“Whatever they say it is, that’s what it’s not”
(why market trends matter more than big ideas) – Part 1
This BeeLine’s a bit different to some of the other stuff I’ve put on the site over the last few years in that it’s sort of part of a set. A set of BeeLines, most of which haven’t been written yet if I’m being honest, but are in my head somewhere or other all the time. The Chubby Cat paper I wrote late last year is one of them and there are probably a few others littered around the BeeHive site too. You’ll know them when you see them. They’re the source I draw on when I’m speaking at conferences around the industry in the peripatetic portion of my particular job; the things I decided a long time ago to put down in writing if I ever got the time. I just got a little time, so I put this one down in writing. It’s really all about what I think I see going on around me in the pension marketplace in the UK right now and where it’s likely to lead us. For all I know it’s all true…
28 June 2006
“Whatever they say it is, that’s what it’s not”
(why market trends matter more than big ideas) – Part 1
“But Eden is burning…
either get ready
or else your hearts must have the courage
for the changing of the guards.”
Looking back over the last decade of changes to the UK pension markets it is not hard to discern a number of fundamental trends. First, and most importantly, the employer sponsored final-salary occupational scheme appears to have had its day. The decline of this erstwhile mainstay of the UK pension system has been rapid when judged in historical context. They’ve appeared to have been doing fine for the last fifty years, but have fallen apart in just the last five. The continued decline and eventual disappearance of this type of pension arrangement, in the private sector at least, appears to be both inevitable and unstoppable. It will also happen at an increasingly fast pace. There are many reasons for this including lack of foresight by central government, but the reasons are no longer important, or even the real issue any more. The fact is the vast majority of private sector employers in the UK have come to regard final-salary schemes as presenting serious threats to their businesses and they are actively seeking out ways of divesting themselves of the open-ended nature of salary-related pension promises. Today this is a widely-held view throughout not just the pension communities, but in wider business circles too.
It’s not just opinion, though, a survey published just yesterday highlights the fact that the number of final-salary schemes that are still open to new entrants today has dropped to just 30%, whereas that number was 60% just three years ago in 2003. Of those closed to new entrants, over half say they are considering ceasing future benefit accrual for existing members in the next three years 1. The years we are currently going through are seeing staggering changes to our pension landscape. Indeed, the National Association of Pension Funds (the NAPF), the trade body that represents the very largest pension funds in the UK, is reported in this morning’s Daily Telegraph as saying that it does not expect there will be any final-salary schemes still open to new entrants by 2010 2.
The restructuring of final-salary occupational schemes has followed a predictable line. Damage limitation by excluding more recent employees from the pension promise with employer commitments for them limited to fixed (and budgetable) monetary inputs into money purchase arrangements has been the most common first step. Things cannot end there, of course, as in the longer run such action will only serve to crystallise the real costs of the promises to older workers all the sooner. But it is a reasonable holding position for employers to have taken up. There are likely to be other interim stages on the road to the eventual closing of the schemes to future accrual for existing members and each company and scheme will choose its own route along that way. The bottom line is employers will be looking to reduce the pension promises they have made; or require increased employee contributions; or ask employees to wait longer to qualify for their pension benefits; or any combination of the three. Employees, particularly those within shouting distance of retirement, may well go along with such an approach in a desperate attempt to keep the old empire alive long enough for them to benefit. There will be some notable skirmishes and battles and even some glorious victories for some employees, but the sun is going down on the private sector final-salary empire. There may well be echoes of these distant battles in the public sector where final-salary schemes continue to survive, but that is something that will need to be resolved between the government, its employees and the electorate. What happens, or doesn’t happen, to public sector pensions has no bearing on the hard-nosed real-life choices faced by private sector employers and their employees. It’s far enough removed from their reality to be a TV channel from another planet.
The restructuring of schemes and the holding of the various entrenchments on the slow retreat from final-salary has provided parts of the UK pensions industry with a remunerative and useful role over the last decade and will continue to do so for the next. The rebundling of services around dying and changing schemes is as natural as the unbundling and widening-out of those services was in the thriving years of growth. The company pensions’ big bang has now moved on to being a big crunch. The legions are going back to Rome. The introduction of European anti-ageism legislation late in 2006 and the structural changes the UK government is about to make to the State Second Pension (S2P) will add extra variables and challenges to this process of retreat and entrenchment and may even bring forward the time of closure for the vast majority of dying final-salary schemes. But that doesn’t really matter either.
