Promises and pots and pension policy
As an elder millennial I sometimes find it difficult to decide whether I share more with my parents’ generation or more recently minted vintages. A lot of debate about generations, especially discussions about values and wealth distribution, has descended into divisive cliché. But there are genuine insights to draw.
One is about public spending priorities. It strikes me as an important insight that lots of the money spent by our government has been focused on people older than me. The median age in the UK has risen steadily in recent years. In 1970 it was 33. In 2022 it was 40. This demographic trend explains why, for instance, national insurance is an easier target for raising public funds than, say, the triple lock on the state pension. In a sense it is democracy at work.
There is a generational divide reflected in the pension system too. Almost all UK employers have changed how their pension works over the last few decades. Because I had a stint in the public sector, I am unusual for my age in having a defined benefit pension. But for businesses, the cost of running old-style pension schemes grew over time; organisations made changes to save money.
It's worth explaining what a defined benefit pension is. In essence it is a promise. You build up an entitlement from your company based on an equation set by the pension scheme. The amount of income you get often used to be linked to your salary at retirement (‘final salary’) but is more often now an average of your earnings over your career (‘career average’). You don’t need to worry about what to invest in. But you should worry a bit about the company and its pension scheme surviving (although the UK government, in the form of the Pension Protection Fund, provides a backstop). You are relying on a group of institutions to honour their commitments; the risk is that the institutions fail.
If you are mid-career today and have never worked in the public sector you are unlikely to have this type of pension. You probably have a defined contribution pension. This is your money; a pot of cash that you and your employer pay in to. You aren’t allowed to touch it until you reach retirement age, but it’s yours. Investing the pot is your responsibility. The risks are volatility, capital loss and inflation.
Defined contribution pensions are generally worse. This is a function of the equations that work out how much income you earn in the future for a period of work. It can get complicated, but the fact that UK companies have almost unanimously moved away from defined benefit pension provision for their workers tells you where the incentives were. They could save money by not making any more expensive promises and instead furnishing employees with some money to invest themselves.
The key exception to this change is public sector workers. In essence, if you work for the civil service, local government, the armed forces, the NHS or the police you are the beneficiary of a deal. You get, generally, a lower salary than you could earn for equivalent work in the private sector. But you get a really good pension relative to your private sector peers. These public sector pensions have not been immune to the trend of cost saving – movement from final salary to career average has been a feature of many of them. The government banned the process of transferring out a pot of money to ‘buy out’ your promise for unfunded government pensions. But you would have to earn quite a bit more in the private sector to build up an equivalent retirement provision to the one public sector workers enjoy.
All of this came about accidentally. Unintended policy mistakes, macroeconomics and court cases have all consistently eroded private sector defined benefit pensions for people my age. Gordon Brown famously removed the 10% tax credit on dividends, which had a big long term-impact on UK pension funds. Prior to this a steady drip of court cases solidified the status of the promises made by UK pension schemes to their members; this made those promises more expensive. Finally we have been in a long era of declining interest rates. Since the early 1980s the trend in rates has been downwards and this was turbocharged in 2008. The mechanics of valuing defined benefit pension promises mean that interest rates going down makes the promise more valuable (and more expensive to make) in today’s terms.
It is something to worry about that the tax relief given to pensions are a huge component of public spending (roughly £50bn). The recent controversial changes to Agricultural and Business Relief that saw farmers invade Westminster to protest are only projected to save the exchequer 1% of this amount. It is a worry because most of us don’t understand how generous the system is because it is also complicated. That makes it easy for politicians pressed by big spending deficits and recalcitrant debt markets to make them less generous. But the better you understand it, the less likely they are to take it away.
If you would like some help participating in democracy by understanding your pension, get in touch here.