe 5 or 6% being put up by the employees). That’s a big ticket cost to employers good enough to offer such schemes to people and today is an increasing rarity outside of the cushioned public sector. The vast majority of private sector final-salary schemes these days are closed to new entrants. The schemes have effectively been closed off and new employees in such companies are offered money-purchase schemes as an alternative. Also, it is not unusual for such money-purchase alternatives to come with a lower monetary commitment from the boss, with average employer contributions somewhere around the 5% mark. From the employees’ point of view that’s a bit off really when you think about it.
In a final-salary scheme the employer takes all the risks; the longevity and mortality risks, and the investment risks. Basically, the employee knows what his or her pension will be relative to final earnings levels, but the employer has no real idea of what it’s going to cost to provide it. Worse still, as general levels of mortality and longevity improve and high investment returns get harder to find; many employers are left wondering why they ever thought giving out such generous promises was a good idea in the first place. Money-purchase schemes, on the other hand, put all the risks onto the employees and none onto employers. In a money-purchase scheme the employer commits a certain amount of cash every year to each employee’s pot and if the investment returns are not too good, or the annuity costs go through the roof following some amazing medical breakthrough, then it’s bad luck on the employees. That would be bad enough if the contribution levels to the money-purchase schemes remained in the region of 20 to 25% of payroll, but it’s made much worse with the sudden drop in contribution levels that have accompanied this flight to safety by employers.
But closing off final-salary schemes to new entrants isn’t such a good idea if you’re an employer trying to get your long-term costs down. The trouble is such schemes rely on the influx of younger people to keep average costs where they are today and cutting off the young blood means costs are sure to rise for the closed scheme. That’s why the closing of schemes to new entrants shouldn’t be seen as an end in itself; it’s just the first stage in the process that ends up with the final-salary scheme being completely dismantled. The next stage, of course, is for the schemes to be closed for future accrual for those left in them and we’ve already started to see incidences of this reported in our Sunday papers lately. There’ll be much more of that to spoil our weekends as time rushes on I’m afraid. I mean, don’t buy the papers if it really gets to you. Or read them on Monday like I do as that day’s a complete write-off good mood wise anyway. Like how much worse can a Monday be?
The death of the final-salary dinosaurs is well documented and I’m sure we’ll read about every stage of the death throes. But the end result, which to me seems beyond doubt, is that we are all heading for a money-purchase future where we will be increasingly dependent on the spending power we can accumulate through thrift while we’re at work to see us through an ever-increasing length of time in retirement, or at least out of the workforce. The proposed National Pension Savings Scheme (NPSS) will do its bit to add to this future by steering many more into money-purchase go-it-alone savings plans, albeit with the paltry addition of only 3% of earnings (above around £5,000 pa and below £33,000 pa) from employers2.
This money-purchase future is one in which more and more of us will be in the position of needing to buy our own annuities when we retire. An annuity, as I’m sure you know, is a true insurance product. We use it to ensure our savings don’t run out while we’re still alive. An annuity pays an income for life in return for a capital lump-sum up front. For people with fairly substantial pension savings there is the option of income drawdown, but for those with more modest savings that’s not really a sensible alternative. For most people in the future it’s likely, as it is now, that converting their pension savings into an income stream (through buying an annuity) is what they’re in for. But buying annuities isn’t something we’re too good at.
A report by the Pensions Policy Institute (the PPI) points out that buying the wrong type of annuity can result in a differential in income of up to 40%3. That’s a staggering difference. But it’s not just buying the wrong type of annuity that brings risks with it. Even where people get that right there are still wild variations in the values of annuities on offer. The FSA comparative annuity tables show that there can be more than 15% differential between the top and bottom rates on offer4. So people need to be in eyes wide open mode when they’re spending their money-purchase pension pots. I would say that if you only ever pay for financial advice once in your life it should be when you are converting your pension savings into an income stream. In the past not many people had money-purchase pensions. In the future practically everybody working in the private sector will. We shouldn’t be worrying about the baby boom when it comes to pensions; we should be worrying about the annuity boom and how we’re going to cope with it. Hopefully there will be enough Independent Financial Advisers around to help us in the difficult transition from being savers to being pensioners.
6 June 2006
1. Pensions Commission First Report published 12 October 2004
2. Security in retirement: towards a new pension system - DWP 25 May 2006
3. "An analysis of unisex annuity rates" Pensions Policy Institute June 2004
4. FSA Comparative tables – Male age 65, level pension, single life, 5 year guarantee, purchase price £100,000
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