With the demise of the final salary pension scheme, Jonathan Crowther looks at the alternatives and what characteristics they will need to be effective
The number of employees in the UK in final salary pension schemes has been overtaken by those in defined contribution (DC) schemes. According to the Association of British Insurers (ABI), 17% of employees pay into an employer arranged DC scheme as opposed to 11% who still accrue rights in final salary schemes.
The ABI figures also show that of the surviving final salary schemes 80% are closed to new entrants and 20% are closed to future accrual of benefits. Another survey estimates that half of these final salary schemes will close in the next five years.
The demise of the final salary or defined benefits employee pension has had several interactive causes:
lthe ending of the reclaimable tax credit on dividends;
lthe ability of employees to be able to transfer pension rights between successive employers so making them less attractive to employers as a means of staff retention;
lthe related demise of lifetime employment with a single employer;
lFTSE company pension schemes investing 'incestuously' in UK equities and therefore being exposed to other employers' deficits;
lenforced disclosure of scheme deficits; and
lemployers taking contribution holidays when stock markets were buoyant.
A further problem for members of existing schemes is that an employee has no rights under the scheme until the pension has vested (ie, an annuity has been purchased by the scheme trustees from an insurance company or a lump sum has been paid out to the employee).
Employees who are made redundant and for whom early retirement and immediate vesting is not an option must either freeze their pension or take a transfer value.
Since the final salary is the final salary on leaving (few schemes will index-link the final salary base), the ultimate pension will be exposed potentially to decades of inflationary erosion if frozen. Furthermore, if the employee chooses to freeze his pension, then the whole pension can be exposed to loss if the company goes into liquidation, receivership or is taken over.
Transfer values, on the other hand, can be less than the contributions made by the employer and, with additional voluntary contributions, the employee.
The ABI reports that 21% of the working population pay into public sector schemes and 13% pay into individual schemes. Therefore, 30% of the working population are paying into schemes where the final pension will depend upon the level of contributions made and the investment performance of the contribution fund, rather than years of service and salary on retirement. This figure can only be set to increase, especially if compulsion is introduced along the lines of the Australian model.
the Australian model
In the 1990s, the Australian government introduced compulsory private pensions for everyone earning more than £191 a month. The required contribution rate - paid by employers - has been gradually raised from 3% of salary to 9%, with tax incentives for employees to contribute 2%-3% themselves.
The size of the 'superannuation funds' - many of which are run on an industry-wide rather than company basis - has risen from A$30bn (£12.13bn) to A$600bn and 95% of employees are members of such a pension scheme, including 75% of part-time workers.
Under such a scenario, tax efficiency has a significant impact on the value of the pension fund available on retirement and the Australian tax regime governing superannuation funds has become extensive and complex.
Pension provision has therefore become a matter of tax-efficient saving rather than either or both of long service with a single employer (because of the demise of the final salary scheme) or a lifetime of social security contributions (because of the Thatcher Government's unlinking of the state pension from earnings).
The role of the employer and the Government has changed from being pension providers to joint contributors to the individual's personal pension plan, whether administered by an employer, a pensioner trustee or personally.
The range of tax treatment of savings vehicles can be summarised by the table above.
Pension related savings vehicles are treated as tax privileged and generally have been given the 'best' tax treatment, subject to limits, usually based on a combination of percentages of earnings/fund value, age and fixed monetary amounts.
The attacks by the Government since 1991 on trusts, culminating in the draconian provisions of FA2006, have made the trust vehicle tax-penalised and essentially subject to the 'worst' tax treatment.
The pension vehicle has therefore become the only show in town for people to achieve the best tax treatment for savings for retirement and provision for dependants on their death.
However, the tax treatment of pension savings vehicles can be complex and tax inefficiency can have a dramatic impact on fund values because of the long roll-up period involved.
the Jersey model
Jersey is phasing in a flat income tax system for individuals known as '20% means 20%', where income tax is charged at 20% of gross income without any deduction for allowances; the exceptions being child allowance and pension contributions, which are deductible up to the maximum of 15% of earnings or £15,000 up to age 39, 25% of earnings or £25,000 up to age 49 and 35% of earnings or £35,000 from age 50. There is no carry back or forward of these allowances.
The requirement to acquire an annuity for a personal pension plan has been dropped, on condition that on retirement the pensioner can show an index-linked pension equivalent to the single person's social security pension. Any shortfall can be made up by transferring gilts to a trust creating an annuity equivalent. The pension fund can then be drawn down as required and any fund balance on the death of the pensioner passes into his estate.
It is relatively straightforward for an individual to set up a stand-alone pension scheme using a Jersey company, which enters into an approved annuity contract with the individual and is then granted exemption from income tax on an annual basis.
A number of contracts can be used to segment the pension fund so that further flexibility can be achieved, say by drawing down against one fund and acquiring an annuity with another. The scheme is entirely self-invested and can hold commercial and residential property. If self-administered, the only cost is the £150 annual registration fee.
There is no limit on the size of the fund, although annual personal transfers are limited to the above monetary amounts, and unlimited transfers can be made from other approved pensions schemes, including UK schemes, subject to approval by the Jersey tax authorities.
However, the take up of these schemes has been low and one wonders if compulsion will be introduced in Jersey, given that at present 25% of the population draws a pension and that percentage is set to increase by 50% over the next 30 years.
The future model of a savings-based pension scheme will need the following characteristics to be effective :
lan element of compulsion both on the side of employer and employee;
lcontributions made by the employer and the Government geared to incentivise contributions by the employee;
linvestments must be capital protected in some way, such as in structured products;
ltax rules to provide the best tax treatment coupled with a discount on pension payments funded by earlier contributions to incentivise early payments into the scheme;
lsimple holding vehicles such as a private company or a discretionary trust with low running costs;
lsimple compliance rules and low compliance costs;
lno limits to the growth of the fund value;
lno annuity requirement; and
lno inheritance taxes on transfer of the fund to dependants.key points
80% of final salary schemes are now closed to new members
Compulsion needs to be introduced to force people to make pension contributions
Australia's introduction of compulsion in 1990 has led to a complex tax regime
Payments into pension schemes need to be incentivised, such as through best treatment tax rules
Women and young people adversely affected
A question of selectivity
Watchdog interviewed 13,000 people