Morning Keynote Address

“Pension protection and the law of unintended consequences”
Nigel Waterson MP, UK Shadow Pensions Minister

US-UK Dialogue On Pensions
Washington DC, USA
July 20, 2005

I am delighted to be able to address this prestigious and timely Dialogue, following on as it does from the most successful similar event organised by our hosts the AARP in England. I am here wearing not only my “hat” as Shadow UK Pensions Minister but also as Chairman of the All Party Group for Older People.

A wise person once said that everyone wants to become old, but no-one wants to be old.

I represent a place called Eastbourne, located on the south coast of England. It is a beautiful seaside resort and a popular place for retirement. I get invited to an amazing number of 100th birthday celebrations – sometimes two a week. Recently one of my constituents – Henry Allingham – celebrated his 109th birthday. A pension provider’s nightmare! And a British man who had been married for 80 years was recently asked the secret of such a long and happy marriage – he replied that it was two simple words – “Yes, dear”.

But greater longevity is but one part of what has been called the “Perfect Storm” in pensions.

We had the collapse in stock markets.

There were those who believed a recovery in the stock market would float most pension funds out of deficit. Despite the modest recovery in share prices in the UK this has not happened; explained by interest rate levels and yet further increases in life expectancy.

In the UK the picture remains challenging.

A major factor is the way actual longevity has outstripped the experts’ estimates. In 1981 the Government Actuary’s Department said that in 2004 male life expectancy in the UK at 65 would be 14.8; in reality it is 19. Back in 1948 when they set up their pension fund, British Airways reckoned on average age of death of their employees at 68; now it is past 80.

Deficits across UK final salary schemes are estimated at £120 billion. Two-thirds are already closed to new members, and the National Association of Pension Funds – represented here I am pleased to see by Christine Farnish - have recently warned that every final salary scheme could be wound up within 5 years – affecting some 9 million workers.

As the independent Turner Commission – set up by our Government - put it:

“As the fool’s paradise has come to an end, schemes have been closed to new members, and a shift to less generous Defined Contribution schemes has followed. The underlying level of funded pension saving is falling rather than rising to meet the demographic challenge, pension right accrual is becoming still more unequal, and risk is being shifted to individuals sometimes ill-equipped to deal with it.”

The present British Government came into office with the stated and thoroughly laudable aim of changing the equation between state and private pension provision from 60/40 to 40/60. But in fact we have gone sharply into reverse. Tony Blair’s first Pensions Minister has said that in 1997 the UK had the strongest pension system in Europe, and now we have one of the weakest.

We also have what some academics have called a “delusional consensus” on pensions. In a recent survey by the Consumers Association, on average the respondents expressed a desire to retire at 58, on three quarters final salary; yet a full 46% of them were not making any contributions towards their pensions! The harsh reality is that most of them will face retirement on the state retirement pension plus means-tested benefits – receiving less than a quarter of national average earnings.

And there is a growing and increasingly visible divide in our society: between public and private sectors and between those in final salary schemes and those who are not. The burden of the public sector promise going forward is now estimated at £600 billion.

The Turner Commission in its interim report concluded that 9 million people are not saving, or not saving enough, for retirement; representing a gap of £27billion a year. And a bad situation has been made much worse by tax changes introduced early in this Government’s life which have stripped pension funds of £5 billion a year.

The most obvious priority is the challenge of restoring confidence in pensions. In my country savings have very nearly halved since 1997. The problem is perhaps worst amongst young people. Surveys show that many of them are completely turned off saving for their retirement; with a lack of trust in government or the pensions industry.

Last year, we passed a major piece of pensions legislation. The centrepiece of the Pensions Act 2004 is the establishment of the Pension Protection Fund. This is loosely modelled on your own Pension Benefit Guaranty Corporation. I use the word “loosely” with care!

When this legislation was first mooted, I flew over here and met with a range of people to get their impressions. In particular, I had a very constructive meeting with Steve Kandarian, then in charge of the PBGC. He had some excellent lessons for us Brits from the 30 years experience of the PBGC.

First, he was adamant that it was vital to ensure the PPF was funded by a fully risk-based levy from the outset. Otherwise serious issues of “moral hazard” would inevitably follow; and there is always the problem of the good subsidising the bad.

Secondly, he said that in no circumstances should the scheme be retrospective in its operation. It was only right that the levy should be there to compensate pensioners and would-be pensioners going forward. Indeed it is interesting to reflect that, although the establishment of the PBGC was prompted by the failure of the Studebaker car company and its pension fund, the Studebaker workers received no benefit at all from the PBGC.

Thirdly, he advised a conservative investment strategy.

Fourthly, Steve advised that we should get the details right at the start, because the US experience was that once the PBGC was set up, it had proved very difficult to get the legislative changes needed later on.

I was also interested in the status of the PBGC. Although it is a Federal agency, there is no formal requirement that government should stand behind it if it got into difficulties. That may be the formal position. But in all my discussions in Washington I found no-one across the political or governmental spectrum who believed that any US government would abandon the PBGC if it got into real difficulties. To do anything different would simply be politically unacceptable.

So how well have we in Britain learned the lessons of the PBGC?

