How can pensions be made to work?

Milarky

In the same vein as the 'Should pensions be compulsory' thread, I wanted to get people's ideas on what would - in practical terms - help build confidence in pension saving - assuming that there is problem to be overcome.

I can't claim to have thought about this too deeply, but I feel that pensions are just too abstracted from everyday concepts of modern consumerism. A 'pension' is itself not one thing but two: It is both the term given to a pot of savings or money over which an individual has claim - and it is also the
stream of income in retirement.

Given that people would like to receive an income they are reluctant to save if the annual return is uncertain - and with pensions it is doubly uncertain on account of unknowable returns whilst paying in and unquantifiable annuity rates all times up until retirement.

Thus what could be done about this haze of uncertainty - assuming that is a cause of people's reluctance to identifying pensions as either a 'good' or 'necessary' place for their own savings?

One idea I had was just to promise a very high return - but this would be expensive for whoever gave the promise. If this were being done by an insurer [eg Equitable Life] the 'high' return could only be guaranteed by creating a drag on either the performance of the collective fund or else taking money from one type of policyholder without such guarantees and given to another with the guarantee.

So, my idea became distilled into this:

1) Offer '10% pa' on any money paid into a pension plan from the start as a 'guaranteed minimum pension'

2) Give tax relief in addition to all contributions

3) Require three quarters of any growth on the money paid in plus the tax relief to be used to buy a conventional annuity - one quarter to be available as a lump sum

4) A further amount equal to two and a half times the 'guaranteed pension' to be available as a lump sum.

The only difference between this prescription and any personal/stakeholder pension at present is this '10% pa' guarantee - which looks unaffordable - but is it really?

The assumption I make is that on retirement - the government will just ask the insurer to remit the lifetime amount of contributions. It will then provide it's own 'annuity' at a level 10% of this amount. Twenty five percent of the original value of the pension fund becomes distributable as a lump sum and the residue used to buy an annuity in the usual way.

Here are some exemplar numbers:

Contributions:
Starting at age 22 paying £78 [net] per month until age 65
Increase by 6% pa for 10 years, then 4% for 10 years, then 3% for 23 years
TOTAL contributions: £110,326

Tax relief:
Level 22% - therefore [22/78]*110326 = £31,117

Assumed Returns:
6.5% after charges [etc]
Annuity rate:
6% at 65 [with 2.5% indexation]
Fund:
£110,326 paid in grows TO £409,370
£31,117 tax relief given grows TO £115,463

Total: £524,838

Lump sum [25%]
£131,209

Pension [75%], of which
Guaranteed: £110,326 @ '10%' = £11,033 - level
Leaving: £283,302 @ '6%' = £16,998 -with a 2.5% indexation

The insurer pays a total of £28,031 in year one with an indexation figure of £425 in the first 12 months.

The insurer continues to pay the 'full' pension but reclaims the guaranteed segment from the government.

Thus, whilst '10% pa' looks expensive and unaffordable at first sight it only represents a proportion of the final pension due to compounded growth on a larger amount - including the tax relief given on those contributions.

What I like about this idea, however, is that it is relatively straightforward - anyone can understand that they will get back £1 for every £10 that they have paid in in this way. It also means that people can build up guaranteed rights very quickly at any stage right up to retirement. In the extreme case, of a 64 year old with no pension and a year to retirement who receives a 'large' sum of £15,000 -say by way of redundancy, he/she may turn this into a pension after just 12 months of:

£1,500 [10%] plus a lump sum of £5120 and a pension based on the residue of £360 - which because it is so small would commute with the lump sum to make it £5480 instead.

And the more you paid in over the longer period the more in 'absolute' terms you could get back via this guarantee - but it would be diluted by the time over which it was saved. So to prevent the rich from 'soaking' this scheme at the back end there could be annual limits in place. In order to maximize the guarantee they have to spread their savings over time also..

Now suppose that your pension investments didn't do so well after all - or there was a sudden drop in a the stock market close to your retirement. At least the amount you would receive would be underpinned by this guarantee - and there should be no problem - one hopes - scrapping up the cumulative net contributions made from the total pension pot however bad things got. Also the presence of the '10%' guarantee would itself underpin confidence in making continued payment of contributions close to retirement even in a falling market as shown in the example above.

What could go wrong - 'Who pays'?
Well, the taxpayer would stand to foot the ultimate bill, of course. But government would begin with £1,000 of your money at the time you retired and only be required to pay this out at £100 a year. It wouldn't be all gone after 10 years - because of the interest saving - let's say government borrowing costs it 5% and another 2% could come in annual growth in the economy. Thus, they really ought to be able to keep finding this diminishing share of your income in order to pay the insurer each year for an indefinite period. As a last resort, they could pair back gradually on tax relief to current savers - obliging them to save a bit more? - to subsidize this effort.