The second main trend that has become apparent in the UK pensions markets is the rise of individualism. Collective schemes based on employer benevolence probably wouldn’t have survived this growing 21st Century movement anyway. In all consumer markets in the internet (or broadband) age the trend is towards niche marketing and individual choice. Control is what people now expect in every aspect of their lives as consumers and citizens. To some extent the regulators along with the consumerists and financial journalists have helped to cement this idea in the public psyche as far as financial products are concerned. The wheel has moved on. Consumers of financial services products such as pensions these days, quite rightly, expect much more from product providers and advisers; and they won’t put up with being patronised. They want products they can control; they are not interested in products that control them. It is questionable whether there will be a place for mass market pension products ever again.
The fact the current Government has embarked on a six-year plan to build such a mass market pension offering is not really relevant. Governments are not best placed to engage peoples’ imaginations through product design and no-one should take them too seriously when they say that is their aim. A collective and redistributive mass-market pension product such as the pension accounts government ministers are touting today are likely to be as successful as would be any attempt by government to sell tape recorders, say, to the iPod generation. It just wouldn’t work, even if the tape recorders were cheap. To the average person that is self-evident. Government ministers, of course, are not average people, or at least they don’t inhabit the same world that younger people today are so street-wise and comfortable in (or uncomfortable even, if they are saddled with student debt and high housing costs). None of that really matters either though. People will make their own choices and do what best suits them. That is the way it should be. Financial services marketers, like market watchers the world over, understand that, which is why products like the Stakeholder Pension and the so-called Sandler Suite of products (the last two big product ideas from central government) would never have appeared through natural processes. Having appeared, of course, these ‘products’ have been treated with the level of apathy marketers would have expected from savvy 21st Century consumers. One day they will be buried properly, but for now they’re just dead in the street somewhere. Even government ministers no longer talk about them.
The third main trend that has had such an effect on the pensions markets in this country has resulted from a deliberate policy of the Government. The growth in means-tested support for those already retired, a noble act that has done a lot of good, has had the perverse effect of also acting as a highly effective disincentive to saving in a pension for millions of people in the workforce. In a nutshell, people who save money in pensions these days are now taxed more than people who choose not to save.
That there is not yet a general understanding of this is not important at the moment. Enough pension providers, pension distributors and employers understand the issue well enough for the spread of pension schemes to the unpensioned half of the workforce to have already ground to a halt. (Many people mistakenly regard this as a crisis rather than seeing it as a natural market reaction to a distorted environment.) It will become more important if the government ever launch the proposed pension accounts in 2012, but by then there may be a better general understanding that what for many seems to be a pension might be nothing other than privatised welfare. Indeed, for many millions of people at work in the UK today the proposed National Pension Savings Scheme might more properly be referred to as a National Voluntary Tax Scheme. Whether people understand that or not, it seems unlikely that pension companies and distributors will ever be able to justify getting involved in distributing such arrangements. Fortunately, the government apparently expects them to do so at a financial loss, which should make it doubly unlikely any will even consider taking the risk. Hopefully the government will, in the meantime, have been successful in their wish to spread financial literacy. A financially literate population would have little trouble in understanding the real nature of a redistributive savings scheme, whatever it is called. And however it is dressed up.
These three main trends; the collapse of occupational pensions; the rise of individualism; and the levying of tax on unwary savers, will between them determine the structure and shape of the UK pension markets of the next decade. There will be just three main market sectors for pension providers and distributors:
- a breaker’s yard for final-salary schemes and a switch to money-purchase future accrual
- an individual pension top-up market for disenfranchised company scheme members
- a mass-market sweep-up of those who are currently unpensioned
There will be niche markets, of course, and other main market sectors such as annuity provision for Baby Boomers will emerge from 2015 onwards, but for the next ten years or so the noise around pensions will be concentrated in these three main areas.
Of these three main areas of activity the third appears to be a false market. The distribution of pensions to people who do not currently have them will clearly either be advice-intensive or a dangerous undertaking if savers are to continue to be taxed for saving. The acceptance by government that means-tested support for pensioners will continue as a feature of our pension system well into the first half of this century unfortunately ensures that. The reputational risks that would be run by those attempting to distribute pensions in such an environment simply look unjustifiable. In any event it is to be hoped that any misdirected drive towards careless distribution of mainstream products that are potentially unsuitable investments for millions of people will not be tolerated by a more financially aware populace.
The other two main pension markets, though, (which are both evolutionary and derive from the action of real forces in today’s markets), deserve serious consideration.
