Thursday, 20 March 2014

Its a Pensions revolution in prospect

I doubt that any forecasters looking at what the 2014 Budget might have in store for us predicted the demise of “Defined Contribution (DC)” Pensions Schemes as we know them. But that is in effect what the Chancellor of the Exchequer announced yesterday. It will take a bit of time to get used to the new world and as the Chancellor hinted it might not just be DC scheme members who “benefit”:

“There will be consequential implications for defined benefit pensions upon which we will consult and proceed cautiously”

Let’s look at what this might mean in a moment. But first what about the saving for retirement revolution that will soon get underway – for that is what it is? I have always thought that to call a DC plan a “Pension Scheme” was a misnomer – the fiction was convenient to some, not least employers, who could claim that they were finessing their Pension offer by moving from Defined Benefit (DB) to Defined Contribution. In fact, of course, DC has never been a Pension Scheme at all but a savings scheme. The only thing that made it comparable with DB was that on retirement the member had to buy an Annuity with the pot of the scheme (or 75% of it anyway). In other words by contributing to a DC scheme you were buying yourself a Pension so in that sense it was indeed a Pension scheme. With one fell swoop the Chancellor has changed that. DC is now a savings scheme pure and simple. Of course as the Chancellor said:

“Those who still want the certainty of an annuity, as many will, will be able to shop around for the best deal.”

…but they don’t have to. If they want to take their pot as cash and spend it on a round the world cruise or two they can. In effect Osborne is throwing down a challenge to the Financial Services sector to invent products that might be so good that retirees won’t want to blow their pots in one go! And those products have to be a darn sight better than the current Annuity based deals don't they? An average DC pot of £25,000 gives you an annual annuity-based income of around £1400 at 65. You'd surely “take the money” if that was the best you could get wouldn't you?

So what about DB schemes and was the Chancellor really hinting that he might apply the same principle to these? Well the ideological driver must be the same. This is what he said about that:

“People who have worked hard and saved hard all their lives, and done the right thing, should be trusted with their own finances”

So if this is you and you happen to be in a DB scheme what is the value of your “pot” if you retire at 65 and will receive a Pension of say £15,000 (the average pension in many major private sector UK schemes). Well based on current Annuity rates that value is around £300,000. So if we apply the  new DC rules to this the retiree could walk away with a sum not unadjacent to this to do with what he will. Attractive for many I would think. If this happened the Liabilities of the DB scheme would reduce coincidentally with the retiree deciding he will have jam today rather than Jam tomorrow. If the majority of retirees took the cash option then there would be major implications for DB schemes of course. Assets would reduce annually by the total amount of pots cashed in, but Liabilities would reduce as well. It will need an actuary to work it out (as always!) but I would guess that the funding ratio would be unaffected, though the fund’s cash flow would be heavily negative of course. In the extreme variant of this you could even offer those of us actually drawing pensions the chance to convert our remaining future Pension entitlement to cash at any time. Sponsors with healthy mature schemes might actually like this a lot – it's the ultimate de-risking!

So given the Chancellor’s declared predilection for “trusting people with their own finances” why didn't he do this? My guess is that the public sector pensions burden makes it impossible – at least for the foreseeable future. Public sector schemes are DB - but most of them differ from private sector schemes because they are unfunded. So there are no Assets out of which to pay the cash pots – the money would have to come from the Treasury! And given the continuing size of the budget deficit no sane Chancellor would want to increase public expenditure if he didn't have to.

So there we are. A Pensions revolution no less with maybe more to come. A challenge ahead for everyone in the Pensions world. Interesting times!