The PPF has now opened its doors for business, and I am sure Lawrence Churchill will testify that is already pretty busy! However, the Fund has started off with a flat-rate levy, and it could be several years before all schemes are paying levies on a full risk basis. (Even though I now understand there are moves to use the “discredited” MFR basis in the medium term). I believe it is a mistake to begin without a risk-based levy from the outset. The Government need not have been in such a hurry to introduce the PPF. As I shall discuss later, the real imperative was to tackle the problems of those workers who had already lost pension rights and who on any view were not going to benefit from the PPF.

A flat rate levy is bound to breed resentment amongst the better run schemes, and give an undeserved break to those that are less well run. It is unfair and regressive. I was interested to read the other day that Bradley Belt the Executive Director of the PBGC warned the PPF of the urgent need for a risk-based levy. He said: “It is critically important that the PPF has a risk-based levy system that discourages risky behaviour and promotes responsible behaviour as soon as possible, which is something we have not had in the States.”

The last time I checked, the PBGC deficit was running at $23 billion. Total underfunding in PBGC-insured pension plans is estimated at $450 billion.

I was interested to read the comments last month of the Comptroller General David M. Walker in his testimony to the Committee on the Budget.

He makes the key point that “bankrupt plan sponsors, acting rationally and within the rules, have transferred the obligations of their large and significantly underfunded plans to PBGC.” And he calls for what he calls “comprehensive reform”. This to include new funding rules, a more risk-based premium structure for the PBGC and changes to the benefits to be “guaranteed” by the PBGC.

Recently, some experts in the UK have warned that the PPF levies could force a significant number of underfunded schemes into wind-up – thus exacerbating the pressures on the PPF itself.

‘No retrospectivity’ began as the absolute principle of ministers, and remained so throughout almost the whole passage of the Bill. The analogy constantly deployed was that of fire insurance. You cannot insure your house against fire after it has already burned down!

But in parallel with the Bill’s progress came growing pressure to do something for those who had already lost out because their pension scheme had wound-up without adequate resources, and who on the face of it would fall outside the embrace of the new PPF, opening its doors only in April this year.

So late in the Bill’s progress, ministers conceded that in certain circumstances compensation could indeed be retrospective. But with a range of major schemes – from Rover Cars to Turner & Newall – threatening to become early customers of the PPF, it remains to be seen how the Fund’s finances will hold up.

The most immediate challenge remains the 85,000 people in the UK who have lost substantial pension rights when their company pension fund was wound up with a substantial deficit. These people have been caught in a sort of legislative no man’s land.

In May 2004, facing possible defeat in the House of Commons, the Government hurriedly unveiled its “Financial Assistance Scheme”. Although at that time the research simply had not been carried out to find out how many people were in need of help, it was also announced that £20 million a year for 20 years would be devoted to this Scheme.

One thing is clear. Those who benefit from “assistance” under the FAS will do substantially less well than those who attract “compensation” under the PPF. The “cap” at £12,000 is half that under the PPF; there is no indexation; everyone will have to wait until 65 regardless of the retirement age set out in the particular scheme.

Nor is our Government out of the woods on providing help to the 85,000. It is facing a court case brought in the European Court by the largest steel union; there is an ongoing Inquiry by the Ombudsman; and the Government itself has now been forced to concede it will have to review the amount committed to the FAS.

And what of the broader – and possibly unintended - corporate consequences of pension protection?

Not that many years ago, the pension “promise” made to employees did not feature high up corporate agendas. Schemes were in surplus, contribution holidays were the order of the day, and I suspect most employers thought (if they thought about it at all) that there was no strict legal obligation to meet that pension promise.

How things have changed! Now deficits are the norm. The pension fund brooks large in corporate concerns. The issue affects credit ratings, analysts’ forecasts and share prices. Takeovers, refinancing and capital-raising have become more problematic. Over half of FTSE 350 companies are worried about the impact of their DB deficits.

It is staggering to realise that the deficit on British Airways scheme is the equivalent of 112% of the company’s entire capitalisation. For British Telecom the figure is 66%.

For many companies the introduction of new domestic and international accounting rules has meant the appearance of pension deficits on balance sheets, with sometimes dramatic effects on their share price or attractiveness for takeover or merger.

In the UK, the pension fund trustees now wield an unprecedented power in corporate affairs, with consequences for good and ill. Some high profile takeovers have foundered recently, at least in part because of the pension fund deficits. The Pensions Act contains some fairly draconian provisions aimed at ensuring that foreign parents and takeover companies cannot evade responsibility for pension deficits. But the law of unintended consequences has kicked in.

The combination of the new Pensions Regulator – with greater powers and a more “focussed” approach – and the PPF means that we now have in effect a new Business Regulator; one who in effect must approve takeovers, mergers and restructuring on the basis of how the pension schemes will fare. This is done by way of the new “clearance” procedure whereby a deal can be put in advance to the Regulator for confirmation that it will not breach the moral hazard provisions in the legislation.

But they have gone further than that.