But the 'who pays' argument will never go away - as today's pensioners are always going to be paid out of the labours of today's working age population irrespective of the funding arrangements. Thus whatever scheme is set up, it simply has to be funded by one means or another - that is not the concern of individual saver/pensioner [who are also taxpayers, of course, so could theoretically afford to put something back in via higher taxes if required]

Thoughts, comments? [not too harsh please!] And remember the open-ended nature of the thread's title.

Thanks

EdInvestor

Hi Milarkey

Excellent piece of work.

To be a touch contrarian for a moment, do you know that in other Western countries, the word "pension" is virtually unknown?

People generally expect a basic living amount from "Social Security" or "National Insurance" ( equivalent to our state pension+S2P) and know that they have to accumulate money/assets/cash/property/shares/bonds/mutual funds etc, which, when they retire, they can get an income from.

Big pile of cash invested = large retirement income (aka pension)
Small pile = low retirement income

If you remove insurance companies from the retirement income picture it suddenly gets a lot clearer

I would be very interested to see a calculation of the effect of also removing both tax and tax relief from the whole savings and investment sphere over a person's whole lifetime.

[Of course I exclude the collateral effect on the revenues of the insurance industry and associates ]

dunstonh

Wow, what a long post. I am going to have to give it another read tomorrow. However, my quick response for changes would be:

Replace all current personal pension contracts with a "retirement account". People can save into these retirement accounts much as they do now getting tax relief on their contributions and receiving tax free growth. Do not allow any withdrawals until age 55 at the earliest. At that point people are allowed an 25% tax free withdrawal and a 5-7% annual withdrawal limit thereafter (not allowed to be more than the rate of return on deposit based and not too high on risk based investments)

This would save the need to purchase an annuity. It would keep the capital in your account, even if you cannot access all of it but would mean on death, the remaining value would form part of your estate (one of the biggest negatives with an annuity). It would also allow the consumer to choose interest backed accounts or investments not just building up to retirement but also beyond. Add in the ability to move it between providers and you have competition from them to provide attractive rates on what should be much higher values than those they currently give on ISAs.

ceebee_2

This thread is going to take some (interesting) time to read and understand.

However, if I could make an observation about the thing that "bugs" me, concerning pension payments, is that no-one seems concerned about, or considers, the effects of income tax. The effect of deducting income tax from pension payments is devastating. I have already stated in another thread that even my govt. retirement pension, consisting of basic benefit+grad.+serps, exceeds the enhanced (over 65) tax allowance.

Just thought I"d get that of my chest.

Anyway, many thanks for an interesting dissertation.

EdInvestor

Hi DH

Basically you're describing a SIPP followed by a well managed income drawdown.You can do this now.It's what I've done, so I agree with this approach if one must invest within a "pension" tax wrapper at all - of which I am not convinced.

I am quite unsure that the 25% tax relief compensates for the risk of having the money locked up and the risk as highlighted by Ceebee of not knowing in advance what tax rate you will pay on the income after you retire.

With an ISA you have neither of these risks and also,often, lower charges for the wrapper.

Unless there is free money coming your way from a company I would always prefer to invest direct or via ISAs than through a pension under the current system.

BTW there would be scope to manage the DH approach with contracted out "free money" - you are forced to pay these contributions so you might as well take themoney as not IMHO, but the DWP doesn't allow contracted out money to be put in SIPPs!

The nanny state lives on. :mad:

roger56

Editor wrote:

Hi DH

I am quite unsure that the 25% tax relief compensates for the risk of having the money locked up and the risk as highlighted by Ceebee of not knowing in advance what tax rate you will pay on the income after you retire.

Me neither. Any future government will adjust tax rules to suit. Any monies locked up (like pensions) are likely to be a prime target. The other dilema is the public vs private pension issue.

The government will tax more if public sector pensions need support (paid via income taxes and council taxes etc). They are unlikely to suffer a fate like for example the Rover workers.

Question is where does support come for those on failing private pensions
to support what the original expectations were. (OK there is now the guarantee scheme .. we'll see how that works in time).

I'd just like to see a scheme where the risks and rewards are the same for all for the provision of a good basic liveable old age income.

Income to support more extravigant life styles should however remain a private matter. The choice is then up to the individual and the free market.

dunstonh

Basically you're describing a SIPP followed by a well managed income drawdown.You can do this now.It's what I've done, so I agree with this approach if one must invest within a "pension" tax wrapper at all - of which I am not convinced.

Its similiar in concept but less risky and its a product solution.

I am quite unsure that the 25% tax relief compensates for the risk of having the money locked up and the risk as highlighted by Ceebee of not knowing in advance what tax rate you will pay on the income after you retire.

You do have to restrict the amount coming out of the pension. Otherwise you will get those who will draw and spend the lot in one go and have nothing left to live on.

The issue regarding tax is highly unlikely to change. Lets be honest about it, if a couple can earn over £14k tax free a year in retirement, then why should it be tax free? If you reduce/remove income tax in retirement, you will reduce/remove the state pension by more or less the same amount.

margaretclare

Hi all

This is a very interesting discussion. As a retiree myself, I was asked by Age Concern to get involved during the election campaign, and I've discussed some of the issues with our newly-elected MP (met him at a social function on Friday).

