Explaining pensions: it's going to get worse

I am a great fan of the House of Commons Library, because they produce wonderful research reports, which explain complicated things in terms that even I can understand. I presume this is because they are for MPs (no, I’m not going to say they are all dim, I’m going to say…), who have to understand a whole range of current issues to explain to their constituents. The papers have very good links to all sorts of official documents, and they are written fairly neutrally, as befits a service for all MPs rather than for just the current or past party in power.

There’s a new one out on pensions, which explains policy issues very clearly, and is a pleasure to read (although it has a lot of misprints: I guess the new generation of civil servants are allowed to be less literate than the older generation, or the proof-reader got sleepy). In this post, I’ve set out some of the explanations about how defined-contribution pensions work in a simplified way, with pictures – even the HofC Library doesn’t do pictures. I’ve done this because I find that even very experienced and able people roll themselves up in a ball and hide when faced with explanations about pensions.

Then I comment on the contents, not neutrally.

You can download the paper from here: http://www.parliament.uk/briefing-papers/SN00712.

Defined contribution pension schemes

The first point to make is that it is dealing with ‘defined contribution’ or money-payment pension schemes, not with the final salary schemes like many of the older generation of public sector employees have and some people in the private sector, but which are disappearing from sight. Defined contribution schemes work by you and your employer paying money in to a savings account to create a pile of money, called a ‘pension pot’. This is a sort of treasure trove to finance your retirement, when you will not be earning. When you retire, you hand over your pile to an insurance company (or some other pension provider) to buy a regular income from it. The insurance company takes your money and guarantees to hand over a sum every month. Handing over the pile to the company is called ‘buying an annuity’ and the regular sum every month is your ‘annuity’. There are various sorts of annuity, of which more later.

So the first stage is accumulating or saving money towards your pension pot; you do this during your working life. Then, when you retire, the second stage is ‘decumulation’ or spending the money. The diagram shows this process of building up to the pot, then spending out from the pot.

Most of the argument you see in the press is about the accumulation stage. The government, the trade unions and the employers are arguing about the best way of building it up so that you get the biggest pot possible, because this is what will pay for your pension. But people have also started to argue about problems with the decumulation phase too, and some people think there’s been much less effort on the part of the government and others involved to solve the problems with the decumulation phase.

The government has recently introduced arrangements to make sure every employee takes part in accumulating a pension, rather than permitting people to opt out. Broadly, people and their employers are free to make their own arrangements, but if they don’t, they have to take part in a minimalist government scheme so that they build up some sort of a pot.

But what would happen if the whole insurance system failed and annuities did not work out? There are real problems with annuities, which I discuss below, after this explanation. The National Association of Pension Funds argues that there should be a national annuity service which should step in if annuities run into trouble. You can see why the government would not want to take on this responsibility. But they’re probably unwise, because it’s sure to go wrong, and then they’ll have to deal with it anyway. A bit of prevention would be a good idea in my view.

How annuities work

There are various types of annuity you can buy. To understand these you need to understand how annuities work. It starts with you giving your pension pot to an insurance company. You can choose the company you accumulated or saved with or you can pick another one. Different insurance companies offer different ‘rates’. What this means is that Company A will offer you more or less money every month when you give them £100,000 than Companies B, C or D. As with anything, you can investigate who will offer you the best rate and go with them.

The next stage is that they invest your money. Some big funds don’t do this because they have enough money coming in from all sources to pay the pensions that they have to pay without getting into investments. From the investment or by other means, the insurance company or other pension provider will pay you your annuity, the monthly sum. When you die, they stop paying the monthly sum and keep all of pension pot, without having to pay out any more to you. If you die quickly, they make a profit. If you don’t die for a long time, they lose. Because they are working with many different people, they plan it so that, on average, they gain more than they lose. This gives them their profit, or, if they are not profit-making, the financial flexibility to cope with unexpected events.

Types of annuity

Now then, different types of annuity. You buy a single life annuity to provide a pension for just one person. If you were a single person, you would buy a single life annuity on your own life. The money would keep coming until you died. The alternative is to buy a joint life annuity to cover two people (or more if you’re living in a ménage-á-trois). If you are married or in a relationship, you might buy a joint life annuity. The money would keep on coming until both of you had died; it might be organised so that it reduces when the first person dies.

