Pensions : a British Success Story

Pensions provision has been one of the major success stories of post-war Great Britain. It is the result of successive Governments of both left and right aiming to achieve a proper balance between state and private sector provision, with the state providing a basic pension for everyone reaching retirement age (currently 60 for women and 65 for men) and encouraging additional provision by employers and individuals through a range of incentives, principally tax breaks.

The reason for this success is primarily the result of a continuing partnership between the State and private sector, originally established for pragmatic reasons of affordability and more lately maintained as the result of a policy endorsed by all political parties that beyond the basic State pension, retirement provision is primarily the responsibility of the individual.

Whilst pensions provision excites vigorous debate both inside and outside Parliament (the debate, in itself, being an important element in developing awareness of the need for adequate retirement provision), the area has avoided becoming a political football. There is, I suspect, something of an unspoken compact on this within the political arena, with a recognition that continuity and security of pensions provision is important to whichever party is in power, with those who are not in residence in Downing Street expecting to inherit what is in place in due course. Change, therefore, is a matter of evolution rather than revolution and is thereby more acceptable to the electorate. This is in sharp contrast with the position in most of the major continental European economies which, as a result of post-war "social contracts", rely predominantly on State run pay-as-you-go systems which are becoming progressively unaffordable as a growing retired population has to be supported by a diminishing workforce.

In Britain, however, it has not been all sweetness and light. Despite generous tax breaks, many people who can afford to provide for themselves fail to do so adequately and personal provision remains a significant problem for those on lower incomes.

One of the penalties of an evolutionary approach is that complexity is layered on complexity and this in itself becomes a disincentive for individuals to do anything for themselves.

Over the past 15 years, some fundamental structural weaknesses have been exposed such as in governance arrangements for occupational schemes (the so-called Maxwell scandal) and in the selling of personal pensions to those who would have been better off remaining in, or joining, their occupational schemes.

But despite these and other problems, confidence in the system in the UK remains high, perhaps because of the combination of continuing commitment of successive governments to make the system work and vigorous competition between providers in the private sector.

In this testimony, I will endeavour to do the following:

- outline the basic structure of pension provision in the UK
- identify where problems have arisen and how these have been addressed
- briefly review the challenges for the future and suggest how they might be met.

1. The basic structure of pensions provision in the UK.

The basic structure can be regarded as something of a layer cake. Starting at the bottom, we have the Basic State Pension. This is covered with a layer of icing for those for whom the Basic State Pension is their only income. This supplement makes up the difference between the Basic State Pension and what is known as the "Minimum Income Guarantee" and is essentially a means tested welfare payment.

The second layer of the cake proper is made up of earnings based pensions. These can take three forms:

- state provided arrangements
- private provision
- a combination of state and private provision.

The technical details of these arrangements can be found in Appendix A to this paper but it is sufficient to note here that individuals can substitute this part of their state arrangements with approved alternative private arrangements and are encouraged by financial incentives to do so.

The private element of the layer cake is made up of a number of components but the main division is between occupational schemes (equivalent to ERISA type arrangements) and personal pensions (equivalent to IRAs and 401(k)s).

Private arrangements fall into two broad categories:

- defined benefit
- defined contribution.

A "defined benefit" scheme is one where the employee on retirement receives a pension which is a percentage of his or her pensionable earnings, the percentage usually being related to length of employment. Defined benefit schemes are limited in practice to large occupational schemes where the employer has the size to take on what is effectively an open-ended guarantee of pension liabilities related to earnings levels many years into the future. Because of this commitment and related costs, there are now virtually no new defined benefit schemes being created and many employers are closing existing schemes to new employees. Defined benefit schemes always involve employer contributions and usually (but not always) employee contributions.

The alternative to defined benefit is "defined contribution", where payments are made into a scheme to build a pot of assets which on retirement is used to generate an income stream from retirement to death.

Defined contribution schemes can be occupational (employer sponsored) or private or a combination of both.

In all defined contribution schemes, the level of pension paid on retirement is a function of the size of the asset pot which is used to purchase a pension (an "annuity", a term which is somewhat different in meaning in the UK context than the US - see Appendix A for details) which is supplied by an insurance company on terms which are determined primarily by medium term interest rates and the actuarially assessed life expectancy of the individual concerned.

Pension funds enjoy complete freedom as to the asset classes in which they may be invested. Restrictions are a matter of actuarial prudence, not regulatory intervention. As a result, most funds have historically been invested predominantly in equities, in some cases in excess of 80%. Property (real estate) and fixed interest have tended to make up the balance at around 10% each. For a variety of financial and actuarial reasons, we have seen a move away from equities in the recent past but this asset class still makes up the majority of investments in most cases. Larger funds tend to make direct investments with the remainder investing on a pooled (mutual fund) or insured basis.

With personal pensions (and the new Stakeholder pension as explained below), investment has to be via an approved vehicle, in practice a mutual fund or insured scheme. Insured arrangements dominate in this area with two distinct arrangements on offer: unit linked (a mutual fund with an insurance wrapper) and with-profits (a managed fund where returns are smoothed over time).

