House of Commons - Treasury

Select Committee on Treasury Fifth Report

2 Recent trends and future prospects

5. The Pensions Commission's starting point for its proposals is the contention that pensions policies over many years have been founded on a false prospectus. The Commission observed that the State has been planning to play a reduced role in pension provision for the average pensioner, a policy "based on the assumption that private provision will grow to offset this decline".[10] Successive Governments have seen rising voluntary provision as an opportunity to contain public expenditure in the face of the demographic challenge.[11] The reality has been somewhat different, characterised in Lord Turner's words by an increasing number of people on or around middle incomes "not making any provision on top of the State pension, while the State simultaneously is planning to do less for them".[12] Far from growing, voluntary private pension provision "is in serious and probably irreversible decline".[13]

OCCUPATIONAL PENSIONS

6. This decline is most apparent in the occupational pensions sector. Ms Christine Farnish, Chief Executive of the NAPF, told us that, for the last half century, most people in the United Kingdom saving for a pension have saved through a defined benefit (DB) scheme—in which payments in retirement are not directly dependent on individual contributions—sponsored by an employer, where the only decision for the employee has been whether or not to join the scheme. This system, according to Ms Farnish, is "dying around our ears".[14] The Pensions Commission has also referred to a "rapid retreat from DB provision".[15] An estimated 54% of DB occupational schemes closed to new members between the end of 2001 and the end of 2004. By October 2005, only 24% of FTSE 100 companies offered DB schemes to all new employees and 67% did not offer DB schemes to any employees.[16]

7. The causes of this general decline were analysed by the Pensions Commission in their initial Report. That analysis highlighted the reasons for the increased costs of DB final salary pension schemes, costs which were partially disguised by the long bull market in equities of the 1980s and 1990s. The finances of such schemes were also affected by major tax decisions—the removal of tax-exempt status for certain surpluses in 1986 and the dividend tax changes of 1997. The "over-optimistic" assumptions of successive Governments and of employers about the sustainability of long-term returns were then exposed by the bear market of the period from 2000 to 2003.[17] Lord Turner told us that there has been "a collective fool's paradise", leading to employers' contribution holidays and tax changes "all of which ... with foresight, if you could roll back the clock, you would not have done".[18]

8. The Commission has noted that the rapid decline of DB schemes has "severely exacerbated the gaps that have always existed in Britain's pension system" and increased the inequality in pension provision.[19] Public sector employees account for 18% of all employees, but 36% of all accrued pension rights and funds. There are many high income members of "top hat" defined contribution (DC) schemes in the private sector which pay far higher contribution rates than members of ordinary schemes enjoy.[20] Inequality is often a feature within companies, with an employee in a DB scheme receiving pension promises twice as valuable as those available to another employee doing an identical job but who joined after a DB scheme was closed to new members.[21]

THE WIDER PROBLEMS OF PRIVATE PENSIONS

9. The weaknesses of private pension provision are by no means confined to those arising from the declining quality and quantity of occupational pension coverage. As the Pensions Commission has observed, "initiatives to stimulate personal pension saving have not worked"; they have also noted that "barriers of inertia and high cost" have deterred voluntary private pension provision.[22] The lack of growth in this market is attributable in considerable measure to three closely linked issues—the weakness of the commission-driven model, the mis-selling scandals of the 1990s and the development of regulation.

10. The problems of the commission-driven life office business model were recently highlighted when Mr Trevor Matthews, Chief Executive of UK Life and Pensions at Standard Life, stated that "our basic business model is flawed".[23] Mr Ned Cazalet of Cazalet Consulting has also cast doubt on the viability of this model.[24] He told us that this model relied on the payment of commission to intermediaries for new sales, which gave those intermediaries an incentive to move business from one provider to another, a process which generated costs to providers without creating new business. He estimated that, in four years, insurance companies had spent about £17 billion trying to obtain pensions business, with little to show for it except business moved from one company to another before it could become profitable. Mr Cazalet thought that "this model is economically defunct ... crazy ... hugely loss-making and ... unsustainable".[25] As our predecessors observed in 2004, the commission-driven distribution model creates a "negative image ... in the eyes of some potential savers".[26]