I would like to see an end to means-testing in the pensions area. Basically, because means-tested benefits have provided a huge disincentive for people to take responsibility for their own retirement income. I've been presented with numerous instances of people whose retirement income is 'just above' the limit for pension credit. Being outside pension credit also means they don't qualify for any of the other means-tested benefits - council tax is one thing that many retirees are very wound-up about, and the fact that some can't get council tax benefit and maybe their next-door neighbour can, gives rise to a lot of bitterness and bad feeling. Many of the retired generation now feel that 'they worked hard, paid their taxes, paid into the system, if it had been invested for them they'd have a decent income, they fought in the war and deserve better' etc etc. Try to explain to them that what they were paying was for the retired generation at the time and not for their own future, and they tend to get very angry. There's no doubt that many of them 'paid in thinking they'd be taken care of' and are very aggrieved that they don't feel they are taken care of.

I would also like to get rid of all these little concessions and additions which have been thrown at us, like throwing a bone to a dog, these last few years. We're promised free local bus travel - useless to me, as I can't walk as far as the bus stop, and as long as we can afford to run a little car, we're fine. Also winter fuel payment - we don't buy winter fuel in advance every November, so giving us £100 each is pointless. The same goes for the council tax rebate - another £100 each in November, but we pay all our bills by monthly direct debit and by November will have paid for half the year! Same goes for free TV licences - we don't qualify for that yet, but it's pointless, we spend more time on broadband than we do watching TV! So what we need is a decent income to spend how we like, according to our own lifestyle and not what officialdom thinks we need. Also when the Chancellor talks about 'single pensioners or pensioner couples' we don't know what he means either. We both get SRP plus SERPS plus annuities in our own right and not as a couple (which presumably would come to the husband?)

I think there has got to be a degree of compulsion otherwise people will just not save for their own retirement. Especially nowadays when there is such a high degree of personal debt, high mortgages, student loans etc.

Aunty Margaret

EdInvestor

I wonder if it would be helpful if we looked at what's wrong with pensions: why don;t they work now? Some people might say there's nothing wrong with them at all, of course

But clearly people are walking away from them: there's an article in the Scotsman today which says that more than 50% of employees are now turning down the opportunity of a money purchase company pension with employer contributions.A reason for this is apparently that over the last five years the fund totals have fallen below the contributions in many schemes

So what are the problems?

Five main things in my view:

1.Risk/safety: people believed pensions were safe and that if they saved up for retirement the money would be guaranteed to be there and would be "enough" .Now, they see many cases such as what has happened to people at Equitable, or in pension windups or other With Profits funds with collapsing terminal bonuses, where this isn't so.They've come to realise that there's no guarantees, and their savings might not be safe.

2.Investment returns: people look at how much they get for their savings and it looks pretty poor compared with, say, their home, or even interest rates at the bank. For taking a risk, they have in many cases been rewarded not with a return, but with a large black hole.This doesn't look to be improving because of the low inflation/ low interest rate environment.

3.Charges and commissions: People are scared of being cheated by pension salesman and suspicious that high charges and commissions are reducing their savings unfairly.The find the overall system very baffling.

4.Distrust of Government: People don't believe the Government will keep its promises and they suspect pension savings are a sitting duck for stealth taxes like the removal of the dividend tax credit. They also don't believe the Givernment will help them if there is regulatory failure like at Equitable.

5.Restrictive and complex rules and regulations, such as compulsory annuities, restrictions on income amounts and the interplay with the benefits system means it's counterproductive for the lower paid to save. Some of this will be tackled next year but the major benefits of the tax relief system go to the people who least need the help - higher rate taxpayers.


Anything else?


I forgot

6.The problems of transferring between company schemes, for an increasingly mobile workforce. This is causing many people to end up with small pensions littered across the landscape which can incur high charges and can't easily be properly invested. An additional problem is the discrination against early leavers on values of transfers and frozen pensions in D/B schemes.

EdInvestor

Re milarkey's original post, I feel that this idea would fall foul of two things:

1.Public distrust of the Government's commitment to keep its promises over the long term

and

2."Moral hazard" : The scheme provides an incentive for providers to milk the guarantee, i.e. extract as much as possible in charges from the fund, knowing the Government will top it up to the 10% return level at the end. I doubt the Government would even consider it for this reason.The providers already pocket quite a big chunk of the tax relief as it is.

dunstonh

But clearly people are walking away from them: there's an article in the Scotsman today which says that more than 50% of employees are now turning down the opportunity of a money purchase company pension with employer contributions.A reason for this is apparently that over the last five years the fund totals have fallen below the contributions in many schemes

That's just stupidity and a lack of understanding and willingness to understand.

We have just had a stockmarket crash so fund values are going to be down (not that you need to told that editor - clearly some do!). This is very short term and pensions are long term. That being said, if you dont like stockmarket investments, then do no invest in. The pension providers have a large range of low risk funds and occ money purchase schemes will as well.

These people are turning down free money and need their heads testing.