Historically, this investment freedom within a regime of actuarial prudence and links to approved investment vehicles has proved to be very beneficial to both scheme sponsors and scheme members.

Tax incentives apply to all private arrangements, with the rate of the tax break from the individual's perspective being at the highest rate paid by the individual. The shape of the tax breaks is shown by the following chart:

There are limits which vary by age to the amount of contributions that quality for tax relief. These limits are a percentage of qualifying earnings and for schemes entered into after 1988, there is a cap on qualifying earnings of circa $150,000.

The UK has gone further than most countries in moving the balance for pension liabilities from the private to the public sector. For an individual retiring recently, their average income can be broken down as follows:

Sources of Pensioner Incomes 1995/6 - UK

State Sources 51% Private Sources 49%		Disability benefits                          5%	} }	Sources of pension split 36% State 24% Private or otherwise expressed in proportion 60/40.
		Means-tested benefits                 10%
		Basic pension*                                                   33%
		Earnings-related pension*                                                     3%
		Occupational pensions*                                                   24%
		Investment income                                                   16%
		Earnings                                       8%
		Other                                         <1%

Source: "We all need pensions - the prospects for pension provision": An independent report to the UK Department of Social Security by the specially formed Pension Provision Group, June 1998.

If we focus on pensions alone (highlighted with an asterisk), these figures demonstrate that 60 per cent of the total "pension" provision currently comes from the State whilst only 40 per cent comes from the private sector.

Personal pensions, introduced by the Conservative Government in 1988, are an investment vehicle for individuals which can be used as a partial substitute for State pension provision. However, such substitution was only relevant for those more than 10 years from retirement and therefore this trend has yet to show through in the

incomes of new pensioners. The Labour Government, elected in 1997, soon announced its intention to develop policy measures to help move this ratio from 60 / 40 to 40 / 60 by the year 2050.

The British pension system is already in a much stronger fiscal position than that of most other countries. In marked contrast to nearly all other OECD countries, State-funded old-age spending in Britain, as a proportion of GDP, is forecast to decrease from 4.5 per cent of GDP in 2000 to 4.1 per cent in 2050. In comparison, spending in the U.S. is projected to increase from 4.2 to 7.0 per cent. The difference between the British experience and that of other countries stems in part from more favourable demographic trends, but more significantly from reductions in the State pensions programme and the use of funded private pensions as an alternative to at least part of the unfunded public pension.

In its Green Paper (Government policy discussion document) in 1998, the current UK Government proposed the principle that the public and private sectors should work in partnership to ensure that, wherever possible, people are insured against foreseeable risks and make provision for their retirement. This was a continuation of a policy started as far back as 1978 when the Government first introduced rebates to allow part of the State Earnings Related Pension (SERPS) to be substituted by private defined benefit occupational pension provision. Contracting out was extended to defined contribution vehicles including personal pensions in 1988. The proposed success measures for this partnership principle are that:

- at the end of the process of reform, there should be a guarantee of a decent income in retirement for all,
- there should be an increase in the amount of money going towards retirement savings and insurance, but without
increasing the proportion borne by the State,
- there should be an extension of high-quality private pension provision to a greater proportion of the working population (with the definition of "work" being extended to include carers), and
- there should be an increase in public confidence in the quality and regulation of private sector savings, pensions and insurance products.

The Conservative Government established personal pensions as a way of encouraging wider voluntary pension provision. They were also developed as a vehicle to facilitate individuals contracting out of the SERPS and into a private pension on a defined contribution basis. At retirement, a pension had to be purchased to provide for a basic level of post-retirement inflation protection, with the State still providing protection against higher rates of inflation thereafter. This protection was removed in 1997.

SERPS, or the corresponding rebates, represent a compulsory element of the State system that has been the subject to continuing change. The proposed change from an earnings related basis to a flatter rate of benefit is expected to take place sometime after 2006. The level of compulsion, and the benefits that it will provide, is designed to try to reduce the amount of means-testing necessary. We expect the policy of compulsion to be reviewed again by the Government in 2003.

The "Stakeholder pension" (see Appendix A) is not a fundamentally distinct concept from its predecessors since it is either an occupational or a personal pension. The key feature, however, is that product regulation has been introduced so that underlying assets and charging levels are pre-specified by Government. The system is being changed through a combination of self-assessment, regulatory pressure and Government regulation. The Government intends to build popular confidence in pension savings by introducing Stakeholder pensions as a new, more accessible and cheaper vehicle, designed to appeal to those on low to moderate incomes. It is hoped that Stakeholder pensions may eventually become as familiar to the UK consumer as 401(k)s are in the US.

2. Problems in the UK pension market

The evolutionary nature of pensions development has inevitably given rise to problems, and whilst hindsight is a wonderful thing, the commitment to the overall system from Government, providers, scheme sponsors and above all, the population as a whole means that the lessons learned have been applied. Some of the issues are now discussed in more detail below.