11. The commission-driven model contributed to what the Pensions Commission has characterised as "a misguided attempt to extend personal pensions to segments of the market where the economics only appeared to work in periods of exceptional capital return".[27] The private pension market suffered both directly and indirectly from its association with the mis-selling scandals of the 1990s. As Lord Turner observed, "twenty years ago we did not call what [independent financial advisers] do 'advice'. We called it 'sales'." He noted that a sales force remunerated by commission "might tend to sell things which were not in people's interests".[28]

12. The combination of a seemingly flawed business model and advice which had leanings towards a particular outcome led to a rapid growth in regulation of advice. In 2004, our predecessors expressed the view that the FSA had delivered a significant improvement in the regulatory framework and concluded that "the current low level of confidence in the financial savings industry is in large part a reflection of the weak regulatory framework and inappropriate industry practices" that preceded the FSA.[29] However, as Lord Turner noted, regulatory changes in recent years have "added an enormous amount of cost".[30]

13. In 2004, the then Treasury Committee concluded that "the bear market has exposed a catalogue of problems and scandals that has left a large body of savers feeling disillusioned with the long-term savings industry".[31] That view was partially echoed by the Pensions Commission, which has observed that "many do not trust the financial services industry to sell good value products".[32]

14. Recent years have seen a diminution in the willingness or capacity or both of employers to take the lead in the making of adequate pension provision for employees. The leading providers of non-occupational private pensions have been ill-equipped to take up the slack. The combined result has been a dramatic growth in the numbers in the private sector workforce who do not contribute to a non-State pension, from just over 8 million in 1996-97 to nearly 12 million in 2004-05.[33] As Lord Turner concluded, "the private pension system, far from growing to fill the gaps left by the State ... is actually doing less".[34]

THE CASE OF STAKEHOLDER PENSIONS

15. The failings of the private pension system in recent years are exemplified by the experience of Stakeholder pensions, which were introduced in 2001. These were foreshadowed in a Pensions Green Paper in 1998 which stated:

People in middle incomes want to save more for retirement, but current pension arrangements are often unsuitable or expensive. Our new secure, flexible and value-for-money Stakeholder pension schemes will help many middle earners to save for a comfortable retirement.[

"Middle earners" were defined as those earning between £9,000 and £18,500 a year.[36]

16. Stakeholder pensions involve a DC scheme with compulsory minimum standards. Employers with five or more staff who do not offer occupational pensions are required to provide access to a Stakeholder scheme if they have one or more relevant employees. Stakeholder pensions are intended to be flexible and portable, with no penalty charges for transfers in and out, freedom to vary contributions and quite small contributions permitted.[37] Stakeholder pensions are sold mainly through financial advisers, either direct to consumers or through the workplace. There is a wide choice of Stakeholder pension product providers with different service and product propositions, and a vast choice in investment funds.[38]

17. Stakeholder pensions have from the outset been faced with uncertainties about the extent to which they can be sold without regulated advice, not least because of the complex interaction between occupational and personal pensions.[39] Following a Government decision in 2004, the FSA has now introduced a Basic Advice regime for the regulation of advice on the sale of Stakeholder products, although there remain several ways in which Stakeholder pensions can be sold, including through a full advice process.[40] Significant concerns persist amongst providers about the limited impact of Basic Advice, the general regulation of sales and the costs such regulation entails.[41]

18. One of the central founding principles of the Stakeholder pension was that there would be a limit on the Annual Management Charge (AMC) that could be levied, alongside prohibitions on certain other charges. The cap on the AMC was initially set at 1%, which providers claimed prevented effective promotion and distribution of Stakeholder pensions.[42] In 2004, the Treasury announced that, for people joining a Stakeholder scheme on or after 6 April 2005, the cap would be 1.5% for the first ten years, reducing to 1% for subsequent years for those remaining in the scheme. The then Financial Secretary to the Treasury told our predecessors in 2004 that the increase of 50 basis points was a "charge explicitly for advice".[43]

19. Mr Cazalet suggested that the increase in the charge cap was actually used to pay more commission to intermediaries.[44] This view appears to be supported by Standard Life, who observed that "providers rationally offered intermediaries as much commission as they could afford within the confines of the charge cap".[45] Standard Life also backed up Mr Cazalet's contention that Stakeholder pensions remain an uneconomic proposition for providers.[46] Mr Mick McAteer, Policy Adviser at Which?, contended that the industry had wished to see the price cap increased to make money at the higher end of the market, not in order to extend reach among those on average earnings or below.[47]

