United Kingdom
compiled by Allianz Global Investors
Pension System Design
The UK pension system is designed with a public PAYG tier that is composed of an earnings-related basic pension and an earnings-related element, as well as voluntary occupational and voluntary personal pension components.
The UK has by far the largest and most challenging pension market in Europe and belongs to the most developed funded pension systems. We expect the market to grow at an annual rate of 5.2% to EUR 5986bn until 2020.
UK pension funds historically hold a large share of there assets in equities. Therefore they are strongly exposed to capital market volatility. Hence, the funding issue for defined benefit schemes and the ongoing shift from defined benefit to defined contribution schemes remain the main challenges. The Pension Protection Fund (PPF) reports the aggregate funding position for 7,800 defined benefits schemes on a monthly basis. In March 2008, the scheme funding was worse than it was in March 2007. The most recent data reported a deficit of GBP 23.6bn (EUR 30bn).
The Pension Protection Fund was established in April 2006 and his fundamental role is to compensate members of defined benefit schemes in the event the employer has become insolvent and where there are insufficient assets in the pension scheme. This Fund has been introduced on account of intense political pressure, due to a large number of employees in various companies losing large amounts of pension benefits as a result of a number of employer insolvencies in recent years.
In order to address the rising pension gap resulting mainly from a low state pension replacement rate and decreasing occupational pension coverage, the British government has taken several actions since 1997. The Pension Credit, the State Second Pension and the Winter Fuel Payment were established, and the value of the Basic State Pension increased in real terms, which mainly tackled pensioner poverty. Improvements to the security for occupational pension scheme members were integral part of the Pensions Act 2004. Furthermore, the Finance Act 2004 basically changed the taxation of occupational and private pension savings by removing the complexity of many separate taxation regimes. The new taxation scheme was launched on April 6, 2006, formally known as “A-Day”.
Moreover, in 2002 the independent Pension Commission chaired by Lord Adair Turner was appointed to review the long-term challenges the pension system faces. The Commission finally published two reports. The first report delivered a detailed description of current conditions and the second contained a detailed blueprint for a major reform of the UK’s pension system.
The government followed the Pension Commissions proposals in large parts and published a White Paper in May 2006, setting out the path for future reforms. The Pensions Act 2007 put the reforms to the state pension system set out in the White Paper into law. It represents the first step of pension reform.
Key changes to the state pension system:
Basic State Pension
The number of years necessary to qualify for a full Basic State Pension will be reduced to 30 years compared to 44 years (women 39) previously. The new rules apply to people retiring as of April 6th, 2010.
The earnings-link to increases in the Basic State Pension will be restored in 2015 at the latest. Currently it is indexed to prices.
State Second Pension (S2P)
The State Second Pension will become fully flat-rate. As of 2010 the earnings-related element will be gradually withdrawn so that people will build up entitlement on a completely flat-rate basis as of 2030.
State Pension Age
The statutory retirement will be increased to 68 for both men and women by 2046. The pension age for women will already rise from 60 to 65 between 2010 and 2020.
DC contracting out
From the date the State Basic Pension will be linked to earnings it will no longer be possible for defined contribution schemes to contract out of the State Second Penion
The second part of the package of reforms to the UK pensions system was introduced into the parliament in December 2007.
Key areas of reform:
Personal Accounts
From 2012 the Government plans to introduce a new low cost saving vehicle, the personal accounts scheme, aimed at employees who don’t have access to a good quality work based pension scheme. The idea behind is to counteract the ongoing trend of decreasing coverage of supplementary pension provision.
Automatic enrollment
From 2012, the Government plans that all eligible workers, who are not already in a good quality workplace pension, will be automatically enrolled into either a qualifying pension scheme or into the personal account pension scheme. Automatic enrolment means instead of choosing whether to join a workplace pension scheme provided by their employer, all eligible workers will have to actively decide not to be in a scheme.
Public Pensions
The UK State Pension system is composed of the Basic State Pension, the State Second Pension (S2P) and the Pension Credit.
