Pensions policy and theft

Some background: From about 2008 to 2012 I spent a lot of time carrying out research on the economics of pensions as well as advising privatised companies and their regulators on managing their pension schemes. This was a depressing experience. Both managers and regulators had little interest and no expertise in dealing with the issues. They delegated everything to accountants who simply followed accounting rules without any comprehension of the consequences. In fact, pension liabilities were the largest single source of financial uncertainty for many companies, but they realised this far too late.

At one point BT’s unfunded pension liabilities were more than double the market value of the company. Ofcom refused to acknowledge this while BT’s senior management stuck their heads in the sand. Eventually, for complex legal reasons, the government was forced to guarantee the liabilities of the BT pension fund. The whole story is an illustration of how little policymakers and even specialists understand about the consequences of policies that affect pension arrangements.

For more than four decades the motives driving pensions policy in the UK have been both confused and dishonest. By comparison with other countries in Western Europe, the contributory state pension developed from 1925 to 1948 was relatively meagre. The typical replacement ratio – the ratio of the standard pension to the average wage – was little more than 30%. Even after top-ups – such as the State Earnings Related Pension and later the State Second Pension - were introduced, the standard pension was close to or below the poverty threshold. Replacement ratios in comparable countries in Europe were above 50% and could be as high as 80% for favoured occupations.

One factor underpinning the relative parsimony of the state pension system was the parallel development of occupational pension schemes. These were primarily offered to white collar workers, but unions negotiated pensions for blue collar workers in some industries, provided they worked for their employers for a sufficient period. Civil servants, local government workers, and NHS employees – plus politicians – benefited from occupational pensions. Hence, the default assumption of policymakers was that the state pension would be supplemented by an occupational pension acquired through long term employment with a large employer. The tax system was structured to favour deferred income paid via pension arrangements.

This model was self-interested and unsustainable. The majority of low- or middle-income workers did not receive significant occupational pensions. Many found themselves in poverty when they retired, especially those forced to leave work before the standard retirement age due to ill-health or the need to care for relatives. The growth of groups which lobbied for the interests of the elderly poor drew attention to the deficiencies of state pension arrangements. Although reluctantly, the government was pushed into establishing state-funded top-up schemes – primarily the pension credit – to assist retired households on low incomes.

The outcome is a complicated and confusing set of arrangements for retirement income. Journalists – and the government – often refer to state pensions as welfare payments, classing them along with other state benefits and income support. In response, retirees point out that the state pension was established as a contributory social insurance scheme, so that any payments were “earned”. They point out that the fact politicians have messed up the social insurance principle cannot be blamed on current recipients.

At the outset there was a National Insurance Fund, though this soon became little more than an accounting sham. Economists are partly to blame for the resulting mess. They pointed out that (a) National Insurance or public pension contributions were no different from a hypothecated tax on wages, and (b) hypothecated taxes are inefficient since they limit the government’s ability to utilise tax revenues in ways that would generate the greatest social benefits. True but utterly naïve in terms of political economy.

For the Treasury, the state pension operates as a pay-as-you-go system reliant on general taxation, including National Insurance contributions. In as far as the public ever think about the matter, the usual view is that pension contributions are (or should be) invested in a fund that receives a return equal to the average interest on government debt. The more sophisticated might argue that the fund should earn a return equal to the average growth in GDP on the grounds that it can be used to fund public investment. The gap in perception is crucial – between the state pension as a contingent welfare benefit and an earned insurance payment.

Another weakness of the whole system is that after the inflation and economic upset of the 1970s private employers became increasingly reluctant to underwrite the returns on pension funds. This reluctance was reinforced by restrictions on how pension funds were managed and by a requirement to increase pensions in payment in line with inflation up to some limit. The final straw was the adoption of accounting rules which, in effect, required that pension liabilities be calculated and recognised on the balance sheet of the company sponsor using accounting rules that companies saw as very unfavourable to them. At the same time the government changed tax rules in a way that penalised the long run performance of pension funds heavily.

