Occupational Pensions
The 'big bang' ahead

Occupational pension schemes already play a larger role in pension provision in the United Kingdom than in other countries, and recent government proposals are likely to expand this role. At a lunchtime meeting on 24 February CEPR Research Fellow Leslie Hannah predicted that the government's recent White Paper, which proposed wider competition between pension providers, would lead to a 'Big Bang' in pensions. Hannah also predicted that new alliances will develop between employers and financial services companies, designed to contain the costs of pensions to employers and to exploit the marketing advantages now available to the private sector. This will create new dangers, Hannah warned: there will be an increased risk of pension fund insolvency and the structure of tax reliefs may lead to distortionary cross- subsidies. Preoccupation with short-term problems had for too long dominated policy making for occupational funds: attention must now be focussed on fundamental long-run questions, he argued.

Leslie Hannah is Director of the Business History Unit at the London School of Economics and a Research Fellow in the Centre's Human Resources since 1900 programme. Professor Hannah based his lunchtime talk on his forthcoming study of the forces shaping pensions over the last fifty years, Inventing Retirement, to be published by Cambridge University Press in April.

Currently around 90% of pension scheme members - nearly half the employed workforce - can look forward to defined-benefit pensions on a 'final' salary basis, but Hannah predicted a resurgence of defined-contribution ('money-purchase') pensions It is often claimed that the contracting-out requirements of SERPS had encouraged the growth of defined-benefit schemes. Hannah disagreed; defined-benefit schemes largely preceded the introduction of SERPS as an ill-considered response by scheme trustees to inflationary pressures. Current plans to scale down SERPS would not therefore necessarily encourage the growth of money-purchase schemes, Hannah argued.

There were other reasons why defined-contribution or 'money- purchase' schemes (which do not guarantee a particular level of benefit) would become more popular, according to Hannah. The costs of money-purchase schemes are known at the time the labour is employed, and firms would prefer this certainty to the unpredictable costs of final-salary schemes. Money-purchase schemes are therefore less sensitive to variations in the rate of inflation, which had created difficulties in the 1960s and 1970s. The availability of index-linked securities meant that money- purchase schemes could now provide satisfactory real levels of benefit. Money-purchase schemes were also attractive because they now offered effective portability on a more equitable basis than did the earlier defined-benefit schemes, and they reduced the inequitable cross-subsidies which were an unintended by- product of final-salary schemes.
Hannah warned that the growth of money-purchase schemes depended in part on the introduction of clearer guidelines on transfer values for leavers. Otherwise, Hannah claimed, employers would attempt to preserve final-salary schemes because they provide a convenient 'smokescreen' behind which employers could avoid the consequences of the new portability of pensions.

There were still obstacles to true portability of pension rights, according to Hannah. The legislative changes of 1973-85 have gone a long way to establishing pension portability. Employees changing jobs after five years' service (two years' in 1988) now have the right to a deferred pension or to the transfer of their accrued pension entitlements. The maximum inflation proofing of deferred pensions is only 5% per annum, however, a restriction which Hannah described as 'intolerable'. It meant that neither the employer nor the employee could assess the value of a deferred pension without forecasting inflation rates thirty years hence! The size of current pension fund surpluses would allow the 5% restriction to be removed. Government compulsion to ensure adequate inflation proofing is clearly desirable, Hannah argued: past experience has shown that voluntary progress in this area is slow. Further changes will probably also be required to standardise the actuArial,Helvetica,Sans-Serif guidelines on transfer values, he noted.

Hannah noted that even large pension funds in the USA and France have become insolvent in the past. British pension funds have an enviable record of stability, but Hannah argued that recent changes in their structure leave no room for complacency. Many funds have in the past been technically insolvent on both an accrued- and a projected-liability basis, and they have been rescued only by employers' willingness to bail them out. Luck has also been a factor, Hannah noted: inflation, contrary to belief, has actually benefitted the finances of most funds. There is no reason to believe that this good fortune will continue. At present large public and private employers dominate occupational pension provision, but government encouragement means that in the future, occupational schemes will be established by smaller and weaker employers who will have less incentive to stand behind their funds. Increased competition between the new pension providers - banks, unit trusts and building societies as well as insurance companies - may reduce profit margins, and this may also threaten the solvency of occupational pension funds. Problems of supervision will increase, and Hannah predicted that insolvency of pension funds will become more common in the future.

There have been alarming predictions that new portable pension schemes will incur heavy operating costs, even rising to the levels common in schemes for the self-employed, which have expense ratios as high as 20%. If this is so, increased private provision will merely increase employment in financial services, while leading to serious reductions in the funds available to the elderly. But Hannah argued that this is unlikely: employers' bargaining power will be sufficient to induce pension providers to limit the increased costs resulting from portability and the right to contract out.
There has been a tendency throughout the last fifty years for financial services to be retailed through employers in order to reduce costs, and Hannah predicted the formation of new alliances between employers and pension providers. Employees would be offered new packages of financial services which combined pensions with other forms of saving such as house purchase and life insurance. Although this would increase the efficiency of financial retailing, Hannah was concerned that such packages would reflect the structure of tax reliefs and not the real costs of transacting business. He noted that the availability of generous tax reliefs for pensions created an incentive for inventive financial services companies to channel as many savings transactions as possible through the pensions system. The government, according to Hannah, might inadvertently create an expenditure tax via occupational pension schemes!

The discussion which followed was lively. One questioner argued that the best policy might be for the government to end its involvement in pensions, withdraw tax subsidies and allow the assets of the funds to be distributed to members to make whatever pension provision they desired. Hannah thought this went too far: the evidence suggests that individuals currently tend to make inadequate provision for their retirement, even with government encouragement.

Problems of pension fund insolvency were also raised in the discussion. The US system of fund regulation had encountered difficulties because of moral hazard. The German system, on the other hand, offered some advantages. Occupational pensions were reinvested in the shares of the employer companies, but a market also existed in which such funds could be traded. This allowed some scope for private insurance against insolvency.