Discussion with Louisa Knox and Harvie Brown, two pensions experts, of the current pensions crisis, the Pensions Act 2004 and the challenges for the industry

Pensions are a talking point. Not since Robert Maxwell’s body was found off the coast of Tenerife (and the Mirror Group’s pension fund was found to be £440m short) has there been so much discussion and concern over the issue. The Pensions Act 2004 is a bid to sort out the growing crisis which has seen employees left with no pensions, a large shortfall in corporate pension schemes and public confidence at all time low.

Harvie Brown, President of the Faculty of Actuaries, is clear on what has led to the current mess. “Essentially what happened was that the surpluses within pension schemes became deficiencies”, he says. Six or seven years ago company pension pots were well funded, and companies started taking contributions “holidays”. Government decided that funds could bear more tax; long term individual returns started to reduce; and additionally the equity markets fell. “As a result many company pensions have massive shortfalls.”

Brown goes on to explain the impact of other factors; “If you account for the sharp increase in the UK’s life expectancy as a result of medical advancements, diet and exercise awareness and better housing, you have a problem. Put simply, there will be too many people drawing money out and not enough paying money in.”

As a direct result of this situation, the number of final salary scheme closures has risen dramatically. According to a survey by Mercer HR Consulting of over 1,800 UK pension schemes, the percentage of companies with final salary schemes open to new members has fallen from 56% in 2002 to 38% this year. This changing nature of pension provision is here to stay, says Louisa Knox of Shepherd+ Wedderburn’s pension group. “Companies are desperate to cut costs and the pension will be an obvious area for them to save money in. With money purchase or defined contributions, there is less risk to the employer.” Harvie Brown expands: “With final salary, the average percentage of your salary which your pension represented was around 20%. With money purchase, you’re lucky if it’s 10%. It’s therefore very simple – if less goes in, less will come out.”

The ground shifts

Louisa Knox believes that changing work patterns are crucial in determining how pensions are viewed, both by employers and employees. “Women now make up half the workforce, there are more single people and more people who divorce. The job environment has also totally changed. There is no such thing as a job for life and there is less loyalty to employees from employers and vice versa. A pension is no longer seen as a given. People are coming to expect to have to provide for themselves, but the first generation who have to will find themselves unfortunate guinea pigs.”

The Pensions Act 2004, designed to address this deepening crisis, received Royal Assent on 18 November. Much of the detail is to be found in regulations, which will emerge over the coming months. The Act introduces two main elements: the establishment of a Pensions Regulator and the establishment of the Pension Protection Fund (PPF). The Act also introduces measures required to comply with the European Pension Directive, including the statutory funding objective. The PPF is to be set up to protect the pension rights of private sector defined benefit scheme members, where the sponsoring employer becomes insolvent with underfunded liabilities in its pension scheme. The fund will only apply to schemes commencing winding up after 5 April 2005 – although this point is under debate. The PPF will charge an annual levy on private sector defined benefit pension schemes. There has been criticism that the PPF will not be financially able to cover all claims.

The Regulator’s main aims will be to protect members’ benefits, reduce the risk of situations arising which may lead to compensation being payable from the PPF and to promote and improve the understanding of the principles of good administration of schemes.

More contentious

So, what do Brown and Knox think of the Pensions Act 2004 as a whole? Louisa Knox feels that “the problem with the Act is its over-complexity and the numerous regulations attached to it. Ironically it began life as an uncontroversial piece of legislation. However, it is now extremely controversial and has been the subject of much press coverage and union involvement. It will have a massive impact and I believe this has been underestimated.” Harvie Brown is in agreement: “The Inland Revenue did a very good job on the simplification of the taxation of pensions. It seems unfortunate that one Government department can get it right, yet the Department of Work and Pensions has increased the complexity in this area. It seems too complex, even for the experts to comply with.”

“You cannot argue with the principles behind the Act – they are laudable”, Brown continues. “What worries me is its implementation.”

Are there areas of specific concern? Louisa Knox feels strongly about the Act’s “moral hazard” clauses – provisions which give the Regulator sweeping new powers, aimed at stopping employers attempting to avoid liability for their underfunded scheme and dumping them on the PPF. The Regulator will be able to issue contribution notices to employers (or persons connected), that will allow the Regulator to recover (where reasonable) an amount up to the full statutory debt, if the employer was involved in an act or failure to act after 26 April 2004, which has as one of its main purposes the avoidance of pension liabilities. The amount would be payable to the trustees.

No easy clearance

The Regulator will also be able to issue financial support directions. These will require provision of financial support to an underfunded scheme. They may be issued where the Regulator concludes that the sponsoring employer of a scheme is either a service company or is insufficiently resourced. A key point is that all the companies in a group can be made jointly and severally liable for another group employer’s pension liabilities. This includes not only contributions due under a schedule of contributions but also any debt due under section 75 [of the Pensions Act 1995] or otherwise. The holding company can also be liable.

