A Short History of Pensions – Part Two
Wise Words
This is Part Two in our guest article series, written by Wise Investment Founder Tony Yarrow
The State pension – changing retirement ages – the rise and fall of SERPS – the Triple Lock and the indexation of the Winter Fuel Allowance – the rise and fall of company pensions – money purchase alternatives, where we are today
This is the second instalment of a two-part article, the first of which appeared in May last year. I began that article by saying ‘it’s hard to find a more complicated, jargon-infested subject than pensions’ in apology for writing on a subject in which no one appears to be interested. Pensions are boring, it’s true, and in fact, they’re worse than just boring. It’s a subject we don’t like thinking about because we’re always being told we should be doing more about our retirement income than we are, which makes the whole subject stressful, and the word ‘pensions’ conjures up images in our minds of those stooping silhouettes that you see on the ‘elderly people’ road sign, of ourselves in wheelchairs, badly-adjusted hearing aids and other unedifying paraphernalia, a kind of shadowland best left unvisited by the young and able-bodied.
The world of pensions is complex, it’s true, but it’s also dynamic and ever-changing, and whether we like it or not, we happen to live in the middle of it.
Welcome to Part Two of ‘A Short History of Pensions’!
My father dreaded retirement and waited to step down until the last possible moment, which, as a university lecturer, was age 65 (he actually retired about two weeks before his 66th birthday). To his and everyone else’s surprise, he lived almost another thirty years thereafter, continuing to enjoy reading, writing and walking, the activities he loved best, almost to the end. A certified workaholic like my father, I was able to put off the evil day until just before my 70th birthday, but have loved every minute up to this point. As my father used to say, being old is a whole lot better than what comes afterwards.
But how can we live a happy life when paid employment ceases? This is clearly a financial question, but it’s a social and political one as well. The history of pension provision reflects the endless tug-of-war between the understanding that in a civilised society, people shouldn’t be made to work until they drop, that some provision should be made, and the question of who should be responsible for that large and incalculable provision. Should it be the individual, the family, the company or the state?
State pensions
Part One of this article covered state pension provisions. There was no state pension in the UK before 1909. The first version was no more than a toe in the water, providing only minimally for the oldest and most impoverished. Over the course of the twentieth century, provision was gradually extended until it became universal after the Second World War.
There have been three major changes since then.
In 1978, the Labour government of James Callaghan introduced an additional pension, originally known as the State Earnings-Related Pension Scheme or SERPS, intended to match the pensions offered by major employers. This scheme turned out to be unaffordable, and after a few decades of furtive pruning, it was eventually merged with the original basic scheme, which survives to this day.
A legal judgement in 1992 outlawed differential retirement ages on the basis of sex discrimination. Up to that point, the State Retirement Age was 65 for men and 60 for women. There would have to be unisex retirement age, and Mr Major’s government decided to achieve this result by increasing women’s retirement ages to 65 in line with men’s, which was phased in between 2010 and 2019, at which point everyone’s retirement age was increased to 66. Naturally, a large number of women feel cheated by the removal of five years’ entitlement for which they contributed for much of their working lives.
It has subsequently been decided that retirement should be a fixed proportion of a person’s lifetime, so henceforward (unless the policy changes again), retirement ages will be altered in line with life expectancy. Since the early 1900s, it has been safe to assume that life expectancy would continue to increase alongside better diets and healthcare. But curiously, life expectancy hasn’t increased over the last decade. Covid has been a factor, but only one. Whether life expectancy will resume its previously inexorable upward march remains to be seen. The UN believes that it will – its figures for life expectancy at birth predict 81.9 years in 2024, rising gradually to 90.8 in 2100. Knowing what we know about climate change and the as-yet-unresolved obesity crisis, this forecast could turn out to be optimistic. Your state pension age will depend on the outcome.
The third major change has been the introduction of the Triple Lock in 2010. This reform is very popular with pensioners because it guarantees that the State Pension will increase annually by the highest of the rate of inflation (measured by the Consumer Price Index, or CPI), the average increase in wages/salaries (the Average Earnings Index, or AEI) or 2.5%. In most years, wages have increased by more than the rate of inflation. From 1979 onwards, the Basic State Pension had been increased by the rate of inflation, which meant that it hadn’t kept pace with wages – between 1979 and 2010 pensions had fallen from 26% to 16% of average earnings, and it was felt to be unfair that pensioners weren’t benefitting from the economic growth reflected in the earnings figures. Also the UK state pension was considerably less generous than those of countries on the near continent – UK pensioners were paid lower amounts and had to wait longer to receive them.
