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As people in the UK live longer many people in work today can look forward to spending about one third of their adult life in retirement. Yet, many people do not understand their pension arrangements nor do they understand the many changes happening to both state and private pensions. Try striking up a conversation with someone about pensions and you will find that “let’s talk about something interesting instead” is a common reaction. Perhaps the Pensions subject frightens many people because they do not want to think about getting older.

Many people are fortunate to be members of occupational pension schemes, but a high percentage do not understand their employer’ pension scheme and they certainly do not want to consider whether they should pay any more to fund their retirement. Faced with so much to think and worry about, many will take the ‘head in the sand’ approach to pensions. How many ostriches do you know that get good pensions?

The Bad News – We are Living Longer

Now is just the time that it is important to understand what is going on in the world of pensions. There have been two recent new acts which affect both state and occupational pension schemes. We will consider these acts in a subsequent edition of Aimzine but in this article I want to focus on the reduction in pensions provision by employers. The impact of this on many individuals and on society in general will be considerable.

The spiralling cost of pensions has forced many employers to rein back their spending on pension provision for their employees. In the private sector particularly, there has been a major shift away from expensive defined benefit pension schemes to defined contribution (There’s a full explanation of these types of schemes on Wikipedia here). These latter ‘money purchase’ schemes are much less risky for employers as costs are always a fixed percentage of payroll.  A typical change is as shown in this before and after example:

The change from the ‘BEFORE’ pension scheme to the ‘AFTER’ one will save an employer significant sums BUT it could lead to a high percentage of today’s workforce having grossly inadequate pension provision – see later example.

Until recently existing members of final salary schemes were able to continue in these schemes while new joiners were being enrolled into a money purchase scheme. However, increasingly defined benefit schemes are being frozen in favour of money purchase arrangements – see a BBC news report on this subject here.

..a major shift away

from expensive

defined benefit

pension schemes

There are three main reasons why pension provision has become so expensive for employers:

1. We are living longer and so our pensions will need to be paid for many more years.
2. Returns available from both equities and bonds have fallen dramatically.
3. The abolition of Advanced Corporation Tax (ACT) relief in Gordon Brown’s first budget in 1997. (Read more about this here)

The switch from defined benefit to defined contribution has, for some employers, produced considerable savings. In some cases the switch has cut the cost of pension provision for an employer by more than half. Furthermore, the risk that the employer will have to find substantial extra sums of money to fund the scheme because of poor investment performance is eliminated. There is also an impact on company balance sheets – you have to account for the deficit on a defined benefit scheme.

But it’s worse than that

Many employees will have had their pension benefits reduced considerably as their employers cut their costs. We suspect that very few of these people are making any additional pension contributions to make up for this shortfall. Nor do we think that many will be taking steps to mitigate their considerable risk of massive under-provision now that their employer has transferred the investment risk to them. Perhaps some believe that their defined contribution scheme will provide them with a good pension. It would perhaps do so if a) Investment conditions improve dramatically and b) people stop living longer and c) Government scraps ACT. We would not bet on any of these.

A proportion of Aimzine’s readers are retired or approaching retirement. Unlike previous generations, retirees are frequently healthy and active people for many years after they retire. In this position, many people find that they ‘need’ more income in retirement to fund all of the leisure activities and holidays rather than the meagre income on which previous generations have survived. How many people are planning to provide themselves with such a generous pension income in retirement?  Perhaps they are relying on some extra capital by moving to a smaller property in retirement. But even this nest egg looks at risk with some pessimistic forecasts for the property market.

Illustration

The pensions section of the Hargreaves Lansdown (HL) website provides access to a number of helpful guides and videos. There are also some useful calculators to help in pensions planning. We have used the HL Pensions calculator to work out some figures for a 30 year old in work today.

For our example we assumed that our 30 year old was earning £30,000 per annum and that 10% of his salary (paid jointly between employer and employee) was being paid into a defined contribution pension scheme.  The calculator estimates that this will produce a seemingly healthy pension fund of £464,000 by age 65. However, when you ask the calculator to show this figure in today’s terms the sum reduces to £191,000. This amount would provide an estimated pension of £8,387 per annum.

This £8,387 pension, even when supplemented by a state pension would be woefully below most peoples’ aspirations. To improve the pension our 30 year old would need to pay more money in to boost their pension pot OR achieve better returns on their funds or both. If they had started paying for their pension into their fund before age 30 that would also have helped.

The Hargeaves Lansdown calculator uses a default assumption that funds would grow at a rate of 7% per annum – a figure that many pension funds have failed to achieve in recent years. If you change the growth assumption to 5% the estimated pension figure is calculated at a paltry £4,375 per annum.

..the switch has cut

the cost by more

than half

but even this nest egg

looks at risk

...woefully below most

people's aspirations

SIPP’s

Next month we look at Self Invested Pension Plans (SIPP’s) as a way for individuals to improve their pension provision. We will also consider the advantages of holding AIM shares in a SIPP and which shares are suitable

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Written by: Michael Crockett

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