In response, most private companies closed pension schemes that offered defined benefits – i.e. a guaranteed income after retirement – to new members and then to new contributions. These schemes were replaced by defined contribution arrangements by which the employer and its employees pay into an investment fund. The pension payable on retirement is either actually or practically equivalent to an annuity purchased using the combined value of pension contributions plus the investment return earned by the chosen fund. Hence, instead of being pooled over time and groups, investment risk has been transferred to individuals.

As it became clear that private employers were unable or unwilling to bear the risks of underwriting future pension payments, the government shifted its focus by legislating the principle that both employers and workers should contribute to a pension scheme, other than in special circumstances. In addition, it has greatly extended the legal basis for regulating pension funds and imposing obligations on employers.

The involvement of the government in private pension arrangements has led to a huge conflict of interest. The government has on various occasions behaved in a way that, in my view, comes close to theft. There are two aspects to the conflict of interest.

First, the government either directly or indirectly has a near-monopoly over the issuance of the financial instruments that it, as regulator, requires pension funds to hold. This is what killed defined benefit pension schemes. Companies were required to recognise defined benefit liabilities calculated using the return on highly rated bonds. In addition, defined benefit schemes were required to adjust pensions payments in line with inflation. The consequence was that defined benefit pension funds had to invest heavily in inflation-linked bonds issued by the government and a small number of regulated businesses.[1]

Pushing up the demand for such bonds decreased yields, which, in turn, pushed up the valuation of liabilities pushing up the demand for the bonds even further. This was a classic variant of financial repression, i.e. the manipulation of financial markets by government with the aim of reducing the cost of public borrowing. The cost was borne by the company sponsors of defined benefit pension schemes, which is why they limited or terminated as quickly as they were able to do so.

The policies which killed defined benefit schemes were effectively a large stealth tax on large and medium companies, especially those whose employment had contracted sharply in the previous 10 or 20 years. Many pension schemes and their sponsors were bankrupted. The costs of supporting pensioners who lost out was transferred to pension schemes which continued, thus prompting more scheme closures and bankruptcies.

Equally important, the drain on company cash flows to top up pension fund assets was taken directly from investment in UK business assets. The political story was that companies had underfunded their pension promises, so shareholders should bear the cost of rectifying past sins. Pension specialists and CFOs knew that the problems were largely caused by deliberate changes in government policy. Further, in a world with highly mobile capital, shareholders were certainly not willing to bear such costs, so the changes accelerated decisions to close pension schemes, reduce new investment in the UK, and abandon existing operations.[2]

Second, the requirement that at least 8% of wages must be paid as a contribution to a pension fund has resulted in the concentration of private saving in opaque but rapidly growing pools of capital. Defined benefit pension schemes are winding down outside the public sector. In many cases, their liabilities have been transferred to insurance companies, so there is no incentive to oversee how well pension funds are managed.

This is a classic agency problem. While employees may have a strong collective interest in how pension funds perform, they have almost no individual capacity to influence the management of funds. Instead, influence over investment decisions has moved to lobby groups – that is the story behind ESG investing – and to the government as the largest lobby group of all. This change is inherently bad because it eliminates the benefits of competition and decentralisation. Mistakes are systematic rather than random.

Governments in many countries have difficulty in accepting that there can be large pools of capital which they do not control. The desire to ensure that such capital is used to fund government deficits is widespread. The larger the share of private savings that is directed to the purchase of government bonds, whether by investment mandates or other means, the larger the share of investment and spending is controlled by the bureaucracy. Now that the issuance of new government bonds is limited by concerns about the cost of debt service, the focus has shifted to forcing pension funds to invest in infrastructure and other favoured sectors of the economy.

This is where we come very close to theft. There is no lack of routes by which pension funds can already invest in such ways – infrastructure, venture capital and private equity funds. The costs of managing such investments are higher than conventional equity investments but there are few barriers to entry and the costs can be justified if the expected returns are high enough. The real problem is that the expected returns are not high enough to justify the combination of higher costs and higher risks.