There is a certain amount of choice about this. For example, take a marriage where one partner (Partner A) has a very big pension pot but the other partner (Partner B) has a very small pot. Big-pot Partner A might buy a joint life annuity, and Little-pot Partner B a single life annuity. This is because Little-pot Partner B will get more while he/she is alive, because there is no need to keep money invested to pay an annuity after his/her death to big-pot Partner A; Partner A will still have a bigger annuity from his/her own big pot. Because Big-pot Partner A is going to be providing the bigger annuity, the couple will need this to cover both of them for the whole of their lives, whichever dies first. Big-pot Partner A won’t miss the annuity from the little pot, if little-pot Partner B dies first. However, little-pot Partner B would certainly miss the big annuity if big-pot Partner A dies first and the annuity was only on Partner A’s life.

You can vary both types of annuity with extra choices. If you buy a level lifetime annuity, you get the same amount of money every month for life. If you buy an escalating lifetime annuity, the amount of money is less than you get with a level annuity, but what you get goes up every year. The main reason for this is to take account of inflation. It might rise in line with inflation or by some agreed amount, say 3%. Some annuities also have a guarantee period. This means you get a payment for an agreed period, perhaps five years. This means you don’t lose everything to the insurance company if you die the day after buying your annuity. These extra choices cost money from the pot. So having an escalating annuity will add to the cost, and so will a guarantee.

The insurance company also has choices. If they think you are likely to die early (for example if you smoke, if you are fat or if you are ill), they will offer you a bigger annuity for the same size of pot. There is an advantage to you, therefore, if you can persuade the company that you are likely to have a short life, because you will get a better income from your annuity. Tell them how sick, greedy and addicted you are.

Do you take it when you can, or are you canny about when you take it?

There are more choices. Even though there is a state retirement age (it used to be 65 for men and 60 for women, but it’s rising for women to equalise the age and then going to rise for everyone), you don’t have to retire, or take the state pension or any other pension at that age. You can choose. For example, if you plan to carry on working after retirement age, you can delay taking your pension.

You can find out what age you have to retire with the government state pension calculator: on the internet here:

The calculator for women’s equalisation: http://pensions-service.direct.gov.uk/en/state-pension-age-calculator/home.asp

The calculator for the new government proposals: http://www.direct.gov.uk/en/Nl1/Newsroom/SpendingReview/DG_192159

If you do this, you will eventually get a bigger state pension and annuity. This is because you may have put more money into your pension pot, because you have worked and paid contributions for longer. Then, because the insurance company, or other pension provider, have had the money invested for longer, they should have made more money to put into the pension pot. Another point is that you will be nearer death, so the period the company has to pay you your annuity will be shorter. Your pension pot will therefore buy you a bigger annuity from the start.

However, you run a risk, too. If you delay taking your pension and you die soon after you take it, you get less money in total than you would if you had taken it at the earliest possible moment. So delaying may mean that you (and your wife or partner) lose. Working in a hospice, I have met people who left it too late to claim their pension and never got anything back because they died so quickly.

The ‘requirement to annuitise’

How have the government dealt with this?

First, there has been since 1921 a ‘requirement to annuitise’. That means that the government insists that you must buy an annuity with a pension pot. You are not allowed to take the pot and spend it how you like. This is for two reasons. One reason is that if you spend all your own money, you might fall back on social security and cost the government more money than it would have had to spend if you had bought an annuity.  The second reason is that the government gives us tax relief in the accumulation phase, to help us build up a pension pot faster. More than half of most pension pots is tax payments from the government. So if it’s being generous about that, it wants to be sure that its generosity is used in the right way when it gets to decumulation.

However, over the years the government has become more flexible about that. You could delay taking your pension until you are 75 under the former Labour government, and the present coalition wants to remove the requirement to buy an annuity, but you have to use your pension pot to buy one of various substitutes for a pension. These substitutes provide for alternative ways of taking part of the pension pot as income, while leaving some of it invested for later.

A point that ministers have made is that the whole purpose of the system is to provide you with a guaranteed income in retirement until you die, and annuities are perfectly designed to do that. The problem with more flexible arrangements is that you might make a miscalculation, or something will go wrong in the investment market, or you might live longer than you think. So, again, there is a risk that by any other arrangement than an annuity you might run out of money.

And remember, there is the risk the other way round. You might leave it too long and lose some or all of your money because you die before you can make use of it.

In reality, 95% of people do not delay all that long: they have taken their pension pot as an annuity by the time they are 70 years old. However, a few people (there are always some) are looking for more flexibility; these are usually people who are investment savvy and have a lot of money. Labour Party ministers, when they were in power, were not particularly keen to allow them to benefit from tax relief on their contributions to pensions and then play around with the money to make profits. Since in most cases more than half of pension pots are tax relief, why should we all pay tax relief to allow rich people to have more richesses to play around with?