Advice to contract out: Advice is an important issue. If there is a public policy intention that individuals should be encouraged to switch from public to private pension funding, then that incentive should be tangible and clearly advantageous. It is unproductive to create a regime in which consideration of an individual's age, future salary, likely future voluntary contributions or attitude to risk is necessary before it is possible to judge whether contracting out is attractive. The original rebates offered an incentive, whereas the current rebates mean that the most obvious choice for someone within SERPS is to stay there. We understand that when SERPS changes to the new Second State Pension, in or after 2006, there may be a disincentive for higher paid employees to remain within the State scheme.

The decision to contract out, and the associated advice, applies on a year by year basis. There is no question of making a decision for life. There is also no question of switching accrued SERPS benefits to a private scheme - principally because accrued SERPS benefits are unfunded and such a policy would be expensive for the State. Moreover, the current Government has no policy intention of allowing switching from the basic state pension to private pensions, although that was a feature of Conservative policy during the recent UK election.

Advice to make additional contributions: The original expectation was that once an individual had set up their own personal pension to accept rebates, then they would make further voluntary contributions on top. This proved not to be the case. In general, data show that fewer than 50 per cent of employees enrolled in personal accounts make any voluntary contributions. Appendix A includes an outline of the alternative investment products which might provide a better form of saving in the UK than does a pension, even for retirement needs. This complicates the choice and highlights the need for advice.

This problem also arises with the new Stakeholder pension. Although this new arrangement gives easy access to a pension scheme and deduction of pension contributions from salary, the need for advice remains. The limitation of charges to 1 per cent of the fund makes no provision for advice. This may be charged for separately. However, experience in the UK suggests that people do not want to pay a fee for advice - although it is probable that at least part of the market will go that way, the lower paid are unlikely to want to pay an additional flat fee. The commission structure that these fees have replaced offered some form of redistribution since commissions were proportional to contributions.

The problem of providing advice to low earners is even more relevant when we recognise that some low paid workers will lose state entitlements under the Minimum Income Guarantee (the absolute state safety net designed to ensure a minimum standard of living in retirement) if they make voluntary pension contributions. At present, State benefit may be lost £ for £ for any private income. The dilemma of whether or not to save at all is being reduced by the proposed introduction of a so-called "pension credit" which will ensure that the entitlement is not lost £1 for £1 of weekly income from a private pension but only £0.40 per £1.

Charges: Whilst the charges for a basic personal pension receiving only the SERPS rebate were kept low, the costs of personal pensions generally have been much higher, including the extra costs of commission. Indeed, since the charging structure seeks to recover the full cost of the initial expenses even if the policy is terminated after only a few years, charges on early termination may be as much as 50 per cent of the premiums paid. For a pure rebate policy the administration of the contribution is as simple as possible with electronic transfer of rebates. Similarly with few initial expenses, these problems on early termination do not apply to these policies.

However, personal pension administration costs have historically been high. The regulatory practice has been to quote an annual reduction in yield, equivalent to an average fund charge (see Appendix B). Although such figures might seem low at between 1% and 3% of the fund, expressed as a percentage of the fund's value after 25 years, even a 1% annual charge on a single premium represents more than 22 per cent of the fund's value over 25 years.

But these criticisms are set to become a thing of the past. The introduction of Stakeholder pensions is now causing the UK pensions market to reduce charges significantly. Indeed, the charges on new pension contracts were reduced in preparation for the introduction of Stakeholder pensions, whilst even the charges for existing contracts have now, generally, been reduced to Stakeholder levels. Changes have had to be made in sales, marketing and administration to reduce expenses commensurately. This is leading to a reduction in individual advice resulting in more workplace direct offer sales with no personal advice.

It should be noted that the maximum 1% charge on Stakeholder pensions is low even by comparison with equivalent products in the US. Whilst it may be difficult to compare like with like, a fact-finding visit to the US in 1999 by a group of pension specialists reached the conclusion that the equivalent charge in the U.S. was between 1.4% and 1.7% depending on the level of technology support, in practice this being internet access and self-service.

The fact that with Stakeholder pensions there is only a low fund charge and no transfer charge means that the criticisms of high charges in comparison with premiums on early termination will disappear.

Pensions Mis-selling: Publicity overseas about the UK personal pensions market is often dominated by mention of what is described as pensions mis-selling. For the sake of clarity, it should be emphasised that these examples of inappropriate advice did not relate to the decision as to whether to contract out of SERPS and to invest the rebate in a personal pension. Indeed, the regulator commissioned a review of this and confirmed that in view of the incentives built in to the level of rebate, contracting out during the first few years of personal pensions was reasonable advice.

Pensions mis-selling occurred largely in relation to incorrect or no advice on the most appropriate scheme for voluntary contributions in addition to the rebate and on whether to transfer from another scheme. Despite the fact that the introduction of personal pensions was designed to coincide with the new regulation of the conduct of business under new sales and marketing rules introduced as a result of the Financial Services Act in 1988, mis-selling arose because of a systematic industry-wide misunderstanding across almost the whole of the retail financial services market about the implications of that complex piece of legislation.