In a landmark case, the PPF allowed the insurance broker Heath Lambert to offload its £210 million pension deficit on to the PPF, in return for a substantial equity stake in the company. Moreover, David Norgrove the Pensions Regulator has made it clear that this is not a “one-off” case.

What are the implications? I believe very far-reaching. Ministers point to some obscure provision in the Act; but I cannot recall this being a selling point for the legislation when it was being debated in Parliament. David Blunkett, the new Secretary of State for Work and Pensions, has described the Heath Lambert move as “prudent and pragmatic” and an “incredibly rational” way to protect jobs and pension benefits. But I believe there is a potential conflict between the PPF’s core obligation to protect future pensions, and that of safeguarding jobs. I have described it as a form of “backdoor nationalisation”.

In passing, I note that no mention of jobs protection appears in the statutory mandates of the PBGC.

And what sort of message does all this give to companies who would also quite like to dump their deficits on the PPF? Do the recent decisions by the Regulator and PPF actually increase the problem of moral hazard?

And there is the closely related issue – what security does it give for pensioners for the PPF to take investments in companies that by definition have been in substantial difficulties?

I recall last year Steve Kandarian gave an excellent lecture at Imperial College in London which I attended. He was explaining his policy of taking the PBGC’s investment strategy away from equities and into bonds. He told a decent joke. He said that otherwise it would be like an insurance scheme set up to protect Eastern Seaboard properties from hurricane damage having an investment policy to invest in Eastern Seaboard properties! I can only imagine what he would make of the recent decisions of the UK cousin organisation.

This is a slippery slope indeed; as The Economist said: “It is hard to avoid the conclusion that the new system of pension protection has got off to an unfortunate start.”

Another key part of tackling the pensions crisis is to kick start the savings habit again. As I have said, restoring confidence is a key part of this; but so is information and incentivisation. What is needed is a new and attractive vehicle for saving for a retirement income – rather than a “pension” – with simplicity, flexibility and accessibility.

We Conservatives believe fundamentally in restoring the savings culture. We have spoken out long and loud against the growth of means-testing inn the UK system. Now nearly half of pensioners will be in receipt of means-tested benefits in addition to the basic state pension. Indeed, across British society as a whole, one third of households now rely on the State for more than half their income.

We are part of a growing consensus in the UK that we must boost the state pension and roll back means-testing. Not only is mean-testing intrusive and complex, it also often fails to help the neediest people because of low take-up. And crucially it means that many people do not know whether they will actually be any better off by saving for their retirement; a problem which also causes fears of misselling in pension providers. This is an aspect the Turner Commission is taking very seriously.

Whilst we welcome the recent rhetoric from the Government in favour of a “consensual” approach, we part company with them over compulsion. We are much more sympathetic to the concept of “auto-enrolment”, harnessing the force of inertia to insure more people at work are involved in their company scheme.

We have looked closely at the US experience, especially 401k savings plans.

On any view this has been a considerable success, drawing many more workers into pension saving. One hallmark is flexibility; employees can change their contribution levels, choose from a number of different investment options and from time to time change where the money is invested within the plan.

As I understand, it is possible to access one’s savings before reaching retirement age, but on strict conditions: including the onset of a disability and first-time home purchase. The system is designed for a whole working life, so arrangements are relatively straightforward to roll over the money from one plan to that of a new employer. 401k’s have clearly worked because they are popular.

Prior to the last Election, we Conservatives floated our own proposals for a Lifetime Saving Account – or “LiSA”.

It was designed to be simple, easy to understand and flexible – in short to appeal to younger people in work. Each person would have their own savings account. The Government would match each £1 saved with another £1 up to a certain limit. This followed the common approach in British retailing of “Buy One, Get One Free”. This has the benefits of simplicity and familiarity, but also gets away from the currently deployed incentive of tax relief – which is difficult to understand and paradoxically incentivises the better off in society.

As with 401k’s, there would be access to the funds saved under certain conditions. You would be able to access your savings for other purposes, but if the funds were not replaced within a certain time, then you could lose the matching funding.

And we are also firmly opposed to compulsory annuitisation – a concept unheard of here in the US. Indeed my colleague Sir Malcolm Rifkind will shortly be introducing a private member’s Bill to seek to ensure this important change in UK law.

So where do we in the UK go from here?

It will take a while to digest the full implications of the new Pensions Act. The PPF have just admitted that the annual burden on British business will exceed the original forecast of £300 million. It seems likely that the concept of DB schemes will only exist in a museum in a few years as companies are deterred by the burdens in running such a scheme. Although I understand some companies and their legal advisers are already looking at placing their pension funds offshore – beyond the reach of the PPF.

We expect the publication of Turner’s final report at the end of November. Turner has already signalled that there are only 4 options or a combination of them; to work longer, to save more, to pay more taxes or to have poorer pensioners.

But our new Work & Pensions Secretary David Blunkett has signalled his intention to publish his own proposals, especially for women’s pensions, shortly before that. So depressingly there seem to be two quite separate processes at work.

All we can conclude with any confidence is that the pensions crisis is still very much with us, and likely to worsen. The Pensions Act will do little to reverse the trends. The time for radical action is here – or this generation of retired people will be enjoying a standard of living unequalled before or in the future.