The Conservatives who are now in power as part of the coalition with the LibDems are happier to allow people ‘choice’ that benefits them, rather than making them take part in the same pool of risk as the rest of us and thereby reduce our payments – remember all of this is an insurance scheme which works on averages, so one person’s gain is inevitably another person’s loss. Having more of these rich and flexible people in more general schemes would give all of us more flexibility; they would, as they would see it, be donating their flexibility to us.

The political issue

The difference on how much flexibility there should be is mainly one of political philosophy. The Labour philosophy is ‘cooperate and share’, the Conservative philosophy is ‘do-it-yourself’. So the Conservatives are always keener to encourage people to do their own thing. They argue that this is partly a matter of personal freedom, that the state should not limit people’s freedom to do what they like with their own money. But it also connects with their economic philosophy – liberalism. This argues that if you leave people as free as possible in a market to do what they want, the individual decisions that people make, when added together, almost always lead to more economic growth and more flexibility in the economy. Labour, or social democratic philosophy, argues that this is nevertheless unfair because some people are freer than others, either because they have more money to start with or because they have greater knowledge of how the market works, so they have an advantage. So they would argue for the system to be planned and regulated so that the advantages of the rich, well-informed (or well-advised) and flexible don’t get out of hand.

Pensions form one of the areas where the ‘cooperate and share’ approach of Labour is particularly relevant, because as with all insurance schemes, the larger they are the better they can accommodate outrageous (mis)fortune, and provide some resources that benefit the poorest.

On the other hand, you can understand those who are frustrated by the inflexibility that sometimes comes out of rules and regulations. A case in point is the problem with annuities, which is leading people to argue against the requirement to annuitise.

To understand why this is a problem, you have to know a bit more about how the investment of your pension pot works. When the insurance company invests your money, it has to be sure that no matter what happens it has the money to pay out your monthly pension. It does this by buying very safe savings schemes, mainly relying on lending money to governments (these are called ‘gilts’, short for  ‘gilt-edged’ investments, that is very safe) or big corporations. When interest rates are low, as they are at the moment, you have to spend a lot of money to get an income. For example, suppose you invest £100,000. If interest rates are 5%, you will get £5000 per year. Interest rates now are much less than this: less than 1%. At 1%, you only get £1000 income per year. So you have to spend £500,000 to get the same income per year.

But that’s not the only factor. Gilts and similar schemes are traded. If lots of people want them, the price goes up but the interest rate still stays the same. So if your insurance company uses your £100,000 investment to buy gilts when they are popular, it might only be able to buy half the number that were possible some while ago. Therefore, going back to the example, you will only get the income of 5% on £50,000 worth of gilts (£2,500) and £500 if you buy gilts which give a 1% income.

The result of this (and various other complexities) is that you don’t get much back for an annuity at the moment, and if you are free to invest the money in different ways, you get a better income. But the higher the income you get, the riskier the investment. For example, we all know you can get a higher income from Greek government debt. The problem is that we all also know that the owners of Greek government debt have recently had to take a ‘haircut’. This means they have lost a lot of the money they invested in Greece. By making annuities very safe, the government and the insurance companies avoid this kind of thing, but safety means we don’t get much income.

The way the government is tackling this is the proposal to remove the requirement to annuitise. But if they do that, they not only have to stop people running out of money too soon, by capping how much they can spend each year, but they also need to stop people hanging on to their money in a pension pot, in the hope of passing it on to their heirs. The government does not give tax relief on pensions to help people pass on a big legacy to their children, so it proposes to tax pension pots that remain at the end of peoples’ lives to get back their tax relief.

However, for most people all this is a fuss about nothing. In 2009, the government estimated that only 1% of people who bought annuities had a large enough pension pot to go for more flexible investments. Professional opinion, reflected in a statement by the Pensions Policy Institute, suggests that while these changes will benefit a few rich people, most people who took advantage of the flexibility would have riskier pensions as a result.

Taking all of this together, I see most of the current fuss about pensions and the government’s reaction to it as leading to richer people doing better and most of us being more at risk. This is not only not good for most of us who are heading in the direction of getting pensions soon. It’s also a worry that as we baby boomers come up to retirement, more of us will be switching from the accumulation phase to decumulation. As a result, we will stop saving and start spending from our investments. This can only lead to a long-term downslide in the investments markets because we’re moving from making investments towards selling them. If a lot of people sell something that a lot of people have stopped buying, the price of what they’re selling goes down. So the investments that underlie our pensions are going to continue to decrease in value for the foreseeable future.And there will also be a further rise in the cost of gilts and a drop in the money we get from our annuities, because more of us will want to buy them. As we saw earlier, that means the price goes up and the income we get goes down.

If you haven’t got an index-linked pension, I suggest keeping working.