Dr David Blake has an optimistic outlook for the future of UK pension provision and predicts that the race to the bottom for occupational pension schemes will eventually be reversed to end up in a position where employees will once again be members of good quality pension schemes that are able to provide decent levels of income in retirement.
The bad news for those of working age is this is going to be at least 30 years in the future and will only come about once the full extent of the nation’s lack of savings has been experienced.
Blake is director of the Pensions Institute at Cass Business School, the first specialist academic research centre focusing on pensions. He has not arrived at this conclusion overnight but says the extraordinarily rapid erosion of quality pension schemes in the last 15 years will lead to sharp and severe fall in pension income that has not been properly appreciated by the general public, while politicians are fundamentally ill equipped to deal with such a long-term, structural problem.
The erosion of final-salary schemes has left DC pensions as “the only game in town”. But Blake says current DC plans are fundamentally flawed.
“Given that DC is the last game in town, DC has got to be well designed. And it is not, it is simply not well designed.”
Blake recently co-authored two reports on optimal investment strategies for DC which laid out much more efficient ways of dealing with different types of saver. He suggests that engaged, well informed, active decision-makers should delay saving until they reach 35 when earnings start to peak and from then on should save significant levels, while lower paid, financially less literate and less disciplined should save regularly from a lower age but should adopt much more conservative investment strategies.
However, he says a paper he wrote three years ago sums up the overall problems with DC much more effectively.
“You’ve got to work backwards, like an airline journey. It is no good going to the airport and saying to the airline ’I want to fly somewhere. They are going to ask you ’where do you want to fly?’ Do you say I don’t know, I just want to get on the plane?
“You need to know where you are going to end up, you need to know how much fuel you need to put in the airplane, you need to know all about wind speeds at different altitudes in order to end up where you want to end up. and that requires that you work backwards.”
He says the same process needs to be applied to DC schemes.
“It has to be designed from where do you want to end up? How long are you going to spend in retirement? When do you plan to retire? What standard of living do you want in retirement? Therefore, what size fund do you need to have built up by the time you want to retire. And then working backwards, what combination of contribution rate and investment strategy give me a very good chance of accumulating that sum. Nothing of this is happening at the moment.”
Another significant problem with DC schemes is the lack of understanding of the risks involved by scheme members themselves. This leads to all sorts of misunderstandings about investment risk, contribution rates and annuity risk to name just the most obvious ones.
Blake cites an anecdotal conversation between two friends comparing the pension schemes. When they get to contribution rates one says, “I pay £100 a week into my scheme” while the second says “What, I pay £200 a week. Why is my scheme costing twice as much as yours?”
More seriously, Blake says the sharp drop in employer contributions, combined with low personal savings rates and poor investment strategies will lead to “19th century levels of poverty” and only following that will we start to see a recovery in the quality pension provision.
He says: “The Baby Boomers look as though they may be the most favoured generation in history. It looks as though the generation following the baby boomers could be experiencing that return to 19th century poverty in old age. Only then will they turn to their children or grandchildren and say ’make sure your company has got a good pension plan’, only then when those people go to look for jobs and the first thing they ask is, ’what is the pension like?”
The introduction of auto-enrolment and Nest will not offer much respite, as Blake says the contribution rate and investment strategy, in common with other DC schemes, is inappropriate and the fact it is Government backed could lead many people to think they have their pension needs taken care of.
“In a way Nest, although it is quite a nice idea, could set a very false impression.
“Nest is providing a standard which is a very modest one. To be fair to Adair Turner, whose idea this was as it came out of his Pensions Commission of 2005, he did say this is only going to provide 15 per cent of the pension of the average worker. The state pension is going to provide a percentage, their private sector pension is going to provide another element and you are expected to make you own arrangements on top of that.
“But most people won’t see that. They will say this is a Government pension plan, we were auto-matically enrolled onto it, and we are getting a few pounds a week in pension. We thought we have a pension plan.”
Blake has a particular issue with the contribution rates set out by auto-enrolment.
He points to behavioural finance and the Save More Tomorrow plans in the US.
The two features of the Save More Tomorrow plans were, first, auto-enrolment and, second, auto-escalation and Nest does not have the second bit, the auto-escalation.
“With Save More Tomorrow, you would put your annual pay rise of 3 per cent into the plan, then you put the next annual pay rise in and then the next and the next one. In four years, you have 12 per cent contribution which is beginning to look right.
“We have only got the 3 per cent plus the employers bit. We don’t have the auto-escalation.”