20. In the early stages of the life of the Stakeholder pensions there were some signs of success in reaching the target market of middle earners.[48] However, in 2003 the Department for Work and Pensions provided little evidence of take-up or interest in Stakeholder pensions among middle earners who did not have an existing private pension.[49] Although the number of holders of Stakeholder pensions exceeded 1 million by late-2002, many of these new pension arrangements seem to have arisen from individuals switching from other schemes (notably personal pensions) and from existing Group Personal Pensions being reconstituted as Stakeholder pensions.[50] Since 2002, the number of new contracts has declined year on year.[51] Independent research suggests that private pension coverage has fallen among the target group of middle earners. There has been some increase in use by low or non-earners, but this is probably an attempt to utilise the tax benefits by the spouses of high earners.[52] Analysis by the Pensions Commission suggests that "at income levels below £20,000 it is difficult profitably to sell pensions at the present charge cap".[53]

21. One of the starting points for consideration of proposals by the Pensions Commission and of rival proposals must be the realisation that Stakeholder pensions have not been successful in halting the decline of non-State pension provision among middle earners. Indeed, a combination of sales approaches, commission incentives, regulatory requirements and decisions about the charge cap have created a position in which Stakeholder pensions are seen as uneconomic to both providers and potential customers among the original target market of middle income earners. The lessons from this process must be learned in taking forward proposals arising from the work of the Pensions Commission. We have sought to draw out these lessons in our ensuing conclusions and recommendations.

Public pension provision

22. A table in the Second Report of the Pensions Commission indicates that, in the coming years, United Kingdom public expenditure on pensions and assistance for those aged over State Pension Age is likely to be towards the lower end of plans of the European Union fifteen.[54] Lord Turner stressed that there was a "good news" component to this fact, because "we do not face the problems of fiscal sustainability that most of continental Europe faces" and "we have the most developed system of voluntary pension saving in the world".[55] However, he also pointed out that, even were the proposals for State pensions in the Commission's Report to be implemented, the United Kingdom would still be left "with one of the meanest and most basic State pension systems in the OECD".[56]

23. Lord Turner emphasised that this meanness reflected the deliberate policy of British Governments for the last 30 years, following the decision in 1981 to decouple the indexation of the Basic State Pension from earnings and increase it in line with prices.[57] If this policy of the last twenty-five years were to be maintained for the next forty-five years, the value of the Basic State Pension in relation to earnings would be expected to decline markedly.[58]

24. Since the late 1990s the Government has sought to combat pensioner poverty through a Minimum Income Guarantee linked to earnings rather than prices. Since October 2003 the guarantee element has formed part of the Pension Credit, the second component of which is a Savings Credit linked to prices intended to reward pensioner households which saved for their retirement. According to the Government, "concentrating resources on the poorest pensioners has ensured that between 1996-97 and 2004-05 over one million pensioner households were lifted out of relative low-income poverty and 2.1 million pensioner households have been lifted out of absolute low income poverty".[59] At the same time, the effect of these changes, including the operation of the Savings Credit, has been to increase the proportion of pensioner benefit units subject to means-testing. The change also results in high tax credit withdrawal tapers. These may be related to the increase in the number of households facing relatively high marginal tax rates. In our Report on the 2006 Budget, we noted that, since 1998, there has been a reduction in the number of households facing the highest marginal deduction rates of 70% or more, although the number of households facing marginal deduction rates in the region of 60% to 70% has increased.[60] The trends relating to means-testing and tapers are expected to continue were the policies on indexation of recent years to be maintained.[61]

10 A New Pension Settlement, p 2 Back

11 Ibid, p 42 Back

12 Q 195 Back

13 A New Pension Settlement, p 2 Back

14 Q 66 Back

15 A New Pension Settlement, p 54 Back

16 The Pensions Regulator: Medium Term Strategy, April 2006, p 13 Back

17 Pensions: Challenges and Choices, pp 121-124 Back

18 Q 221 Back

19 Pensions; Challenges and Choices, p 125; A New Pension Settlement, p 60 Back

20 A New Pension Settlement, pp 60, 62 Back

21 Ibid, p 60 Back