The tinkering that ruined pensions

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The tinkering that ruined pensions

By Richard Lapthorne

Newsday, April 22 2003

Twenty years ago the UK enjoyed a big competitive advantage through its company pension schemes. They were low-cost, fully funded and responsibly run. Now we hear talk of a pensions crisis, as if the UK faced the same problems as France or Germany with their huge state pay-as-you-go schemes. What has gone wrong?

It boils down to an unholy mixture of attacks on pension fund surpluses and tax credits, the detachment of directors' interests from those of employees and a mass of other tinkering by politicians and accountants.

Rewind the film to the 1980s when these defined-benefit schemes started to come under attack. On the government side, Nigel Lawson, the chancellor, was concerned about the use of pension funds - built up through tax-free contributions - to dodge taxes. In 1986 a cap of 5 per cent was put on surpluses.

To recover the surplus, the company would have to pay 40 per cent tax on it. The alternative was to run down the surplus by taking contribution holidays. But to get that agreed by the trustees, benefits were improved.

This set in train a dangerous cycle of curtailing the build-up of funds while raising members' expectations. Any expansion of long-term liabilities was set to be exacerbated by increased longevity.

At about the same time another little dent was being made in contributions. The first trimming of advance corporation tax (ACT) reduced the tax credit that pension funds could claim from 30/70ths of the dividend to 29/71sts. It sounded innocuous enough, especially as companies earning a growing proportion of profits overseas were having difficulty offsetting ACT against their actual corporation tax bill.

By the time ACT was abolished by Gordon Brown in 1997, the related tax credit had shrunk to 20/80ths. It was still worth £3.5bn a year, on the government's sums. Others put it at £5bn.

The background for these policy shifts was one of reducing tax rates (and therefore tax credits) while closing loopholes. But it was also one of growing antipathy towards company pension schemes.

Until the late 1980s, employees could be forced to join the company pension scheme. That was fine for the jobs-for-lifers, but it hit early leavers. The world was moving against paternalistic employers and the immobility of their traditional workforces, locked in by long-term benefits. Debate swirled around portable pensions and their transfer values. Younger companies avoided defined-benefit schemes. Personal pensions were the coming thing.

In boardrooms, the long-held view that defined-benefit pensions helped retain key staff - right up to director level - was undermined by the capping of the earnings on which "final salary" benefits were based. As directors sought other ways to build up their pension entitlements, their personal interest in the staff scheme was bound to wane.

On top of that, they received a series of reminders that the company's promise to stand behind these schemes might prove a headache as regulators kept moving the goalposts. One example was the equalisation of pension rights between men and women, stemming from European directives and court rulings in the Barber and Coloroll cases. Whatever the moral merits of these suits, the outcome added to the difficulty of predicting pension fund liabilities.

The law of unintended consequences arising from tighter regulation is even more amply demonstrated in the changes to the way pension funds are accounted for.

Robert Maxwell's raid on pension fund assets, uncovered after his death in 1991, prompted a sledgehammer response. Following the recommendations of the Goode report, the 1995 Pensions Act brought in the minimum funding requirement.

Taken with the ratcheting-up of accounting standards, culminating in FRS 17, attention has switched away from the assumptions behind a long-term "going concern" valuation to immediate outcomes: is the fund in surplus or deficit? Does the scheme flatter profits? If it were wound up today, would there be a "black hole"?

The rising level of liabilities - boosted partly by falling bond yields - and the volatility introduced into asset values by the use of market prices have changed the course of these two streams, reducing the links between them. In the face of such unpredictability and volatility, it is no surprise that boards are shying away from defined benefit pension schemes.

After nearly two decades of company pension schemes being treated as a soft touch, especially by governments, they have become so depleted that many more people will have to rely on the state for their retirement income. The taxpayer will eventually pay for the lost tax breaks and the increased burden of pensions regulation.