Pensions

In this post I argue the case for the following changes to the state and public sector pension schemes, as I believe the recommendations from Lord Hutton’s report in 2011 fell far short of what is both required and possible.

1). Funding the state and public sector pension schemes, thereby saving in excess of £20bn a year in employer (taxpayer) contributions, and hedging future demographic risks,

2). Removing employers from public sector pension schemes altogether thereby creating a purely bilateral relationship between members and administrators. This can be achieved simply by adding employers’ contributions to salary and treating them subsequently as employees’ contributions. This would then :-

a). enable members to tailor their schemes to their individual requirements. They would be able to set two of the three parameters – contribution level, retirement age and pension level – and obtain a quote for the third,

b). amalgamate all of the many thousands of public sector schemes into one, thereby saving millions on administration costs as well as addressing Hutton’s concerns over local accountability and scheme variation. Hutton actually doubled the number of schemes required, each with its own board of trustees and administrators,

c). allow members to move between the public and private sectors without suffering a break in their pension arrangements,

d). enable the defined-benefit arrangement to be retained by presuming an underlying growth rate of 4% (Piketty’s 5% unmanaged average – see below – less 1% risk premium). The taxpayer would still bear the risk of any shortfall, but would benefit from fund growth in excess of 4% (more likely). It is the 4% fund growth allocated to the scheme that enables the contribution rates to be reduced. However during the transition from the pay-as-you-go to the funded basis the cash-flow shortfall would be made up from additional government borrowing as for the Sovereign Wealth Fund. Borrow twice what is required for cash flow and the extra will grow sufficiently over 30 years to pay off the full amount on redemption plus interest. If funds are not available at 3% or less the transition is simply extended until they are once more.

3). If necessary introduce clawback to state pensions to balance the books. This is in any case in line with the insurance principle indicated by the name NIC’s. These measures give the lie to those Ponzi-scheme artists who propose ever greater immigration to fund future pensions.

4). Limiting the amount of cash lump sum withdrawals from any pension, public or private, so that the member could not end up back on benefits later on.

Funding

It is around this time of year that my pension schemes send me their annual statements showing whether my funds have grown or not. I have a couple of defined contribution (money-purchase) schemes, and it is twenty years now since I stopped paying into them. They are both now invested fully in global managed funds of one sort or another, though in the early years there were some fixed interest and with-profits funds as well. Each year I calculate the net growth after charges and before income draw-down. So this year I thought I would calculate also the average net growth over twenty years. You can do this in two ways. You can either calculate the annual rates first or then average them, which give you a compounded rate, or you can take the growth on the opening value and divide by twenty, which gives you the simple rate. On the first basis the results are 6.2% and 7.4%, and on the second 10.4% and 13.2%. I also looked up the performance of one of the leading investment trusts, the Alliance Trust, and found a corresponding growth in share price of 5.4% and 7.4% respectively. That of course is ex-dividend, so you can add another two or three percent to get the full return.

These all compare favourably with Thomas Piketty’s 5% long term compounded rate of return on capital. Clearly his is an unmanaged average. Any half-competent fund manager should be able to beat it. I mention this also in the light of my previous recommendation to hedge the National Debt with a Sovereign Wealth Fund.

When I read Lord Hutton’s report on the reform of public sector pensions four years ago I scoured it for his conclusions about funding. In fact there is only one short sentence in the entire report about it in which he states that the “benefits of funding are not clear”. I have to say I suffered something of a Victor Meldrew moment when I read that! Not clear? Try going to Specsavers, m’lord! And then the penny dropped. To anyone with experience of corresponding with HM Treasury and its Ministers, this phrase “the benefits are not clear” is standard mandarin-speak for “over our dead bodies”. What is clear is that poor old Lord Hutton had been squished by the Treasury long before he had even sat down to write his report! I can quite see that he would want to continue on a defined-benefit basis, but that doesn’t rule out funding. I can also see that there would have to be some form of interim funding to cover the cash-flow switch from using contributions to pay current pensions in payment to investing them, but with 30-years bonds currently only costing 3% pa the same conclusion applies.

Hutton provides tables which show the level of contributions typically paid into public sector schemes. There are in fact thousands of them, one for each employer, including local authorities, and a few of them are funded or semi-funded. Some, where early retirement is normal, such as the Fire and Armed Services have combined contribution levels over 30%, but most work out at about 20%. Of these typically 30% of the totals are employee contributions.

In the late 80’s I was involved with the setting up of two employer money-purchase (defined contribution) schemes. I cannot recall exactly what contribution levels we settled on, but I am pretty sure the combined contributions were less than 10% of salary. This indicates that at least half of the public sector contribution levels could be replaced by fund growth. According to Hutton the cost of the public sector employer contributions (70% of the combined total) is around £30bn, so half the combined total would be in excess of £20bn.

Employer Participation

Employer participation is rooted in the days when employers adopted a patrician attitude, and when jobs were for life. For me this simply does not fit with a libertarian approach or with the flexibility people now require for careers involving many different employers and for varying life-styles. The employer’s pension contributions are all part of the salary package and in my opinion the employee should have maximum flexibility on how that is deployed.

The simplest way of doing this is to set the reduced total contribution rate, 10%, as the employee’s contribution by adding the amount transferred from the employer’s contribution onto gross salary. That would on average represent an increase in gross salary of 4%. The resulting benefits in terms of transportability, flexibility and administrative cost were set out above and are I trust self-explanatory. In the early years the employers’ contributions would still be required for cash-flow purposes, but would phase out later as the fund builds up, though as these would boil down to borrowing either way there is no need to retain the link.

The next question is should this be a compulsory employee contribution, or could employees opt to receive some or all of it in pay now? The national interest surely does not extend beyond ensuring that as many people as possible are not dependent on the state for non-pension benefits in retirement, so we have to look at the overall position.

The role of the State Pension

Many people have noted the absurdity of the National Insurance system when there is no separate insurance fund to pay for those services. In fact almost all the NIC contributions go towards paying for the state pension on a pay-as-you-go basis. Total NIC receipts in 2014/5 were £110bn whereas the total cost of both state pensions and pension credits came to just over £95bn. However ONS forecasts suggest this cost will have risen to over £435bn by 2062/63, or nearly £500bn if you add in other benefits paid to pensioners such as housing benefit and disability benefit. Clearly this is unsustainable unless massive changes are introduced.

Possible ways of meeting this cost could include:
• Increasing the statutory retirement age (already increased to 68 by then)
• Funding
• Increasing employee NIC’s
• Introducing clawback where pensioners have other income over a certain threshold, say £25k. A clawback rate of 50% would then give a taper up to around £40k. This would also be in line with the insurance description of the contributions.
• Allowing Inheritance Tax relief (or CGT relief in the hands of the beneficiary if IHT is abolished but replaced by CGT) for legacies paid into a pension fund (or to pay off student loans for that matter!)
• Allowing members to switch state pension funds into other pension schemes for a reduction in qualifying years.

The answer probably lies in a combination of all of these, but I do also suggest that when an individual’s total pension provision, taking state, employer, private schemes and SIPPs all added together, at any age exceeds the annuity cost of providing a pension from that age at the top of the benefit tapers, then they should no longer be required to pay NPCs. The same test could be applied to reducing public sector contribution rates.