Over the last decade, the Triple Lock has become a political hot potato. Pensioners’ incomes can’t fall relative to the incomes of working people and will rise in the years when the AEI isn’t the highest of the three factors. Over the past thirteen years, the State Pension has increased by around £800 more than it would have done if indexed by either one or other of inflation or earnings. Today the triple lock costs the Treasury around £10 billion a year, almost enough to fill half of Rachel Reeves’ Black Hole. It has done a good job but is becoming unaffordable. But who dares tamper with it? There are 12.6m people in receipt of the State Pension, a little over a quarter of the electorate. We pensioners all think the Triple Lock is a Good Thing. Our new government could have used its overwhelming mandate and need to balance the books to take a pruning knife to the Triple Lock, but has chosen not to, instead guaranteeing the Triple Lock for the lifetime of this parliament, presumably until 2029.
Instead, they decided to means-test the Winter Fuel Allowance. I imagine that their thinking was that for a retired married couple, the Triple Lock guarantees a pension increase of £920 (£460 each) in April 2025, which will comfortably offset the loss of £200 between them (£300 if one of them happens to be over 80) from the Allowance, so no one ought to mind. It has turned out that a lot of people do mind very much. The Government should perhaps have taken more trouble to remind us pensioners just how generous the Triple Lock has become (with each year’s generous increase compounding the previous years’ generous increases), and it appears to have overlooked those whose incomes are low, but not quite low enough to qualify them for the benefits that entitle you to the Winter Fuel Allowance. Provision for those people should have and still could be made.
I would advise my fellow OAPs, all 12.99 recurring million of you, to enjoy the Triple Lock while it lasts. It won’t.
Company pensions
In primitive societies, care tends to fall upon the extended family. Older people perform domestic tasks while their younger relatives do the breadwinning. These structures survive in many places. In the West, as society has gradually been monetised over the last millennium, financial provision for older people has become increasingly the norm, accelerating in the last 150 years or so.
There were company pension schemes as early as the late seventeenth century, but the trickle became a flood only in the Victorian era. Many of the railway companies started schemes in the 1840s, alongside the Gas Light & Coke Company Superannuation Fund (1841), followed in the latter half of the century Reuters, the National Pension Fund for Nurses, WH Smith, Colmans, Boots, JP Coats, and in the 1890s the teachers, Police and poor-law officials.
By 1936, there were 6,500 employer-sponsored pension schemes in the UK and by 1956, 37,000. The idea of a salary-linked employer-sponsored pension for all was universally accepted in the post-war period. The concept behind SERPS, mentioned above, was to fill in the gaps left by employers and trade associations.
Company pensions can come in various forms. The one universally adopted in this country is known as a Final Salary or Defined Benefit scheme because the employee receives a pension directly linked to his or her final salary, the one they earn directly before retirement. The final salary figure can’t be known in advance, and in periods of high inflation, such as the late 1970s or, more recently, the period 2021-3, it can shoot up alarmingly just to keep pace with the cost of living. Likewise, someone who received a big promotion shortly before retirement would receive a pension income linked to a much higher final salary figure. Though employer and employee pay contributions in a typical scheme, the entire responsibility for finding the money to pay the pensions rests with the company. Funding could be achieved in one of two ways. The company could simply pay the pensions of its retired employees month by month as they fell due, as it does with the salaries of current employees. This is the way the UK Government has always done it, but nearly all other employers establish a fund for the purpose to which both they and their employees contribute. The contributions are invested, and the growing pot is used to pay retirement income.
But is the pension fund large enough to meet its future liabilities, which could fall due in several decades’ time? That’s an extremely complicated question, and the short answer is that there’s no way of knowing, as no one can predict future longevity, inflation or investment returns. So, the scheme actuaries, whose job it is to tell the company whether the scheme is on track and whether they should be thinking of increasing or reducing their contributions, use a series of assumptions, relying on things like the latest life expectancy forecasts. The yield on UK government debt is used as a proxy for future investment returns.
Blissfully unaware of the fiendish complexity of the calculations taking place behind the scenes, the employee has her contribution deducted from her monthly salary as she looks forward to the long and comfortable retirement which it will secure for her.