The final-salary breaker’s yard
The final-salary occupational pension schemes in the UK have assets of around £1,000 Billion tied up in them 3. That is an enormous amount of money, but it is not enough to meet the benefit promises that employers have made to their employees and those they have allowed successive governments to make on their behalf. The black holes in UK private sector schemes are well documented as are the remedies to remove them proposed by the new regulator. The bottom line is employers will have to pay more money into their schemes to ensure the promises are met. They will also have to fund at a higher rate in future to ensure the black holes don’t return.
Finance directors tend to want certainty when it comes to pension liabilities and the money-purchase approach is obviously appealing in that respect. With a final-salary scheme the employer really has no clear idea of what the eventual cost of the promises made will be. Nervously watching each new investment or mortality development, while stumping up the cash to cover them required under modern accounting and funding rules, hasn’t been much fun for FDs over the last decade. With the money-purchase approach finance directors know where they stand. They put an agreed and fixed amount of cash into their employees’ pension pots and that’s the last they have to worry about it.
The vast majority of the private sector final-salary occupational pension schemes in the UK are now closed to new entrants and offer a money-purchase pension to their more recent employees. What started as a trend has now become an avalanche. Having taken this action employers have been looking to reduce the costs of the closed-off final-salary schemes that now contain an ever-dwindling number of their older employees and the deferred and pension benefits of their ex-employees. For those pension providers that have maintained sufficient expertise within their businesses to run final-salary schemes this trend has turned into a significant growth market with much potential. In particular, the previous two decades’ trend towards the unbundling of services around final-salary schemes that saw the investment, actuarial and trustee functions outsourced to a burgeoning community of specialist providers, is now sharply in reverse. The rebundling of such arrangements can come with serious cost reductions in tow. It is something FDs looking to put their final-salary past onto the corporate back burner find hard to resist.
The demise of final-salary schemes and their mutation into the money-purchase schemes of the future is something many lament, but that is really to miss the point of what is happening. Things evolve, have their time, and evolve again. Final-salary schemes had their time in the era of mid 20th Century post-war employer benevolence. They flourished in the 1960s and were particularly useful to large employers in the collective-bargaining and wage-capped turbulence of the 1970s. They survived the boom and bust of the 1980s and 1990s, but emerged from that period saddled with massively increased benefit promises imposed by central government. The low inflation, low return world we stumbled into at the turn of the century has caught them short on cash and high on promises. That wouldn’t have been so much of a problem in the sixties or seventies, but it’s a show-stopper in the fight with globalised competition in the 21st Century. Bob Dylan’s point about the changing of the guards that I put in quotes at the beginning of this paper is particularly apposite in this context. As far as final-salary schemes are concerned Eden is burning.
The real market for personal pensions
For the millions of people who are members of final-salary occupational pension schemes the past few years have been a bit of a rocky ride and the next five years will come with momentous changes to their pension plans. All of those in private sector employment will soon work out that they are unlikely to be able to rely on their employers bankrolling their future pension accrual on the comfortable basis they have taken for granted in the past. For many, the game is already up, for the rest the writing is on the wall.
But it’s not all doom and gloom for people who so far have enjoyed the benefits of their employers taking on all of the risks and most of the costs associated with saving for a pension. For a start, the advent of the new Pension Protection Fund, and the clampdown on solvent employers walking away from their pension promises that preceded its introduction last year, means that such peoples’ pensions promised to date are now as good as guaranteed. That’s a real bonus for them as it means that for the first time in their lives they have past-service pensions they can really count on (although they will up to now have been blissfully ignorant of the thin ice they’ve been on pension-wise in the past). The past is in the bag.
That’s not such a bad time for all of them to catch breath, work out what they’ve got stacked up to their credit on the pension front already, and look to see how they can build on that in the future. Sure, that future’s not so secure any more, but they’re not powerless to do anything to help themselves either. Far from it in fact.
A good final-salary pension scheme, providing sixtieths of final salary as a pension for each completed year of loyal company service, would have given a long-term employee (some would refer to as a ‘lifer’) the reward of a handsome pension for life of about two-thirds of their earnings close to retirement. For a man on national average earnings of around £24,000 4 such a scheme would deliver a pension of £16,000 a year for life. A pension for that amount, with built-in increases and continuation rights for a spouse, would cost a 65 year-old around £400,000 to buy on the open market 5. Or to put that another way, more than double the cost of the average house in the UK today 6. The average person in an average house, but with no pension, couldn’t downsize far enough to buy themselves an annuity of £16,000 a year; something those obsessed with property as an alternative to pension saving would do well to think about. Final-salary pension schemes are not just about fat-cats whatever the national press would have us believe. Most of the £1,000,000,000,000 in company schemes is held in respect of Joe and Josephine Average.