If this was a case of just a few people undersaving, it may be manageable but when the problem starts to affect the majority of the population, it becomes a systemic problem and a major problem for the Government. If a small number of people don’t save for their retirement, it is not a problem. The rest of us can say, ’That is very unfortunate, we can pay a bit extra in taxes for you and you can have a decent pension’. Or the rest of society can say ’Tough luck, you should have been aware of this, you spent your money when you were young, you should have worked this out, you are on your own’.
“But if everybody does not save for their pension, this becomes an aggregate, systemic problem, which the next generation of taxpayers is going to have to bail out.”
Using compulsion or increasing the state pension could alleviate the problem but Blake says this does not get rid of the problem.
“That nationalises the problem and that is not the British model. The British model is to provide a very modest first pillar state pension and for you to make your own arrangements. We know the problems of the Continental model, the Germanic model which is very high state pension and very little private sector pension, we know from what we’re seeing in Europe that this leads to national debt.
“The real problem, not just in Britain but in Europe and North America, is the national debt. If you take into account the unfunded state pension, debt is two or three times the official level and it is much more in Europe because of his unfunded promises. At least we’re not as bad as that.”
The design of the British political system also prevents pro-active measures to deal with the problem from being taken.
“Because politicians can’t think beyond the next election, our political system is not designed to solve long-term problems that we are now being confronted with, serious long-term problems not only in terms of population size, not only in terms of pensions, in terms of demographics or in terms of climate change, the government can’t deal with these problems.”
A good example of this lack of foresight is the increase in longevity. The row over the recent changes to the state retirement age for women could be set to be played out again and again. Blake refers to a graph in a recent piece of Pensions Institute research which shows that every official Government estimate of life expectancy since 1966 has significantly underestimated actual longevity increases. The result is that while official Government spending predictions look more presentable, another increase in the state pension age is “unavoidable”.
Blake says the statistics show life expectancy has increased by a steady two and a half years every decade since 1840 and this is showing now sign of altering. But it is not just Governments who get life expectancy very wrong. Blake says individuals estimations of life expectancy is almost invariably linked to their parents life expectancy.
“People think they are going to live only as long as their parents, so they don’t factor in the two and a half year a decade improvement in life expectancy that they will enjoy over their parents. That is equivalent to at least seven or eight years longer than their parents.”
This inaccurate assessment makes the decision of how and when to move into retirement a very difficult one for pension savers.
The options to solve these problems are limited. Education about the size and scale of the problem are one option but the possible avenues to bring this about are limited.
Blake says: “Another interesting area is advice because you have got this problem of regulated advice versus generic advice. The Government knows that financial education is terrible and it is trying to do something about it in terms of improving school leavers and school children. It also has the Money Advice Service which is providing generic advice on the internet.
“There will be a section of the population who say if you have a reliable website, it will really be very useful to them but for most people, the Money Advice website will be as useful as a very simplified website on astrophysics.”
“Not many people trust financial advisers while the consensus view is the sources of advice you would trust most is family and friends, although whether family and friends have the right type of advice. Then the next one down is the employer so really it ought to be the employer that provides advice as there is the £150 a year limit which is for tax free advice as long as it is generic advice.
“A lot more has to be done around the emp-loyer and the provision of long-term advice and communication.”
This brings the conversation round to having the right type of pension scheme to give advice on.
Blake says: “We gave up something very precious in this country, our final-salary pension schemes. 150 years of development of pension schemes in this country disappeared in 10 or 15 years without an inch of protest. That is one of the most remarkable transitions that I have personally seen in my lifetime and I cannot believe that it was given up so easily.”
Blake says it is possible to design good quality DC schemes to replace the pension schemes that have been lost but seems mostly resigned to the fact that it will take a very long, difficult retirement for a whole generation before any real attempt is made to revive good quality pension schemes.
“You can design a DC plan that with a high degree of probability, but not certainty, will replicate these final salary plans and give someone a decent standard of living in retirement.
“Someday someone is going to say why don’t we introduce that. It is going to be in about 30 years time and they will think they are great originator – although you and I will know we thought about it now.
“It is going to take a generation finding themselves in extreme poverty, finding that they cannot go on strike because there isn’t a generation behind them that is going to bail them out, finding that they can’t believe this could have happened and then saying at least we tell our children or grandchildren that they must not do what they did.” “If every-body does not save for their pension, this becomes an aggregate, systemic problem, which the next gener-ation of taxpayers is going to have to bail out’