Pension action plan

05 October 2005

If you're not worried about your pension, you probably should be. Experts estimate that 12 million people are not saving enough towards their retirement, creating an annual savings gap of £27 billion. Now, that's a lot of people and a lot of money. No wonder there is talk of a pensions crisis.

So how did we get here – and more importantly how can we get back on track?

The roots of the current crisis are deep, stretching back to the misselling scandal of the 1980s when millions of people were wrongly persuaded to opt out of their company schemes into personal pensions. The industry was eventually forced to stump up more than £11 billion in compensation. But it lost more than money, it lost the trust of savers. And once you've lost the trust of your customers, it's very had to get it back.

It's even harder when one of the most respected names in the pension world has a spectacular - and public – fall from grace.

In December 2000 Equitable Life closed its doors to new business after it admitted to a £1.5 billion black hole in its reserves. The company is still limping on, but last month it dropped a legal case against its former auditors, Ernst & Young. It performed a similar climbdown last week when it pulled out of a court action against two former directors. The future now looks bleak for the insurer's long suffering customers.

The demise of Equitable Life is largely down to mismanagement, but the fall in the stock market didn't help. A big chunk of our pension savings are invested in shares – and share prices started to drop in 2000, marking the beginning of a three-year bear market.

The latest survey from Money Management magazine shows that 90% of typical personal pension funds are worth less now than savers have paid in over the past five years.

You might think that's understandable given that the FTSE All Share is down by about 10% over the same period, but the companies that run our retirement savings must accept some of the blame. They not only failed to spot the signs of a stock market downturn, but they also failed to invest our money in a broad enough spread of assets to cushion the fall.

Of course, that didn't stop them from slapping high charges on their schemes. The government's Pensions Commission has calculated that fees can rob you of 20% to 30% of your savings by the time you retire.

Of course, while the stock market was struggling to make headway, the property market was racing ahead. Over the past five years, it has gone up by about 60%. The contrast is stark – and made a big impression on disillusioned pension savers. Instead of handing money over to Prudential or Standard Life, they chose instead to invest in property, or simply to rely on the increasing value of their own home to fund their retirement. In a recent survey by Abbey, nearly three quarters of the nation's homeowners said they expected property to keep them afloat in retirement.

The government is not immune from blame for any pensions crisis. In his first budget after Labour came to power in 1997 the chancellor mounted a tax raid on pension funds that costs them an estimated £5 billion a year. Gordon Brown is also responsible for the means-tested pension credit. The credit tops up the pensions of people who have only modest savings, but it has been widely discredited since its introduction in 2003. It is not only complicated, but it can act also as a disincentive to save. Tom McPhail of Hargreaves Lansdown, an independent financial adviser, says: “ The pension credit was a sticking-plaster policy; a short-term quick fix to improve the standard of living of pensioners retired now. There are three problems with it. For people not yet at retirement it acts as a disincentive to save. What i! s the point in relatively low earners saving for retirement if they are going to be taxed at 40% when they get there? It has also missed a lot of pensioners - there are still hundreds of thousands who could claim and haven't. Finally, over time more people will fall into the Pension Credit bracket, ultimately it could be as high as 80% of the population, at which point it would make more sense to simply deliver a more generous basic state pension.”

If all that were not bad enough, the current generation of savers is witnessing the demise of the final salary pension. Final salary schemes are the Rolls Royce of pensions because you are paid a percentage of your salary when you retire depending on your number of years of service. So, the stock market could tumble and management fees could soar, but you would still get your pension. The typical scheme pays 1/60 th of your final salary for every year of service, so you would get two thirds of your final salary if you worked for the same employer for 40 years.

Now that's what I call a pension scheme: the employer not the employee carries the risk.

Sadly, final salary schemes are on the way out, unless you happen to be a politician or other member of the civil service. In 2004, 10% of final salary schemes closed to new staff, according to the National Association of Pension Funds (NAPF). The figures were 26% in 2003 and 19% the year before.