The introduction of personal pensions in 1988 also coincided with a relaxation of Social Security legislation which prevented employers from making membership of their pension scheme an absolute condition of service, despite the fact that the presence of an employer contribution almost invariably makes membership of the scheme better than a personal pensions alternative. This fact was, sadly, often not communicated to those who had chosen not to join their occupational pension scheme. Although membership of an occupational pension scheme was not regarded as a regulated investment under the legislation, the regulator later in the 1990s decided that any salesman who had recommended a personal pension to someone who had not joined their employer's scheme was likely to have been guilty of mis-selling.

As regards advice to transfer the value of deferred rights in an occupational pension scheme to a personal pension, the problem was the result of inadequate transfer values from the occupational scheme. Here the problem stemmed less from the decision to transfer, but more from the fact that the amount of the transfer value was often unlikely to reproduce as much as the deferred benefit, under any reasonable investment strategy. Although transfer values were required to be "fair", this was measured by comparison with other scheme members rather than the absolute amount of the transfer value. Hence if a scheme was underfunded it was unlikely to offer a sufficient enough transfer value for the purposes of the standards effectively set by the

Financial Services Act when judging whether such a transfer was good advice. It was also a feature of many schemes that their transfer values made no allowance for discretionary increases once the pension would have started. Eventually, in about 1993, in advance of any action by the regulator, personal pension providers introduced systems to analyse the transfer value.

A thorough case by case review by providers of transfers, opt-outs and non-joiners is seeking to ensure that no-one has lost out as a result of bad or inappropriate advice. Indeed, the review has gone further and has also effectively compensated many people for the fundamental change in economic conditions that has occurred over the last 10 years. As personal pensions are defined contribution and occupational pensions are most likely to have been defined benefit, the policyholders are, in effect, also being compensated for any adverse effect of the additional investment risk that they assumed.

Investment performance: The UK Government has recently announced a review into the UK markets for medium and long-term savings products purchased by retail customers. The stated purpose is to identify the competitive forces and incentives that drive the industries concerned, in particular in relation to their approaches to investment, and where necessary, to suggest policy responses to ensure that consumers are well served. A similar review relating to occupational pensions proposed a set of the principles of investment and the retail review will look at their applicability in the retail markets.

The review will examine such important influences as:

- the drivers underlying competition,
- information flows to consumers, and consumers' understanding of them,
- the nature and quality of consumer advice,
- advisers' incentives and skills,
- charging structures for products,
- the principles of governance within the relevant products.

A significant proportion of personal pensions invest in "with-profits" funds in the UK, and that class should be considered separately, although there should be little if any difference in the underlying fund performance, other than that such funds are likely to remove any innate conservatism that exposed investors may feel.

With-profits: Contributions which are paid into a with-profits fund are pooled with those of other policyholders and invested in a wide range of assets. Depending upon the size of the capital base supporting the with-profits fund, a large proportion of the fund will be invested in equities, although to reduce the possible risks there will be diversification into both overseas equities and property. Over the long term, real assets are not only the most likely to provide the best long-term returns but also provide protection against inflation.

Bonuses are set annually to give each with-profits policyholder a return on the contributions paid which reflects the earnings of the underlying investments whilst smoothing out the peaks and troughs in investment performance. The importance of such an approach is clear for personal pensions (and indeed any defined contribution pension arrangement) where the individual is taking the risk of volatility in the market close to retirement. Such smoothing also takes into account the expected future trends in underlying investment performance.

If we look at the Prudential with-profits fund over the last 5 years, depending on when the premium was invested in 1995, the 5 year growth rate for with-profits ranged between 80 per cent and 84 per cent, whereas for an equivalent discretionary fund, the range would have been between 61 per cent and 96 per cent. In order to operate a with-profits fund, a company needs to hold a substantial amount of capital in order to provide the benefits of smoothing and guarantees whilst investing a high proportion of the fund in real assets. This was one of the problems for Equitable Life, where, largely because that institution was a mutual with no ability to call on shareholder funds for support, the capital base was inadequate to carry the costs associated with current market conditions. We will return to this below.

Over time, the fund will pay policyholders their fair shares reflecting the long-term performance of the fund less the costs of any smoothing and guarantees supported by the capital. The balance of the fund that is not expected to be paid out to the current generation of with-profits policyholders is the working capital of the fund. It is sometimes called the "inherited estate" or "orphan assets" and provides some of the solvency capital that the regulator requires companies to hold.

Equitable: Bad news spreads quickly and the US investor may have heard about the demise of this, the oldest of UK life insurers. Equitable offered defined contribution pensions on a with-profits basis. It is important to point out that the situation at Equitable is specific to the approach adopted by that particular company and not a symptom of any more general problems in the UK pensions market, or in the concept of with-profits itself.

A number of factors conspired to work against this policyholder-owned company, thus causing it to need to ask its policyholders (other than those with guarantees) to meet the costs of liabilities that the directors had not anticipated. With-profits policyholders in a policyholder-owned company participate in the overall profits and losses of the company, and in this case the losses were quite substantial. Operating on the basis of distributing as much of its investment return as possible to policyholders it held very low reserves. When the recent changes in economic conditions, resulting in lower interest rates, triggered relatively generous interest rate guarantees the company had expected to call on those policyholders with the guarantees to share the costs. However, the costs were not only substantial but also had to be shared by all the policyholders, without any orphan assets to call upon.

