In my last couple of articles, I started to identify and discuss recent and upcoming developments affecting pension planning. This week, I would like to do a quick but important tour of two further topical issues – contracting out of the state second pension and the pension credit.
Contracting out of the state second pension is an issue which might well haunt a large number of financial advisers in the not too distant future unless they take a more proactive approach.
For about a decade, many financial services organisations were very active in advising employees who were not in a contracted-out employer-sponsored scheme to contract out of Serps using an appropriate personal pension. Some advisers also marketed similar proposals to small to medium-sized employers to introduce convenient and relatively easily managed contracted-out schemes for employees.
At the time, close attention was paid to actuarial assessments as to the maximum age at which it might be likely for employees to benefit financially from contracting out, necessarily using assumptions of likely future earnings growth, future investment growth, the expected level of future interest rates and the level of the contracted-out rebate. Typically, females over the age of 40 and males over the age of 45 were deemed unlikely to benefit from contracting out.
Millions of people were contracted out of Serps but since then a number of very important things have changed. First, life expectancy has improved and is widely expected to do so for the foreseeable future. This trend has reduced annuity rates, making the attractions of the money-purchase alternative (contracting out) less attractive against the earnings-related option (Serps, now the state second pension).
Second, interest rates have fallen heavily since the start of personal pension contracting out at the end of the 1980s, again hitting annuity rates and adversely affecting the possible attractions of contracting out. Third, most commentators agree that the current outlook for future investment returns is less favourable than it was a decade or so ago. Of course, contracting-out decisions rely heavily on future investment returns whereas decisions to remain contracted in do not.
Finally, contracting-out rebates have changed significantly – on more than one occasion – again working against the majority of would-be and have-been contracted outs.
All these issues combine to mean that individuals who might previously have expected to benefit from contracting out can no longer retain such expectations. Recent actuarial studies indicate that very few people of any sex, age and level of earnings could now be expected to benefit from contracting out. These studies – illustrated in relatively simple charts – have contributed to very few pension advisers now advising clients to contract out of the state second pension.
Fine, but what about the millions of people we have contracted out over the last 15 years? I am certain most or all readers will be aware that the decision to contract out is a yearly one but once the decision has been taken to contract out this will be assumed by the Department for Work and Pensions to continue until it is notified that an individual wants to contract back in.
I have seen recent statistics which indicate that exceptionally few people have contracted back in and, knowing that the vast majority of them should now reverse their previous decision, this means that they are likely to be financially much worse off as a result of their inaction. But, I would suggest, most of these people would not have known to contract out unless they had been advised to do so, so would it not – some might suggest – be fair for them to expect equivalent advice as to when to contract back in? Could advisers be held negligent if they do not go back to these clients and give appropriately updated advice?
Not being a lawyer, I do not know the answer to this question and I am not even sure any lawyers do. But we will all find out the answer if just one of these clients sues an adviser. A precedent will be set for probably millions of others to follow. I know that the FSA has for some time been aware of this potential problem but, at least at present, appears to be hoping that a solution can be found within our profession.
This will be very difficult as, although the vast majority of appropriate personal pensions resulted in commission being paid to the adviser, there is no commission for the time taken by the adviser to advise the client to contract back in. Nonetheless, we simply cannot allow clients to continue to direct money to a pension arrangement which will by all actuarial calculations lose them money.
In closing, when I have included this issue in pension update talks, it has frequently been suggested by at least one delegate that for many or most people there will not be such a thing as a state second pension as the Government will either abandon it altogether or significantly reduce the benefit structure (as previous Governments have done on a number of occasions in the past) or will deny payment to a large proportion of members by making benefits means-tested.
Perhaps so, but I suggest that it would be extremely dangerous to form a recommendation – or excuse for inaction – simply or mostly on crystal ball predictions of what future Governments might or might not do. For what my personal opinion is worth, I concur with the predictions of these cynics and remain personally contracted out of Serps for that overriding reason. Of course, I know the risks involved and so remain outside the state scheme with my eyes wide open. Most clients are not in that position.
This brings us nicely on to a separate but in some ways connected development – the pension credit. Most people will know this scheme better for its previous title – the minimum income guarantee. This guarantees that everyone in the country (well, subject to conditions such as residency) a certain minimum level of income in retirement.
If someone reaches retirement with no earned pension or investment income, the full level of this minimum income promise is paid by the Government. Under the old scheme, every penny of income the individual received from elsewhere reduced the Government's payment, so small or even modest levels of income transpired to be useless to the recipient as, in effect, they were simply replacing benefits they would receive from the state. The new scheme gives some credit for small levels of income from pensions but this still has relatively little value and is only given up to a highly restricted level that it will often prove near worthless.
The bottom line is that great care should be taken when giving advice on pensions – or, indeed, on any other form of savings – to people who appear likely to otherwise qualify for the minimum income from the state. This care might not need to be so great for a young client who, even if he currently has little income and savings, has enough years to go to retirement to accumulate some. For an older person with less time to turn round his financial affairs, the duty of care should be much higher.
In my next article, I will move on to an issue which has even wider ramifications on which I have written before but which now has a formal date for introduction and more certainty about the detail – age discrimination.