The word ‘loyal’ that I used in that last paragraph is important. Employer-sponsored pension schemes have been seen as the best tool for engendering loyalty amongst a company workforce now for a couple of generations. Larger employers have been the ones who have been able to pick up on this, but today they’re just as likely to use other means such as SAYE share option schemes for the same purpose, but at less risk. The example I’ve just given demonstrates how an average person earning a modest salary throughout a long working career can benefit enormously from a final-salary company pension scheme. I doubt many people on average earnings whose employers do not provide a company scheme would have a spare £400,000 left over in the bank by the time they hit 65 after paying off their mortgage and footing the bill for getting their kids a good start in life and maybe having had a beer or two and a couple of laughs on the way. The national stats bear this out. The fact is people on average earnings whose employers provide final-salary pensions are actually earning much more than people on average earnings whose employers don’t provide such schemes. It just doesn’t seem that way while we’re all in normal life. It’s hard to spot the difference in earnings when people have similar cars, houses, holidays and financial problems while they’re at work. The deferred income paid for loyalty, which we call a pension, makes a real difference for about half the working population in the UK (and about half of that half work in the public sector, working for the government in one way or another 7). For an employer offering a final-salary pension it comes at a cost of about 23-25% of payroll. That’s sort of the going rate these days. Employees typically stump up 5 or 6% of that with the employer usually picking up the lion’s share of the cost 8. Any increase in costs because investment returns aren’t so good, or when annuity rates are improved because of general increases in expected longevity, usually fall on the employer. It is unusual for such increased costs to be reflected in a hike in the ongoing costs of employees.
But all that is now in the past. We’re about to witness the changing of the guards.
If I am right and employers are now drawing a line under the pensions past then they will be either looking to share the costs of pension provision more equitably with their employees, or they will seek to scale down their promises or do away with them altogether. For many private sector employers simply paying off the past debts of pension promises made so far will come at a crippling cost. Either way, the average person in a typical private sector final-salary scheme is likely to feel the chill when their employer starts scaling things back. This change in the direction of the wind will change their attitude to pension provision for ever. And for the better.
It is at this stage, I think, that personal possession will kick in. It is a prime driver of human activity, but so far has not affected the cosy pension markets that half our working population have so much money tied-up in.
- The personal possession of pensions (an aside)
Don’t underestimate the power of personal possession. It drives markets big time. In my view, we are just about at the point where people with substantial pension wealth already to their credit are just about to find out what it is worth. Sure, they’re likely to find out what it’s worth because their employer is canning it for the future, but that’s not the point. The individualised value of the pensions already put aside for millions of people at work today in the UK is about to stop being a well-kept secret. Many people are about to find out that they are much better off than the neighbours and friends they share their lives with. Ironically, at the point that final-salary schemes hit the wall they are finally about to be recognised for the valuable assets they are and always have been.
This isn’t unusual really, many people in the past have discovered, one-by-one as they’ve hit retirement, that their pension pots are actually little goldmines. What’s different today is that people are about to be let in on the secret while they’re still at work; not because they’re about to retire, but because their employer is withdrawing from providing so much pension in the future.
My guess is that when so many people find out that their pensions earned to date are worth more than their houses they will become pretty interested in pensions.
The other thing these people will be painfully aware of by then is that their employers will be cutting back on their input to their pension pots in the future in one way or another, or at least they’ll be talking about such things for the first time ever and thus worrying them to bits by doing so. No-one, neither the employees nor the employers really, can change this. The battles I spoke about in the opening part of this paper will be fought, of course, and some ground will be won, and other ground hard-fought even if lost, but the inevitability is there in the background. Most of us have come late to an understanding of what’s going on around us, and we’re in the end-game already. It’s a question of cutting our losses, counting our blessings and looking to the future in a different way.
(end of aside)
The real market for personal pensions (continued)
My point, I guess, is a simple one. People who have substantial past service pensions that are effectively guaranteed, but have little chance of their employer footing the bill for all their future pension accrual, may want to add extra to their pensions themselves. The new pension tax regime that came into force on 6th April 2006 (the so-called A-Day) is just the right environment for people who want more control over, and input into, their pensions. To start with, the new annual benefit statements given to final-salary scheme members every year will for the first time show the "notional value" of people’s pensions earned so far. For someone with a reasonable amount of past service this will be a six figure sum. For the first time all members of final-salary schemes will find out how much of the £1,000,000,000,000 locked up in such schemes is earmarked for them. We can expect to see a number of shellshocked people walking around any day soon. But, for me, one of the biggest changes wrought on A-Day was to allow people in occupational pension schemes to save in personal pension schemes at the same time if they want to. This is referred to as ‘full concurrency’ in the legislation and has finally come just in time.