The Basic State Pension is a flat-rate payment that requires a contribution record of 44 years to receive full benefits.
State Second Pension was introduced in April 2002, replacing the old State Earnings-Related Pension Scheme in order to provide a more generous additional state pension for low and moderate income earners. The S2P system will be converted stepwise to a flat-rate system, becoming fully flat-rate as of 2030. However, the S2P system is sometimes considered to be a quasi-occupational system because of the ability to contract out. Employers that fulfil certain requirements can opt-opt of the S2P if they provide an equivalent private or occupational pension instead. In this case the National Insurance Contributions drop by 1.6% for the employee and 3.5% for the employer.
According to a government survey, in 2005 about 63% of existing defined benefit pension schemes and 3% of existing defined contribution pension schemes were contracted out. A declining trend of contracting out has been obvious for several years; in 2000 still 92% of defined benefit and 22% of defined contribution schemes were contracted out. As of 2015 contracting-out for defined contribution schemes will be no longer possible. Regarding the treatment of defined benefit schemes, no decision has yet been made.
In October 2003, the government introduced a new means-tested old-age pension, the Pension Credit. It tops up the income of pensioners without other adequate sources of income or assets.
Occupational Pensions
The UK operates a voluntary occupational pension system. The current reform proposals are intended to counteract the decreasing trend in coverage with supplementary pension provision.
Personal Pension Plans and Stakeholder Pension, both third pillar schemes, are increasingly being used by employers as low cost alternatives to traditional occupational pension schemes. In 2001 it has become mandatory for employers with 5 or more employees to offer access to a Stakeholder pension scheme; however, employer contributions to such a scheme are not required. Accordingly, the take-up has been slow up to now. This is one of the reasons why the government intends to introduce mandatory personal accounts in accordance to the Pension Commissions National Pension Savings Scheme proposal.
Membership in private sector occupational pension schemes has been declining since the 1960s. Apart from a period in the late 1980s and early 1990s, coinciding with the admission of part-time employees to some schemes, this downward trend has been continual. This can partly be explained by the introduction and increasing prevalence of Personal Pension Plans. However, since the number of employees in the private sector has been growing since 1995 (when membership of private sector schemes stood at 6.2m), the fall in the membership (to 5.7m in 2000) represents an even more significant fall in the proportion of private sector employees who are members of such schemes. Membership in public sector schemes has been more stable. Currently 56% of the private sector workforce, the self-employed included, have no occupational or personal supplementary pension coverage.
Pension schemes can be either defined benefit or defined contribution schemes. Traditionally, pension plans were defined benefit schemes. This has changed: defined benefit schemes have been rapidly falling out of favour and have increasingly been replaced with defined contribution arrangements. The main reasons are employers’ efforts to contain costs and risks as a result of the funding difficulties after the downturn in equity markets, accounting issues and demographic trends. The defined contribution plans, which were usually set up instead involve much lower employer contributions and the investment risk is shifted from the employer to the employee.
There is no obligation to fund occupational pension schemes externally but is it advisable to maximise tax advantages. For external funding two plan types are available, namely insurance schemes and pension funds (self-administered plans).
Self-administered plans (pension funds) and insured schemes are set up under trust law as a separate legal entity and the legislation for both is very similar. Most medium and large-sized companies sponsor their own pension plans; industry-wide schemes are not common. Small employers favour insurance schemes, whereas larger companies generally use self-administered funds without insurance, although lump-sum death-in-service benefits are usually insured.
1. Pension funds (self-administered plans)
For pension funds, the appointment of an investment manager and a custodian is required. Investment managers have to be authorized under the Financial Services Act 1986 and formally appointed by the trustees.
As of 2006 new defined benefit scheme funding regulations replaced the old Minimum Funding Requirement (MFR). The Pensions Act 2004 implemented the Statutory Fund Objectives (SFO), which require that salary-related occupational pension schemes must have sufficient assets to cover their technical provisions. A pension plan is required to set up a recovery plan if it fails to meet the SFOs.
Investment regulation
The Prudent Person Principle applies.