The lesson from the Equitable experience is that guarantees are both expensive and potentially risky. Hence, in the context of providing a private alternative to a scheme where a benefit is "guaranteed" by public finance, whilst it might be tempting to insist that guarantees be built in, the costs would be self-defeating. It is possible that a Government may be in a better position to provide such guarantees itself, although it is worth noting that public pension "promises" can be changed. What private scheme would be allowed to defer maturity by 5 years and in so-doing require increased contributions and payment over a shorter period of time, as has happened recently in the UK with the change in female State retirement age from 60 to 65? Interestingly, the change was made with little or no adverse public comment. Similar changes elsewhere in Europe have brought protestors onto the streets.

Adverse selection in the Annuity Market: We should not just focus on the fund build-up prior to retirement. In the UK, strict rules govern the retirement benefit which has led to a substantial annuity market. The annual market for the purchase of annuities at retirement currently stands at approximately £9bn in the UK - approximately £6bn in guaranteed annuities backed by bonds (broadly equivalent to a fixed benefit annuity in the US), £1bn in with-profit annuities backed by equities (broadly equivalent to a variable annuity in the US), and £2bn left in a fund with regular income drawn down periodically.

There is an often-repeated allegation that annuities offer many retirees a poor investment. This is primarily a problem of perception rather than fact. First, when setting annuity rates, companies make assumptions about mortality which have recently underestimated the anticipated average lifespan - this represents an unexpected bonus for average retirees. Second, although annuity rates have fallen over the last 10 years this is due to both the increase in life expectancy and the fall in interest rates. Third, there is criticism that for some people who die early their return is very poor - this is a feature of any form of insurance where those who do not have a claim pay part of the benefit for those that do. In the case of an annuity, insurance is against living longer than expected, where the underpayment to those who die early is used to meet the costs of the long-lived.

A legitimate criticism relates to adverse rate setting against lower income groups. Based on the assumption that on average lower income groups have a shorter life expectancy than the better off, then companies should, in theory, offer them better annuity rates.

Governance: The development of the occupational pensions success story in the UK has also reflected the need for any regime to evolve. The most recent example is the introduction of the Pensions Act 1995 which followed the Maxwell Affair and the subsequent Pension Law Review's recommendations to improve the governance of occupational pension schemes.

The death of Mr Robert Maxwell in a boating accident led to the revelation of misuse of pension scheme assets in some companies in the Maxwell business empire. In response, the UK House of Commons Select Committee on Social Security identified weaknesses in the regulatory framework and made a number of recommendations - these included the establishment of a committee to carry out a thorough review of the regulation of occupational pensions.

As a result, the Secretary of State for Social Security established the Pension Law Review Committee. Its over-riding recommendation was to clarify the roles and responsibilities of sponsoring employers, trustees and their advisers, and the establishment of a regulator to whom "the whistle could be blown in the event of wrong-doing".

If "whistle-blowing" were to have any impact, it is important to have a regulator to respond. The Occupational Pensions Regulatory Authority (OPRA) was set up in 1997 with the following responsibilities:

- Scheme trusteeship.
- Minimum funding requirements.
- Modifications to trust deeds and scheme rules in appropriate circumstances.
- Scheme wind-up and breaches of the requirements for the use of surplus in such circumstances.
- Transfer payments.
- Breach of pension scheme regulations.
- Contravention of scheme requirements.
- Contravention of the requirement to pay the regulator's levy.

These important issues remain under ongoing review. However, we regard the ability to review such matters periodically and implement appropriate changes as a strength not a weakness of the occupational pensions regime in the UK.

3. Challenges for the future

Retirement provision for the low paid: The obvious difficulty is that the low-paid have insufficient funds to save. The UK Government accepts that it has a role in providing a safety net and will use the public pensions and benefits regime to provide a minimum income in retirement.

Some of the issues that need to be resolved are:

- Should the low paid be encouraged to save?
- Are pensions the best savings vehicle for their retirement?
- How much more generous can the State safety net become before it acts as a disincentive for average earners?

Increasing the level of compulsion: The current social security regime in the UK includes an element of compulsion ⁽²⁾. Other countries have introduced compulsion in pensions provision at an even higher level. Some believe that the extension of compulsion will need to be a significant part of the solution in the UK.

Some of the issues that need to be resolved are:

- Is it appropriate to compel pension contributions from those who cannot afford it?
- Is it appropriate to compel pension contributions when accessible shorter term savings would be better advice?
- Should employers be compelled to make pension contributions or will that simply represent unwanted salary sacrifice?

Operating within a 1% market: The historical criticisms of the high charges in the UK pensions market have led to a very strict 1% charge cap for the new regime of Stakeholder pensions. The challenge for the whole industry is the extent to which radical changes will be necessary to operate within that environment.

Some of the issues that need to be resolved are:

- Is there sufficient capacity within the UK market to operate at that level?
- Will there be pressure to further reduce the 1% maximum limit as funds grow?
- Does a 1% charge cap necessarily produce a better overall return for the customer?

