Can the pension system be fixed?

The UK pension system used to be world leading, but it has a long way to go before it reclaims that title

by David Pitt-Watson and Hari Mann

Most of us face what is known as a ‘longevity risk’; we do not know how much longer we will live. This means, if we save individually, we need to set aside a lot if we are to have a reliable pension. A well-designed pension system allows people to share this risk and — a generation ago — the UK system worked to this logic; while there was no ‘promise’ associated with your pension, with appropriate governance and expertise, expectations were generally met. The system was the envy of the world.

Today, few are jealous of our system. What went wrong? In the 1980s, many pension plans looked to be ‘overfunded’ and employers requested that they should have a ‘pension fund holiday’, where they no longer contributed. Although concerned, trustees agreed, as long as employers guaranteed paying out. Successive legislation then insisted that all collective pensions must be guaranteed; Defined Benefit plans were born.

These guarantees sounded great. But, as life expectancy rose, and returns fell, there was no longer enough in the pension plan to meet the promises made. Defined Benefit schemes were closed, and replaced by Defined Contribution plans, individual savings accounts that had to be used to buy an annuity (an income for life) when the employee retired.

But again, the best laid plans went wrong. As interest rates fell, annuities became very expensive and, in 2015, the government decided that pension savings no longer needed to be used to buy pensions.

The good news is that things are changing, with the potential of making British pensions great again. Over the past decade, the RSA Tomorrow’s Investor project has played an important role in this shift. A central conclusion of this work was the need to create ‘Collective Defined Contribution’ pensions, with the aim of giving a wage in retirement, but without the cost of annuities; the government has indicated that it intends to allow large employers to establish such pensions.

What does this mean in practice? All studies, including those done with the RSA, suggest that Collective Defined Contribution pensions will give a more predictable payout than Defined Contribution plus annuity. They also suggest that the result will be a 30% higher pension. However, given that there is no ‘promise’ involved, it will need to be possible to vary pensions-in-payment. For example, the Dutch reduced theirs by 2% on average following the financial crisis.

But for this to work, proper safeguards are needed. The government needs to ensure that pensions are always managed in the interests of the beneficiary, that what is expected is fairly delivered (not benefiting one age group over another) and that their nature is well communicated, particularly the absence of a ‘promise’. Money needs to be well invested and the structure needs to fit with other pension solutions; the scheme will not be for everyone, but will be a solution for many whose Defined Benefit schemes have closed.

This change will take some time, but the opportunity is huge. Some 6.5% of GNP is set aside every year to pay for private pensions and £3trn is invested. Imagine if this was able to be 30% more productive. But the biggest upside will be pensions that truly fulfil their purpose: an income in retirement.

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