Ros Altmann, a pension campaigner and government adviser, says: “Final salary pensions were designed to last five to ten years at most, with no real guarantees. But improved longevity, coupled with government moves to make companies take on responsibility for social welfare, by forcing them to provide cover for spouses and index linking, for example, has made them quite unsustainable. The system is now coming apart at the seams.”

A number of firms have even wound up their final salary schemes, leaving all their staff in the lurch. The plight of workers who have saved for years only to retire with next to nothing prompted the government to set up the Pension Protection Fund (PPF) earlier this year. The PPF, funded by an industry levy, will pay some compensation to members of pension funds that collapse after April 2005. Workers will get 90% of the value of the pension they expected, but only up to £25,000 a year. Payments will rise in line with inflation.

The Financial Assistance Scheme offers compensation to workers whose pension plans collapsed between January 1, 1997 and April 5, 2005. However, it will pay out only to people who are within three years of their normal retirement date. They will get 80% of the value of the expected pension, but only up to a maximum of £12,000 a year. Payments will not be linked to inflation so their purchasing power will be eroded over time.

Our greater longevity is a drain on final salary schemes because they have to pay out for longer. A 65-year-old man can now expect to live on average until he is 86 years and seven months old – an increase of three years since 1998, according to figures for the Continuous Mortality Investigation set up by the insurance industry.

The figures also drag down annuity rates. If you have a personal pension, or your company runs a so-called money purchase scheme, you usually have to buy an annuity with the bulk of your pension fund when you retire. An annuity pays out a guaranteed income for the rest of your life, so the longer you are expected to live, the smaller the income. Since 1994, annuity rates have fallen 41% for men and 39% for women, according to Moneyfacts, an independent data analyst. And that's another reason why people don't like pensions, because once you have bought an annuity you are locked in – you cannot later switch to a better deal.

The government is set to relax the rules on annuities in April next year, as part of an overhaul of the pensions system. The new regime is intended to encourage more people to save for their retirement.

The government wants more people to make their own provision so they are less of a drain on the state. And it needs to sort it out quickly, before the benefit system is blown apart by the demographic timebomb.

The current generation of workers effectively pays for the state pensions of the people who are already retired. Pensioners are not only living longer, but the forecast low birth rate will produce a near doubling of the percentage of the population aged 65 and over between now and 2050.

The Pensions Commission, which was set up in 2001, is due to publish its second report at the end of November, recommending some policy changes. But the choice is stark. We either have to save more into our own pensions, raise taxes to fund a bigger state pension, work longer – or a mixture of the three. But what we can no longer is afford to do, is nothing.

Pension action plan

1. Don't dismiss personal pensions out of hand. The tax breaks on all pensions are generous: the government pays 22p for every 78p you invest, taking the total contribution to £1. Higher-rate taxpayers can claim a further 18p through their tax return.

2. If your company offers a final salary pension you should almost certainly join up, as long as you assess the risk that the company will go bust or voluntarily wind up the scheme.

3. If your company runs a money purchase scheme – where the return depends on the level of contributions and the performance of the fund - it still usually makes sense to join. Your employer will probably contribute on your behalf, so you are getting something for nothing. But keep an eye on the performance of the fund and make sure you shift gradually out of equities as you approach retirement.

4. If you are not eligible for a company pension, then consider a personal plan. Stakeholder pensions are usually cheapest because charges are capped at 1.5% a year for 10 years and 1% thereafter. But many stakeholders run by life insurers offer a choice of only six or seven of their own funds. Look for stakeholder firms that offer external funds, such as Scottish Widows and Legal & General.

Self invested personal pensions (Sipps) give you more control over where you invest, but charges can be higher.

5. Make sure you are contributing enough. If you took out a pension at 25, you would need to save 11% of your salary to retire on 50% of your gross earnings at 65. The figure would rise to 14% if you started saving at 30, 18% at 35 and 23% at 40. The figures do not take into account the state pension and assume average earnings. There are a number of online pension calculators, including www.pensioncalculator.org.uk and www.hargreaveslansdown.co.uk/sipp.