The future of advice: The interaction in the UK market between pensions and other savings products with different advantages will continue to make advice important. This is further aggravated by the State safety net which may not only act as a disincentive to save but may be used as a reason to claim mis-selling in future if that safety net continues to be improved.

Some of the issues that need to be resolved are:

- Can "best advice" be expected in future?
- Are decision trees an adequate alternative to personal advice?
- Should individuals be allowed to claim if they lose future means tested benefits through having saved?

Financial Education: Most pensions markets accept the need for simplification both of their administration systems and of the choice presented to customers. At the same time it is recognised that greater resources need to be put behind a campaign to increase general financial education.

Some of the issues that need to be resolved are:

- Can general financial education be expected to cover anything more than a superficial understanding of the need to save?
- Will a financially literate population simply seek to maximise their State entitlements from the Welfare system or tax relief?
- Does financial literacy help an individual to manage their own financial risk?

APPENDIX A

The UK Pension System

The British pension system consists of two tiers, a flat-rate pension provided by the State called the Basic State Pension and a second tier consisting of supplementary pensions provided by either the state (SERPS), the employer, or through individual accounts

Basic State Pension (BSP): The BSP is indexed to inflation rather than to real wage growth and has therefore declined over time relative to average earnings, falling from approximately 20 per cent of average earnings in 1977-78 to 15 per cent in 1996-97. Prior to 1980, BSP benefits were indexed to earnings; the change to a price index allows for significant cost savings, estimated to be two per cent per year. The normal retirement age is 65 for men and will increase from age 60 to age 65 for women in small steps between 2010 and 2020. Workers are entitled to the full BSP if they have contributed for 44 or more years for men and 39 years for women. While the majority of workers have additional pensions to supplement the BSP, about 12 per cent of workers have only BSP alone and do not participate in one of the second tier programmes. However, the BSP benefit is currently below the Minimum Income Guarantee (MIG) provided by the State. Thus, for those with no second tier pension benefits, the income floor is the amount legislated through the welfare system and not that obtained from the pension system. Furthermore, because MIG is indexed to earnings the gap is expected to increase over time. Average earnings in the UK are currently around $35,000.

Earnings based pensions

The second tier of the British pension system offers three options for workers all of which base benefits either directly on earnings (i.e. defined benefit or "DB" plans) or on earnings-based contributions to a retirement fund (i.e. defined contribution or "DC" plans).

State Earnings-Related Pension Scheme (SERPS): The first option is participation in a public programme called the State Earnings-Related Pension Scheme (SERPS) which began in 1978. This programme is the default for workers who do not opt out of the public system and into an employer-based or personal pension. It is financed on a pay as you go basis. Benefits are a function of average "reckonable earnings," (i.e. earnings between a lower and upper limit, currently approximately 15 per cent and 110 per cent respectively of national average earnings). Lifetime earnings are adjusted for earnings growth when determining initial benefits, although after retirement SERPS benefits are adjusted for price inflation rather than earnings.

The self-employed are not members of SERPS.

Pension reforms in the 1980s gave workers the opportunity to participate in private pension plans in lieu of SERPS; this was known as "contracting out" (a term not to be confused with the generally unwise practice of "opting out" of a scheme sponsored with employer contributions and taking out a personal pension instead - this was part of the well-publicised Pensions Mis-selling). Contracting out applies to SERPS only and not to the BSP. It also only applies to future benefits and not those already accrued. About one-half of those who were members of SERPS in 1985 have since contracted out. Workers who contract out and choose a private plan receive a rebate on contributions. In 1996-97 about 30 per cent of workers were contracted into SERPS (about 26 per cent in SERPS alone and 4 per cent in both SERPS and an employer-sponsored occupational scheme). The data shows that workers enrolled in SERPS are more likely to be female than workers opting out, and they are disproportionately low-income workers - this is both because in the UK females are more likely to be on low incomes and because of an inconsistency in the rates of rebate for males at some ages.

On-top voluntary contributions cannot be made to SERPS.

Occupational pension schemes: As an alternative to SERPS, workers can participate in employer provided pensions (occupational pensions) and approximately 33 per cent do so (as noted above, an additional 4 per cent have both occupational pensions and SERPS). Most such plans are defined benefit plans (where it is the benefit that is earnings linked) but as in the U.S. there is a trend towards defined contribution plans (where it is only the contribution that is earnings linked). By law the minimum benefit available from an employer provided pension must approximately equal the benefit from SERPS, but benefits are typically more generous. For a worker with 40 years of employment, defined benefit pension plans provide up to two-thirds of their final salary. While pension contributions are made pre-tax, eventual benefits are subject to tax. There is, however, a one-time option at retirement to make a tax-free lump sum withdrawal of up to 150 per cent of final salary or 25 per cent of the value of the plan, thus reducing the future pension in payment by that equivalent amount. Retirement benefits must now be indexed to inflation up to an annual inflation rate of 5 per cent.

As in the US, a drawback of these defined benefit pensions is that workers can appear to lose substantial pension wealth from changing jobs but recent reforms have sought to improve the portability. In the UK, the final salary on leaving employment must be indexed to inflation up to an annual inflation rate of 5 per cent when calculating the pension payable at retirement.