Especially for infrastructure the government does not expect the returns on investment to increase. For example, the claims about the falling costs of renewables require, at a minimum, that the cost of capital for such investments be much lower than it has been in the past relative to inflation and the returns on other assets. The same is true for investment in energy and water networks, hydrogen, carbon capture, and so on.

Who will bear the costs of low returns on such investment mandates? Certainly, it won’t those who run the pension funds! It will be today’s workers who will receive a lower return on their savings and, thus, lower pensions when they retire. That retirement will almost certainly be delayed because their accumulated savings will not be as great as they had expected.

This is where the issue of deception enters the picture. As any investment adviser should emphasise, the returns on all forms of investment are uncertain. As the proverb tells us, the only certain things in life are death and taxes. However, we expect that taxes are somewhat transparent. Hidden taxes in the form on lower returns on pension saving go beyond stealth taxation because they rely on deception – on hiding what are really taxes as poor returns on mandatory savings. In regular speech this comes close to being “dishonest appropriation” which is a core part of the legal definition of theft.

What can the regular worker do? Few of us have the inclination or time to spend on monitoring the performance and choices of their pension fund. Probably the key choice is to move away from whatever is the default option offered by the pension fund. These are the funds that the current government is targeting, largely because they consider them to be “dumb” money that is unresponsive to such interventions.

By switching to non-default funds that have better defined investment objectives it should be possible to reduce the risks of being exposed to the kind of hidden taxation that is being proposed. I do not give investment advice but at least consider funds with low charges that are designed to track broadly-based investment indices.

One counter argument is that pensions benefit from tax benefits, so what the government has done is to claw back a part of those benefits. I don’t accept that at all. We have a tax system which is strongly biased against saving, other than in the form of housing. The primary benefit for pension saving is only what any sensible tax system would do by deferring taxation on qualified savings to the point of expenditure rather than when the income is received.[3]

I would accept that the right to receive 25% of a pension fund as a tax-free lump sum cannot justified on that basis, but it may be the price of getting people to trust to putting aside money for 30 or more years. European countries that tax current income heavily without treating saving in a sensible way must deal with very strong resistance to reducing the cost of state pension schemes.

The bigger picture is a lack of trust in the capacity of governments and large financial institutions to act in the interests of their customers. Pension arrangements are the ultimate version of a long-term commitment with money being held for 50 years or more. Governments that act in a deceptive manner not only undermine the trust of those who are directly affected but they sabotage what are already fragile bonds between the population as a whole and the elite.

The behaviour of the UK government – especially its consistent reluctance act in a way that is both honest and transparent – has convinced many that every policy must be scrutinised with profound suspicion. Its proposals to require that pension schemes allocate a minimum share of their assets to fund what are, in essence, government priorities suggest that such suspicion is fully justified. The issue is not whether the government and the bureaucracy believe that they are acting appropriately, but whether they are willing and able to persuade those who will bear the cost of failure to endorse this strategy. So far there are no indications that they understand the issue or are prepared to address it.

[1] The issue is not the adoption of rules requiring inflation-proofing of pensions and proper recognition of pension liabilities. These and other measures to protect pensions could easily be justified. The problem was that the government was effectively the sole supplier of the assets which pension funds had to acquire to fulfil the new obligations.

[2] The public position of the government was that it had merely adopted prudent rules to protect the interests of pensioners and those expecting to receive pensions in future. The difficulty is that the life of pension schemes is so long that even small changes in regulations can have large consequences. That is exactly what happened. The government cannot claim that the effects were unanticipated because it was warned repeatedly. Further, as Chancellor of the Exchequer Gordon Brown consciously increased taxes on pension fund income, thus completely undermining the financial position of defined benefit schemes. This was a clear decision to extract more revenue to meet short term fiscal targets at the expense of pension schemes and their beneficiaries.

[3] Anyone who is interested in more detail can read about Kaldor’s proposal for an expenditure tax. It would never have worked in the form originally proposed, but subsequent work by the Meade Committee in 1978 and the later Mirrlees Review in 2010 endorsed the broad idea. The difficult is that governments strapped for cash want to limit the capacity of people to defer taxation through savings schemes.