By the mid-1990s, all the UK’s largest companies were offering final-salary pension schemes, typically offering one-eightieth of your final salary for each year worked, plus a lump sum of three-eightieths. Someone who had worked at the company for 40 years could look forward to a pension of half their salary (40/80ths) index-linked for life and a one-and-a-half-times salary lump sum (120/80ths), which could be invested or used to pay off a mortgage, and with the state pension scheme on top.
Life was rosy for the companies and their actuaries during this period, too. Most pension schemes were heavily invested in UK shares. Between the 1987 stock market crash and the end of 1999, the UK’s main stock index, the FTSE-100, rose from just above 2000 to just below 7000, a growth rate of around 11.0% a year, with another 3-4% of dividend payments on top. By the mid-1990s, company schemes were awash with surplus cash, and most companies ceased making payments altogether. But nemesis lay in wait.
Underlying the 1990s stock market rally was the extraordinary boom in the shares of technology companies, a boom driven towards the end of the decade by the advent of e-commerce. By 1999, the technology sector had outperformed the overall market every year since 1985. Many pension fund managers assumed that these conditions had always prevailed because, during their careers, they always had. The sector had always beaten the market, and so, they believed, it always would – even though some of the companies in the sector were already dangerously over-valued, while others weren’t really companies at all, in the sense of having saleable products, established customers and dependable revenues. Many late ’90s companies were little more than a name and an idea.
When the crash came in 2000-3, most UK pension funds lost heavily. To make matters worse, life expectancy had been rising steadily during the decade 1990-2000, so the companies’ pension fund liabilities had increased before their assets fell off a cliff. Result – the scheme actuaries demanded the immediate resumption of contributions, augmented with eye-watering ‘remediation’ lump sums, all in the middle of a recession. This was the moment at which many companies came to look upon their in-house schemes not so much as a trouble-free perk for employees as an uncontrollable open-ended liability. Pension funds began to close to new entrants, who were offered a money-purchase (of which more below) alternative instead. One pension fund, Boots, brilliantly switched its assets to UK Government stock in late 1999, avoiding the stock market crash altogether. Many of their peers were wise after the event and made the switch to ‘gilts’ in the early years of this century.
Worse was to follow. Following the Global Financial Crisis (2007-9) the world’s central banks agreed that the best way to kick-start economic growth would be for them to buy huge quantities of the world’s government debt, a process known as Quantitative Easing or QE. They believed that if they could buy government stock in sufficient quantity, they would raise its price and hence reduce its yield, which would make borrowing cheaper for everyone. Government debt pays a fixed rate of interest. For example, an issue might have a face value of £100 and pay an annual ‘coupon’ of £4.00, making its yield 4.0%. Hefty buying by central banks might raise the price of the issue to £200, but the ‘coupon’ would still be £4.00, making the yield 2%. As most borrowing takes its cue from government debt, the central bankers’ desired result ought to have been cheaper borrowing all round, leading to healthy investment by companies and individuals and a recovering economy. In fact, most people didn’t have the appetite for that kind of investing activity following the traumas of 2007-8, so borrowing in the ‘real economy’ didn’t increase very much. Instead, investors noticed that the government debt market was being supported by central banks, so prices could rise but weren’t being allowed to fall. In other words, here was one of those rare opportunities to make money without risk. The party went on for twelve years, with prices getting sillier and sillier, until inflation returned in 2021, when the whole house of cards collapsed.
Do you remember the phenomenon of ‘negative-yielding bonds’? This was craziness on an epic scale, it happened just a few years ago, and it’s relevant to our story, the demise of company pensions. Let’s go back to our government stock issue with a face value of £100 and a ‘coupon’ of £4 a year. Let’s say that this issue is due to mature in four years’ time, when the government will repay our £100. But in the latter stages of the QE bubble, this issue might be trading at £120. A buyer who held it for four years would receive £16 in interest payments, and lose £20 of capital, a net loss of £4, or a guaranteed ‘yield’ of minus 3.3% on the investment. Who in their right minds would buy the issue at this price? Institutions would, particularly banks and pension funds. At one point there was $15 trillion ($15,000,000,000,000) of negative-yielding bonds in the world’s financial system.