2. Insurance schemes
Insured schemes are arrangements provided directly by insurance companies where the benefits provided are secured by one or more insurance policies or annuity contracts. They are set up under trust and are legally treated in the same way as self-administered schemes (pension funds).
3. Personal Pension Plans
Personal Pensions Plans were introduced in 1988 as arrangements which the employee can establish individually with an external provider. Group Personal Pensions are increasingly being provided by employers as occupational schemes because of their flexibility and cost-effectiveness. The governing rules are the same as for Personal Pensions in the third pillar but are set up in a group arrangement, thereby mixing second and third pillar schemes. All Personal Pension Plans are defined contribution in nature.
An employer can contribute to a Personal Pension scheme and they can also be used as a vehicle to contract out of the State Second Pension in the same way as occupational pension schemes.
4. Stakeholder Pension
Since October 2001 employers with more than five employees have been obliged to provide their employees with an access to a Stakeholder Pension, although neither the employer nor the employee has to contribute to it. Only companies which already offer a comparable standard of pension scheme or which already contribute at least 3% of pay to an employee’s personal pension are exempt. The employer selects the provider and all Stakeholder schemes are on a defined contribution basis.
5. Unfunded schemes
Unfunded and unapproved plans, financed on a pay-as-you-go basis from corporate funds, are also possible although these are rather uncommon. A non-tax-deductible book reserve would be established to account for the liability. These schemes are primarily used for executives to provide enhanced benefits.
Tax treatment of contributions and benefits
Radical changes to the taxation of occupational and personal pension schemes took place in April 2006. The Finance Act 2004 basically changed the taxation of occupational and private pension savings by removing the complexity of many separate taxation regimes. The new taxation scheme was launched on April 6, 2006, formally known as “A-Day”.
According to the Finance Act of 2004, since 2006 new taxation rules apply. The previous system was replaced by a universal lifetime allowance on the aggregate value of tax-favoured benefits, with a universal maximum accrual in every year. The lifetime allowance is the maximum amount of pension savings that can benefit from tax relief and was initially set at GBP 1.5 million. In addition an annual limit of GBP 215,000 applies. Individuals will pay tax at 55% for amounts exceeding the annual allowance. The limits will be adjusted regularly. The value of individual pension assets will be tested when the pension becomes payable, which is easy for defined contribution plans. Applying a multiplier of 20 to the annual pension payment will assess the worth of a defined benefit pension.
The new rules also provide more flexibility in withdrawing benefits. Supplementary pension payments can begin at any time between the age of 50 (55 from 2010) and 75, or earlier on incapacity. 25% of the entire pension amount can be withdrawn as a tax-free lump sum.
Outlook
The new pension legislation will further change market practice and structure.
The abolition of DC scheme contracting out in 2015 will lead to an immediate saving of approximately GBP 4bn a year for the Exchequer which reversely means rising labour costs for employers since the rebate on National Insurance Contributions will then cease to exist. It is very likely that employers won’t be willing to further finance supplementary pensions in addition to their contributions to the State Second Pension. This will lead to a loss of revenue for the financial service industry. But compared to the share contracted-out occupational defined contribution schemes count in the market, the effects will be kept within limits. Only 3% of the existing defined contribution schemes were contracted out during 2005. A decision on the abolition of defined benefit scheme contracting out was indefinitely postponed.
Higher spending due to rising pension rights and payments from the State Second Pension will offset the positive fiscal impact for the social security budget.
Current pension reforms in the UK are moving in a different direction than reforms in most other European countries owing to the country’s unique starting position. While reforms in Continental Europe often try to encourage funded pensions in general, reforms in the UK strive to provide adequate pensions for lower-income earners, as its funded pension sector as a whole is already very mature. Attention is paid to lower-income earners as these are most affected by the low replacement rate of the public pillar. The first step towards improving this group’s pension situation was achieved by introducing stakeholder plans and forcing employers to facilitate access to them. The planned auto enrolment into personal accounts is a second step. If implemented, these reforms will likely be the driving force of an otherwise mature pension market.