It was a perk so widespread that it was virtually unappreciated. Work for 40 years for a company and you could retire on an income equal to two-thirds of your final salary.
This promise, called a defined benefit pension, was a fantastic deal for those who received it in full. But private sector workers are finding the deal is disappearing fast. Most schemes are closed to new members. Some schemes have folded, leaving thousands of workers without the retirement income they counted on. Before long, public sector workers, who have the taxpayer to foot the bill, may be the only people able to join defined benefit schemes.
When defined benefit pensions were first offered by many private sector companies in the 1960s and 1970s, it did not seem such an onerous pledge to make. Those people who did make it to retirement age after a full career were effectively subsidised by those who left early. When pensions did come to be paid, companies had flexibility over the need to award annual increases and many pensioners (particularly in manual jobs) did not survive that long after retirement.
Gradually, however, the flexibility of the corporate sector was eroded. Early leavers were seen as unfairly penalised; indeed, such a system was deemed to be detrimental to the economy as it eroded labour market mobility. Their rights were duly enhanced. The inflationary 1970s savaged the real value of fixed pensions; limited price indexation was introduced. Other promises such as spouses’ benefits were made. The costs of making a pension promise greatly increased.
For a long while those extra costs were disguised by a rising equities market. As share prices soared, and pension funds devoted a greater proportion of their portfolios to equities, they seemed to have more than enough money to meet their promises.
According to actuarial calculations, many pension funds were in surplus. Chancellors worried that companies were using their pension funds as a tax dodge and imposed restrictions. So companies took pension holidays, stopping their annual contributions into the fund. Ignoring Joseph’s biblical example, they made no provision for the thin years in the fat years.
Trouble hit when the stock market fell sharply from 2000-02; the asset value of pension funds rose in line. At the same time, funds were adjusting to a new way of measuring their liabilities. Under the accounting standard FRS 17, future pension payments were discounted to a present value using corporate bond yields. That means as bond yields fell, the present value of liabilities rose.
Two further blows hit the pension fund industry. The first was Gordon Brown’s raid in his first budget which, by abolishing the dividend tax credit, took an estimated £5bn annually from the sector.
The second was longer term; the improvement in longevity which meant that pension payments had to be made for longer periods.
All this combined to send the sector, which had been in surplus in the late 1990s into crisis. Watson Wyatt estimates that the deficit of FTSE 100 companies alone reached £40bn by June 2002 and £90bn by March 2003; even now it is nearly £64bn.
Pensions are not disappearing altogether. Private sector companies have generally replaced their defined benefit schemes with defined contribution schemes. Under the former, you know how much you are going to get out; under the latter, all you know is how much you put in – the final value of the pension depends on the investment performance of the fund. If that performance is poor, tough luck; the company will not step in to help.
Under a defined benefit pension, the investment risk falls on the company; under a defined contribution scheme, it falls on the employee. So a switch from DB to DC is, on the surface, a bad deal for the latter. Furthermore, it has tended to be the case that employer contributions into a DC scheme are lower than into a DB scheme. In effect that translates into a pay cut for employees. Trade unions have understandably resisted the shift from DB to DC.
But DC pensions do have some attractions. For a start, they tend to make life easier for very mobile employees, as their value is easily calculated. Second, although they expose employees to investment risk, they do save them from the risk of the company going bust.
This was a risk that employees tended to underestimate in the past. It was easy to do so. After all, hadn’t the employees themselves been making contributions? And weren’t the funds held in a trust? All that money could surely not have disappeared.
But this was not an issue of fraud. Pension funds operate on the basis that they will continue for a long time. Actuaries have traditionally allowed for higher investment returns from equities, and future employer contributions when assessing the solvency of the fund. They have not made their calculations on the basis of the fund closing immediately. So when a company goes bust, there may not be enough money in a fund to meet the members’ claims in full.
In the past, existing pensioners have had first claim on the fund. In some cases, their claims will have used up all the assets. So employees (or former employees) can be left with nothing, or a vastly reduced payout, even though they are just a couple of years from retirement.
This did seem deeply unfair. The government response has been the Pension Protection Fund, a kind of insurance scheme set up to protect the rights of pensioners. All pension funds will pay into the scheme, which will then step in when a fund fails. A similar scheme operates in the US.
But the scheme will not provide full protection. Those below retirement age will only get 90 per cent of their benefits, subject to a cap of £25,000 a year. Existing pensioners will get 100 per cent of their benefits but annual increases will be limited to 2.5 per cent a year. If meaningful inflation returns, such a restriction will be painful.
So employees considering whether to stay in a defined benefit scheme need to decide whether they believe their company will have the financial strength to pay their benefits after they reach retirement.