The disappearing yield on government stock had a calamitous effect on company pensions. Actuaries calculate future growth rates based on government stock yields. When yields are high, they expect higher investment returns, and vice versa. As government stock yields were artificially pushed closer to zero, the actuaries were forced to lower their return expectations in parallel. The lower the rate of return, the larger the fund has to be now. The actuaries’ calculations, based on ever-crazier bond yields, showed that pension funds were ever less capable of meeting their obligations, and the companies had to contribute ever more to plug their deficits.
I watched this process with astonishment. Surely there would come a point where actuaries would realise that government bond prices were now so distorted that they were no longer remotely capable of predicting future investment returns, and find a better alternative? Surely they would stop short of forcing every company pension scheme to close? But they didn’t – and pension schemes did close. Today there are no only a handful of company final-salary pension schemes left open. All that really remains are the closed books, which are all in surplus on account of the huge ‘remedial’ payments companies have had to contribute since 2009, and the vast majority of new employees are offered money-purchase schemes instead.
There have been many explanations for the lack of productivity in the UK economy since the financial crisis of 2007-09, and I’d like to offer another one. Instead of investing in the growth of their businesses, companies were forced by their actuaries to divert huge sums to shore up their pension schemes, where the payments were mainly used to buy ridiculously over-valued fixed-interest securities.
The only exception is the UK government, which still offers proper final-salary schemes, financed not from a ring-fenced fund but from current spending. The employee contributes 5.45% of salary, and the employer a whopping 27.1%.
Money-purchase schemes
These pension schemes are what most of us have today. They’re also known as ‘defined contribution’ schemes, because you know what’s going in, but you don’t know what’s coming out, as there’s no one on the other side of the transaction to guarantee anything. Money-purchase schemes are a neat way of transferring the investment risk from the company to the individual employee.
The rules are very simple. You contribute money to your scheme and receive tax relief on the contribution, subject to certain limits (which keep changing, and may change again in the Budget on October 30th). Wise Investment can be on hand to guide you through this.
There used to be an upper lifetime limit on the amount of a pension fund. When introduced in 2006, the Lifetime Allowance was £1.8m. The limit was subsequently tinkered with endlessly, until it was finally abolished earlier this year.
On retiring, one can take up to 25% of the pension fund as a tax-free lump sum, similar to the tax-free cash in Defined Benefit schemes. The income derived from the rest of the fund is taxed as income. This basic structure has survived more or less intact since personal pensions first became popular in the 1980s, but it too is subject to change.
On retirement, one can choose between an annuity (a fixed income for life) or drawdown, where the fund remains intact and money paid out according to prudence and the needs of the individual.
The tax relief on pensions is like that of ISAs but the other way round. An ISA contribution is made from taxed income, but the resulting income is tax-free. A pension contribution attracts tax relief, but the resulting income is taxed.
The structure of money-purchase pensions makes the pension income we receive depend directly on the success or otherwise of the investment. This direct responsibility is either an advantage or a disadvantage, depending on your point of view. It is beyond the scope of this article to give any advice at all, but I will venture two observations based on over 40 years of investment experience.
First, it generally isn’t a good idea to what everyone else is doing. As Sir John Templeton so beautifully put it ‘To sell when others are greedily buying, and to buy when others are despondently selling, requires the greatest fortitude, but yields the greatest rewards’. I first read this statement in 1988 and have never forgotten it. That’s why I didn’t buy into the technology sector in the late1990s, or into the recent fixed-interest bubble, or any of the other more minor crazes that have come and gone. It has paid me to buy sound assets for the long term, and to do so at times when no one else wanted them.
Second, regarding annuities, I don’t believe that insurance companies have yet recovered from the traumas they experienced in the early 1990s. First they were caught out by increasing life expectancy. New pensioners in the late 80s have lived a good ten years longer than they had been expected to, and those extra ten years have cost the life insurance companies dear. Then came the dramatic decline in interest rates in 1992, when the UK fell out of the Exchange Rate Mechanism of the EU. Overnight UK interest rates halved from 12% to around 6%, and the cost of providing an annuity roughly doubled. Ever since then, whenever I have looked at an annuity rate, as I did last week before beginning to write this article, it has always struck me that the rate has been set in such a way that the insurance company can’t possibly lose, at levels that could hardly be described as generous to the prospective annuitant. Insurers have been caught out by inflation many times, so inflation-linked annuities, when you can get them, are comically expensive.
Happy retirement!
Tony Yarrow
October 2024
Please note – this article contains the personal opinions of Tony Yarrow at the date of writing and is not intended in any way to be a source of financial or investment advice.