In the past, people in company pension schemes were said to be in something called ‘pensionable employment’. If you were in pensionable employment it was not possible to have a personal pension as well in respect of your earnings from employment. Any additional pension savings you wanted to make had to be made within the employer’s scheme, in so-called ‘additional voluntary contributions’, or outside of the scheme (but within the restrictions of the legislation supporting the scheme) in a free-standing version of the same thing. Needless to say, AVCs (as they were called), or Free-Standing AVCs, were not the sexiest of pension products – people stayed away from them in their droves.
Personal pensions, on the other hand, were pretty sexy what with the tax-free cash they offered and the flexibilities at retirement and have just got a whole lot more so since the A-Day changes. The Self-Invested Personal Pension (the SIPP you read about all the time in the Sunday papers) is the one everyone now raves about and today that is available to anyone in a company pension scheme who fancies a bit of extra on the side. I won’t go into the new flexibilities of SIPPs here, I’ve done that to death elsewhere on the BeeHive site and it’s all over the financial press all the time anyway, but I just want to say that the flexibilities on offer now for pension top-ups are much better than ever before, particularly as the low annual limits on contributions have been scrapped. This means that people in company pension schemes will be able to redirect the output from company profit-share arrangements (the new corporate loyalty schemes), for example, into their personal pension top-up vehicle with the addition of substantial tax breaks at the point of investment if that’s what they want to do.
For those engaged in providing and distributing voluntary pensions in the UK at the moment it seems self-evident to me that it must be far easier to distribute pension top-ups to people who already have substantial pension savings, but a problem with their employer’s commitment to future funding, than to attempt to distribute pensions to the currently unpensioned for whom the suitability of pension saving is very much in doubt. That simple fact, coupled with the relative costs of distributing products where suitability is guaranteed compared to where suitability can only be established with great effort and the corresponding levels of justification of the advice given in each case reflecting that, it is not that hard to work out where the bulk of private pensions will be sold in the next ten years or so. The pension top-up markets are set to boom. They will be driven by the withdrawal of employers from their future pension commitments and facilitated by the personal control and contribution possibilities the Post A-Day environment now affords personal pension savers.
This would all change, of course, if government were ever to be able to ensure that pension saving were to become a suitable investment for all in the UK workforce, but that doesn’t seem very likely. In this there seems to be a big difference in opinion among pension commentators with some saying the government’s current proposals ensure suitability for all, but others (like me) saying that’s not the case. But that’s a phoney war too. The plain fact is that unless every pound saved in a pension makes savers at least one pound better off than non-savers it will not pay millions of people to save in a pension. More importantly it won’t pay pension distributors for the time taken to work out suitability on an individual basis each time a pension is considered. That is a regrettable fact, and one that I wish were not the case, but we gain nothing by denying the fact that pensions should not be pushed onto people who would be better off using their money in other ways. Confusing this important point in the public mind with the cost issue isn’t helpful either. A pension that is cheap and unsuitable is still unsuitable.
The future we are heading for is already taking shape. It always is and it owes everything to the trends we see in the present and the recent past. It is not the one that our legislators envisage, but it rarely is. If that were not so we would have a market saturated by Stakeholder Pensions and the rest of the suite of Sandler products. That’s not to say that our future is not determined by the acts of politicians. The financial environment is entirely dependent on the form of the underlying legislation. But in the absence of compulsion, it’s common-sense and self-interest that drive markets. There’s nothing new or particularly strange about that. It’s just the way it is
what you can’t understand”
Any research and analysis has been provided by us for our own purposes and the results of it are being made available only incidentally.
1. Investment and Pensions Europe, 'Aon says DB closures continue', 27 June 2006
2. Daily Telegraph Business, 'Rising costs 'will make final salary schemes obselete'', 28 June 2006
3. European Federation for Retirement Provision, Total second pillar pension fund assets (1995-2002), excluding book provisions within sponsoring companies, figures for 2002.
4. National Statistics online
5. FSA Comparative Annuity tables based on a male smoker age 65, spouse 3 years younger, purchase price £400,000, 5 year guarantee, 67% spouse's pension, increasing at 3% per annum. Average figure for all 14 companies listed.
6. BBC Online, ' UK House Prices', 8 May 2006
7. National Statistics online
8. The First Report of the Pensions Commission, 12 October 2004.