Voluntary contributions (up to a specified limit of overall employee annual contribution) can be paid into a defined benefit plan, although these normally purchase benefits on a separate money purchase basis rather than by purchasing so-called "added years" (i.e. effectively increasing the notional period of employment on which the overall defined benefit is based).

Personal Pensions: A second alternative to SERPS is a personal pension. These instruments are similar to IRAs. Investments in personal pensions are composed of the rebate the worker receives for opting out of the SERPS plan along with any additional voluntary contributions the worker makes subject to a specified limit - that limit is at least £3600 gross of tax relief (about 15 per cent of national average earnings) although age related contribution rates increase that limit for many. In 1996-97 of the approximately 25 per cent of employees enrolled in personal accounts, about three-fifths made no voluntary contributions. The rebate is calculated by the Government Actuary so that on realistic assumptions it will provide approximately the same as the SERPS benefit foregone, although estimates are that for young workers even this low level of contributions will yield a larger pension benefit than SERPS. These personal pension plans have the advantage of being fully portable with respect to job changes but, as with any defined contribution pension, at the cost of letting the worker assume all of the investment risk.

Stakeholder Pensions: Recent reforms introduced in April 2001, now require any employer with more than 4 employees to make access available to a defined contribution scheme known as a Stakeholder Pension, or to a suitable alternative pension scheme. The Stakeholder scheme may be either an occupational scheme or a personal pension, either in a scheme operated by trustees or a Stakeholder manager. The key feature that Stakeholder pensions introduced is that, although no employer contribution is required, the scheme is subject to a form of product regulation not previously seen in the pensions market in the UK. They have minimum standards for charges (a maximum charge of 1 per cent of the fund), low minimum contributions (schemes have to accept one-off payments as low as £20 (i.e. only about $30), and transfers must be allowed to another pension scheme without charge. In general, contributions will be by deduction directly from salary rather than by direct debit from the bank and this may make it easier for individuals to maintain their commitment to voluntary contributions once they begin. These schemes are expected to improve the opportunities for those who do not have the option of occupational pensions. It should be noted, however, that they also extend access to children (there is no lower age limit), to those without income (the personal pension limits apply with a minimum of £3600 per annum for anyone) so anyone can make a pension contribution of £3600 gross of tax relief (effectively offering the advantages of tax relief to those not required to pay tax), and existing pensioners up to age 75. Although it is much too early to tell, there is some anecdotal evidence that these schemes might be being used by some as a way of gaining even more tax relief rather than by the lower paid target market.

Outcomes

The overall impact of the UK pension system is that the average income of the elderly has risen substantially since SERPS benefits were introduced. The after tax income of "pensioner units" (single pensioner or couple) increased by 64 per cent in real terms from 1979 to 1996/1997 compared to an increase of 38 per cent in earnings over the same period. However, the upper portion of the income distribution has fared substantially better than the lower. Gains in real income varied from 28 per cent for single pensioners in the bottom fifth of the distribution to approximately 80 per cent for married couples in the highest fifth. This difference is due to the growth in occupational pensions (up 162 per cent in real terms between 1979 and 1996/97) and investment income (up 110 per cent). Furthermore, those elderly who receive only the BSP have seen a deterioration in their relative incomes as the BSP benefit has remained approximately constant in real terms despite growth in earnings.

Major Reforms over the last 20 years to reduce the future cost of BSP and SERPS

Reforms of the 1980s and 1990s centred on reductions in the generosity of the public pension system and incentives for firms to offer private pensions and for workers to choose such plans or to invest in personal savings plans. The major changes included:

• Indexing State pensions to prices rather than wages.
• Plans to gradually raise the retirement age for women from 60 to 65 in monthly steps from 2010 to 2020.
• Reductions in SERPS benefits of approximately two-thirds by changing the benefit formula from 25 per cent of "reckoned earnings" to 20 per cent, increasing the number of years of employment used in the calculation from the best 20 years to an average of all years, cutting spousal benefits for widow(er)s from 100 per cent to 50 per cent, and reducing wage indexing.

An important aspect of these reforms was the decrease in the generosity of public pensions. The changes were possible politically for several reasons. First, the SERPS regime was relatively new, having begun in 1978, and therefore had few pensioners drawing benefits. Second, its complexity made it difficult for people to understand the changes. Third, many of the changes were phased in gradually and the impact was not apparent. For example, the change to inflation indexing rather than wage indexing for benefits will save a substantial sum but will not result in a noticeable difference in benefits for several years. Fourth, the possibility of opting out of the government programme is likely to have decreased opposition to the cuts. Finally, some argue that the most important factor was that public pensions account for a much smaller fraction of retirement income in Britain than in other countries, making decreases in benefits more tolerable.

Although each of those reforms reduced both the future cost and the value of public pensions, from 1988 to 1993, the rebate into a personal pension included an incentive to induce workers to contract out of SERPS. Personal pension schemes were launched as providing greater choice to individuals and with increased portability, being initially developed under the name portable pensions. More recently, the greater flexibility of withdrawals on retirement from personal accounts has increased their attractiveness.

