The last eight years have seen turmoil among workplace pension schemes. Sally Hamilton assesses the damage and finds A-day changes will add new complications
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Eventful would be a slightly understated description of the workplace pensions arena in the past eight years. Even the least sceptical observer would have to say that the pensions industry is punch drunk, lurching from one crisis to another, with increasing uncertainty for the employers who run pension schemes and for their members.
The first left hook came in 1997 from chancellor Gordon Brown, who soon after the Labour party came to power for the first time since 1979, ‘reformed’ Advanced Corporation Tax (ACT) on pension funds.
This measure boosted the Treasury’s coffers by preventing pension fund managers from reclaiming the tax deducted on dividends but had the effect of draining pension fund values by an estimated £5 billion a year.
According to Terry Faulkner, who until May 2005 was chairman of the National Association of Pension Funds, this is one of the key reasons behind pension funds facing such serious deficits today and a catalyst for many of the changes to pensions since then, including the steady shift away from final salary schemes.
Initially, the impact was shielded by a strong stock market and the fact many pensions schemes were in surplus. Some employers even enjoyed a number of years without having to make any contributions to funds because they were in such robust health. However, the impact of the tax grab was soon exposed.
Faulkner says: "Schemes also faced a double whammy of the collapsing stock market that began in 2000, which reduced the value of the assets in the scheme on top of new rules demanding higher minimum funding levels. At the same time, interest rates were falling, hitting people drawing their incomes from annuities. All this was a blow to anyone in a pension scheme."
Steve Bee, head of pensions strategy at Scottish Life, agrees that the removal of ACT automatically damaged the retirement prospects of millions. He says: "Many employers were prompted to stop allowing new members into final salary schemes."
Another significant change for employees since 1997 is that the burden for their retirement funding has shifted firmly on to their own shoulders.
Life expectancy has improved sharply since generous final salary schemes were set up in the sixties and seventies, and employers can no longer afford to accept the extra financial commitment and uncertainty this brings. It is far easier, and less risky, for employers to offer money purchase pension schemes instead.
These depend on contributions made rather than being calculated on a worker’s final salary. Employers have no responsibility for the amount of pension income this generates when a member retires.
The result is that the number of employees in final salary schemes that promise an income based on earnings at retirement is dwindling.
Bee says: "Estimates suggest that 70 per cent of final salary schemes are now closed to new entrants. This is by number of schemes rather than number of people. Some of the biggest schemes are still open, but it shows the trend towards closure."
Abigail Morrison, pensions marketing manager at Standard Life, says: "Employers can control their costs more with defined contribution schemes. Their only commitment might be to pay a certain amount of salary into the scheme and their only uncertainty is how high salaries might go."
In 2001, while all the stock market mayhem and concerns surrounding the funding of pension schemes was taking hold, the government launched stakeholder pensions. This simpler, fairer charging pension was designed to encourage the less well off to invest for their retirement. In terms of sales, stakeholder has faced a lacklustre uptake, even though all companies employing more than five people had to offer access to one. Yet its arrival provoked a revolution in the world of pension charges.
Morrison says: "While stakeholder plans were officially launched in 2001, their impending arrival had a dramatic impact by forcing down charges." Before stakeholder was mooted, pension fund charges were typically 2.5 per cent a year. Soon after their launch date was announced, charges swiftly dropped to one per cent or less.
Pension experts believe it is just as well for the government that the target audience did not gobble them up, as it quickly emerged that savers with small stakeholder pension pots were in danger of losing means-tested state benefits on their retirement. In effect, if things were left as they were, the government would be punishing thrift. Bee says: "It looked like privatised welfare."
In response to these complaints, and to reward retirement saving rather than penalise prudence, the government introduced the Pension Credit in October 2003. This takes into account a certain amount of pension savings.
All this was against the background of yet another scandal to rock the pensions industry when the once highly regarded Equitable Life revealed in 2000 that it would renege on guaranteed annuity arrangements because it could no longer afford to meet them. The ripples are still being felt today. Morrison says: "The Equitable Life situation had a profound effect and particularly undermined confidence in with-profits plans."
Employers with final salary schemes faced a further blow when new accountancy rules, introduced in 2003, required them, for the first time, to account for their long-term pension commitment to their employees. Bee says: "This happened at a time when fund values were not only affected by the stock market but when they were being taxed heavily. It was enough for board rooms to make the decision to move out of final salary schemes."
Pensions are now a huge issue for companies that want to take over other organisations. Mark Rowlands, business development director for corporate benefit solutions at Axa, says: "Companies must look at what obligations they might face regarding the target firm’s pension scheme, and some may find them too great to go ahead with a deal."
In a bid to tackle pensions’ worsening image and the massive retirement savings gap, the government will introduce legislation simplifying the system. Some of the biggest changes, including lifetime allowances for individual pension pots, come into force on April 6, 2006 – A Day.
Scottish Life’s Bee says: "The government is replacing one complex system with another. I call it complification. It is marvellous news for advisers who have to explain all the changes." However, Bee and other observers welcome the new Pensions Regulator, which has more powers than its predecessor, the Occupational Pensions Regulatory Authority, including the right to intervene in troubled occupational pensions before it is too late. It also encourages whistleblowers to report any detrimental activities to the scheme.
Rowlands believes the Pension Protection Fund, introduced in April in a bid to rescue members of schemes that go belly up along with their employers, may well put another nail in the coffin of final salary schemes.
He says: "The fund is paid for through a levy, which is fixed for this year and will vary from next April depending on a risk assessment. But some companies may decide it is a cost they do not want. If they have a well funded scheme, they may wonder why they should pay towards lesser schemes."
New legislation arriving in April 2006 plans to shake up the pensions industry for the better by introducing:
– a single tax regime for pensions rather than the eight currently used
– a lifetime pension fund allowance for individuals, starting with a maximum £1.5 million in 2006
– an annual maximum contribution allowance, starting at £215,000 in 2006
– the rule that pensions cannot be drawn before the age of 55 from 2010 Additional Voluntary Contribution schemes will be treated like other pensions, meaning that pensioners can convert 25 per cent to tax-free cash on retirement.