These powers will have a large impact. The area which concerns Louisa Knox is that of pre-clearance. She explains: “Where a set of circumstances (such as a corporate or scheme restructuring, or the sale of a business) could potentially give rise to the service of a contribution notice or a financial support direction, a company can apply to the Regulator for a clearance statement in relation to that set of circumstances. The Regulator is required to deal with the application as soon as reasonably practicable. The effect of the clearance statement is to give the applicant comfort that the Regulator will not subsequently serve a contribution notice or a financial support direction.”

However, Knox does not foresee plain sailing for the pre-clearance procedure. “The question remains, how is the Regulator going to get all the pre-clearances through in such a short timescale? How do we give comfort to companies and deal with things effectively, without stifling activity? For the moment, until the Regulator’s procedures are up and running effectively, I think it will have a detrimental effect on business, and could seriously hamper mergers and acquisitions and other corporate transactions. It will be very difficult because clients may very innocently move assets around, which will look as though they are trying to avoid their liabilities. I do believe in time it will be fine, but it is the transition of events that will be difficult to navigate.” She feels that companies are going to require expert advice in terms of these moral hazard clauses. “There will be an increased need for legal, actuarial and accountancy advice in terms of keeping within the Act.”

Harvie Brown identifies the issue of Trustee Pension Scheme Governance as crucial. The Act states that trustees have a statutory duty to be conversant with the trust documents, as well as having an understanding of pensions laws, funding and investment principles. Brown says: “ This is essentially moving the trustee’s role towards that of a director. Whilst I believe that it is correct and right that trustees should have the necessary knowledge to run the pension scheme, the problem is – how do you get the person who has no knowledge in this area to understand the complexities of pension law and scheme management? It will no doubt have the effect of discouraging people from being trustees.” Louisa Knox adds: “My feeling is that independent trustees are the best route but that only makes sense if the company can afford it – what about smaller companies?”

The funding issue

Both agree that scheme-specific funding is also a live issue. Under the new funding requirements, each scheme will be required to meet the “statutory funding objective” of having sufficient and appropriate assets to cover its “technical provisions”. Where that statutory funding objective is not met, the scheme’s trustees must put a recovery plan in place. Harvie Brown explains: “there was a feeling that the minimum funding requirement was too broad a brush. The Myners Review wanted more people to go into equities. Yet the scheme-specific funding will have the opposite effect – it will mean that they will go into the safer area of bonds. This will be a difficult area for the scheme actuary, and they will need guidance from the actuarial profession on this one. It seems that they will become less of an adviser, and more of a decision maker.” Louisa Knox feels that “This may shift the balance of power between trustees and employers on occasion.”

Knox continues: “There is also the issue of TUPE – the Act does not take into account the possible impact of the European cases of Beckham and Martin, which may transfer contractual early retirement and redundancy benefits. Therefore there is a potential conflict between the Pensions Act and the European case law, by which we are bound.”

So, although the Pensions Act is tackling some areas, the overarching problems of underfunded schemes, less pension provision and lack of saving remain. What is the way forward? Louisa Knox highlights the concept of salary sacrifice management, whereby an employee agrees to a lower salary, but gets the difference between that and the usual higher salary in some form of subsidy without paying national insurance – and, from April 2005, tax – on the amount. “Unions are very big into this, and are encouraging their members to do this. The Government has not shut off the loopholes on this one and the Inland Revenue encourages it.” Yet, explains Harvie Brown, this is not necessarily a solution as “the people who can do it are the ones who can afford to – those who are on the breadline or less well off, simply cannot afford to do this, it’s not practical. They have to use their money for survival”.

Louisa Knox discusses the concept of compulsion whereby employers could force people to be in schemes. “Employees don’t often join schemes now, as they are losing trust in pensions. People read the press and believe that their pension is not safe. However, it could be made a condition of employment. The stakeholder scheme was merely a nod towards it, as there is no requirement to pay in: the employer merely has to set it up.”

Harvie Brown reiterates: “The main problem is not saving. Young people are simply not putting the money away. The current Government mandatory levels are simply not enough. It would obviously be much better if the state pension provided enough for people. Another problem is that people do not know what they are entitled to.” He believes that reform is badly needed and is in favour of the UK Government considering the citizen’s pension model, which New Zealand operates. “This type of pension is a basic amount paid to all people over state pension age that pass a residency or citizenship test. It helps women in particular, who don’t work in order to bring up their children.” He asserts that changes to pension provision will run in tandem with changes in the way we work. According to Brown, “Work patterns will change. It will not always be the case that you work full time and then suddenly retire. There will be a phasing out of your working life, from full time, stepping down to part time and then finally retirement. You will be able to start to take part of your money.”

From talking to Louisa Knox and Harvie Brown, it seems clear that, whilst the Pensions Act promises us “Simplicity, security and choice”, complexity, confusion and uncertainty for employers and their employees seem to be winning the day.

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