The current government has focused reforms on low-income workers:

• Introducing a minimum income guarantee (MIG) separate from the BSP beginning in 1999, at a level above the BSP, with that gap set to rise since MIG will increase at least in line with earnings whilst BSP increases with earnings.
• Replacing SERPS in April 2002 with a new State Second Pension (S2P) that eventually (possibly as early as 2006/7) pays a flat rate benefit although contributions are expected to remain earnings based. The goals of the S2P are to get more middle income workers out of SERPS and into private plans (once Stakeholder pensions have become established) and to provide more retirement benefits to low income workers. S2P ensures a higher minimum pension for workers with incomplete earnings histories than SERPS and covers the disabled and those who provided childcare.

Other tax advantaged schemes

Any summary of the UK pension system should be set within a wider context. In most countries a key feature of the pension system is that they are tax advantaged (in the UK that means tax relief on contributions and gross roll up on investment, but with the exception of up to about 25 per cent of the fund being able to be taken as a tax free cash sum the pension in payment is subject to income tax). Unlike in some other countries, there is no provision to access those funds before retirement (which itself cannot be before age 50) - although a transfer value may be taken (for example on a change in employment) that is only payable to another pension scheme and not directly to the individual.

The locked-in nature of a pension, means that other tax advantaged savings schemes offered in the UK may appear more attractive in meeting individual needs in planning their savings regime, including saving for their retirement. Not only is the pension taxed in payment, it also has to be taken as a regular and fairly inflexible stream of income - it cannot for example be used up before age (say) 75 at which point an individual might believe that their income needs will have reduced. This makes non-pensions products potentially attractive even for retirement planning.

In the UK, individual savings accounts, national savings schemes and employee share option schemes offer tax relieved alternatives to more conventional pension savings. These arrangements may allow immediate access, can be taken after a term unrelated to any pre-set retirement age (the Government has suggested that it is inclined to increase the minimum age at which a private pension can be taken from 50 to 55), and do not involve benefits as a stream of income. In some cases the benefit may be subject to a tax on capital gains, so they may be a tax advantage in spreading the benefit over a small number of years. The flexibility of these contracts mean that pensions may not be the automatic natural basic block of retirement provision that they are in other countries. This has advice implications, and possibly leads to an expectation that someone should be directing the consumer towards the most appropriate purchase.

Annuities

We should not just focus on the fund build-up prior to retirement. In the UK, strict rules govern the retirement benefit which has led to a substantial annuity market. For example, the fund accumulated from the SERPS rebates cannot be taken in cash at all. The whole of the fund has to be taken as an income, from age 60 at the earliest, providing an escalating pension linked to inflation subject to a maximum of 5 per cent on the basis of the individual and their assumed spouse on a unisex basis. Such unisex and unistatus provision is otherwise virtually unknown in the UK market, although the absence of choice at retirement (other than to defer it) reduces the risks associated with such an approach.

An "annuity" in the UK means the provision of an income stream on pre-agreed terms either for a defined period or until death. This is quite distinct from the fixed and variable annuity products sold in the USA.

For defined contribution schemes, the benefits are generally provided by an annuity purchased in the competitive UK insurance market. Since these annuities are purchased outright at retirement, the investment mix in the accumulating pension fund is changed from equities to gilts or corporate bonds close to retirement in order to reduce the volatility of the benefit to be purchased. An alternative approach, known as "income drawdown", is possible whereby the fund remains invested (probably in equities) and regular benefits are drawn out of the fund, broadly in line with the benefits that would otherwise have been purchased under an equivalent annuity. In any case an annuity must be purchased by age 75.

The fund accumulated from the voluntary contributions can have 25 per cent of it taken as a tax free cash sum at retirement from age 50 at the earliest, and the balance must be used to purchase an annuity in the form selected by the individual. Rates are gender-based, and some addition may be allowed if the individual can demonstrate a shorter expected lifespan (for example, as a result of a smoking addiction). Again, an income drawdown approach is possible, although the same requirement exists to purchase an annuity by age 75.

APPENDIX B

Personal Pension Charges

If the Subcommittee is looking at the flat fund charge equivalent of the charging structure used on monthly and stand alone premiums of various terms on personal pensions, the following tables show the industry average and the effect of the advent of Stakeholder. Naturally, we would expect these charges to reduce substantially for equivalent products in the future as they are moved down ever closer to 1%.

 

	One Stand Alone SP of £10,000
Term	5 years	10 years	15 years	20 years	25 years
2000 Survey	1.934	1.4547	1.2777	1.1902	1.1248
1997 Survey	2.3031	1.5955	1.3161	1.1827	1.1065

Source: Money Management surveys October 1997 and October 2000, covering personal pensions only showing the position as at 1 July 1997 and 2000 respectively.

1. Prudential plc is a leading international financial services group (not related to the U.S. company with a similar name) and has been a key player in UK pension provision for more than 70 years.

2. In the UK, at present, employees pay contribution of 10% of their salary between £87 and £575 per week and employers pay 11.9% on all earnings above £87 per week. This entitles the employee to sickness, maternity, disability, unemployment and pension benefits.