Government plans simpler, affordable and secure pensions

National insurance rebates will be excluded from the calculation.

Contribution and benefit rules

The existing limits on benefits and contributions that depend on the type of pension arrangement will be scrapped. Instead the same limits will be applied to all arrangements. Members will be able to pay the higher of 100% of earnings or £3,600 in pension contributions in a year. A knock- on effect of this proposal is that full concurrency will be allowed, so a worker could belong to several different arrangements.

The only limit on the form that benefits can take will be that tax-free lump sums are restricted to 25% of the value of the member's fund, or of the lifetime limit if less. The Revenue is also planning to increase the value of trivial pensions that may be fully commuted.

Proposals on annuities

Following the DWP's consultation on annuities early last year (OP, March 2002), a series of proposals have been put forward for reform. These are:

In a related area, the government plans to ensure protection for consumers taking out home reversion plans, which provide people with an income from their home in retirement. These are not currently regulated by the Financial Services Authority (FSA).

Promoting pensions

The government believes that the impact of its proposed changes will be to encourage employers to maintain or introduce occupational pension schemes. To encourage more people to save for retirement, it intends to "rebrand" tax relief. Quite what this means, or how it will be achieved, is not made clear.

One concern about the proposed new tax regime is that it may precipitate the rush towards DC schemes as it will be easier for DC plan members to check their benefits against the limits. In addition, it will become increasingly difficult to provide tax efficient pensions for senior employees, especially as the report makes no comment on how unfunded and funded unapproved retirement benefit arrangements would fit into its system, other than to say that the Revenue will be consulting on detailed rules to apply to the latter at a later date.

Tucked away at the back of the paper is the suggestion that in future the government will apply the same investment standards to all schemes. It proposes to restrict self-investment and limit loans to members and employers. This will have the greatest effect on small self-administered schemes.

Source: Based on an original summary devised by Mercer Human Resource Consulting.

EXTENDING WORKING LIVES

For some time the government has been concerned about the trend of rising life expectancies coupled with a high early retirement rate. Employment rates for both men and women tend to decline rapidly after age 55. Several employment initiatives have already been introduced to increase the number of older people participating in the workforce. The government is also under an obligation under EU legislation to introduce anti-age discrimination laws by December 2006.

Both the Green Paper and the tax simplification paper contain proposals relating to retirement ages. Much of what is in the Green Paper is a reiteration of existing proposals or other consultations and puts forward few new ideas. In addition, the Department of Trade and Industry is due to consult on its proposals to combat age discrimination in early 2003 and it is not clear how the two separate consultations will fit together.

Greater flexibility in retirement

The main, much-trailed retirement reforms are contained in the tax simplification paper. The government says it wishes to remove the "cliff-edge" that people face when moving from work to retirement. The Treasury is proposing that the concept of normal retirement age will no longer feature in tax rules. This will enable schemes to introduce flexible retirement arrangements whereby an employee can continue to work part time while drawing benefits from the employer's occupational pension scheme. This is not permitted under current Revenue rules. All benefits would still have to be drawn from pension schemes by age 75.

However, flexible retirement will only be possible if the pension scheme rules permit it. There will be no compulsion on schemes to introduce the provision, although the Green Paper states that as a matter of best practice employers should ensure that the scheme rules do not discourage flexible retirement.

The paper suggests that occupational scheme rules should do the following:

This latter point is already included in the government's Code of Practice on age diversity.

Deferring the state pension

Currently, if someone defers receiving a state pension beyond state pension age, that pension is increased by approximately 7.5% for each year of postponement for a maximum of five years. The government is now proposing to bring forward an existing provision whereby the rate of enhancement of deferred state pensions is increased to 10.4% pa. This was due to take effect in 2010, but the government now hopes to introduce the change by 2006. It is also proposing to remove the five-year limit, but it is not clear if there will be a maximum age by which state benefits must be taken.

It also suggests that people who postpone taking their state pension will have the choice of receiving the increased amount either as an addition to their state pension or as a taxable lump sum.

There has been pressure on the government to raise the state pension age to 70. However, it rejects this idea, one of its main reasons being that lower-paid workers would be disproportionately affected by the change.

Restricting early retirement

The government has no such qualms about raising the normal pension age under public sector schemes from 60 to 65. Although the Green Paper states that the increase will only apply to new entrants, commentaries on both the civil service and local government websites⁵ imply that public sector schemes will be consulting on extending this proposal to existing employees.

In fact the Local Government Pension Scheme has had a normal retirement age of 65 for new entrants since 1998. However, it has an "85-year rule" whereby employees with long service can be allowed to retire at a younger age with an unreduced pension. This will have to be phased out.

Certain public sector workers, such as firefighters and police officers, can retire at relatively young ages. In view of the perceived special nature of their work, the government concedes that they still need to be able to take their pensions at younger than normal ages. But if they leave those occupations before their normal retirement age, their pensions would be deferred until age 65.

People in other occupations that currently have relatively young retirement ages will not be so lucky. The Treasury wishes to abolish the present Inland Revenue concessions which permit those with short professional lives, such as sports people or models, to have normal retirement ages under 50. In future, it recommends they should be subject to the same rules as everyone else.

The tax simplification paper also proposes that the minimum age at which an early retirement pension may be taken should be increased from 50 to 55 by 2010. This idea was first promoted by the Performance and Innovation Unit (now the Strategy Unit) of the Cabinet Office in its paper, Winning the generation game (OP, July 2000), and has now been taken a step further. The government believes the rule is no longer appropriate because it was introduced at a time when life expectancy was shorter. However, it is consulting about whether the change should be phased in using legislation or whether schemes should be left to choose how (but not if) to bring in the new rule. It will still be possible for schemes to pay ill-health early retirement pensions at any age.

REDUCING COSTS AND SIMPLIFICATION

One reason often given for the decline in occupational pension provision is the administration costs of meeting complex regulatory requirements. The latest National Association of Pension Funds survey (see NAPF survey: DB scheme closures double in 2002) supports this view. A whole section of the Green Paper is devoted to measures which the government believes would reduce the administrative burden on pension schemes. In addition it contains proposals that would make it easier for people to understand their pension arrangements.

MFR saga continues

The government has been reviewing the much-criticised minimum funding requirement (MFR) since 1998 and issued a paper setting out its ideas for reform in March 2001 (OP, April 2001). At that time it proposed replacing it with a scheme-specific approach. The Green Paper sets out what this would involve but does not progress the matter as much as might have been expected given the time that has been spent consulting on the issue.

The key features of the report's proposals are:

The requirement for payments to the fund to be made in accordance with a schedule of contributions will be maintained. Trustees will also have a duty to report to the new regulator if the employer is not making the correct contributions.

Another change touched on in the DWP's technical paper is to simplify the provisions concerning transfers and to remove the requirement for the minimum transfer value to be calculated by reference to the minimum funding requirement. Instead schemes will be able to determine their own fair transfer basis.

Reducing contracting-out complexity

Although the Green Paper makes much of the idea that the government is seeking to simplify contracting-out, it contains no firm proposals. Instead it seeks views on a number of suggestions originally put forward in the Pickering report.

The major cost-saving suggestion is to change the reference scheme test (RST) for contracting-out by reducing the minimum accrual rate from 1/80th to 1/100th. However, all earnings would be used to calculate the RST rather than just those between the lower and upper earnings limits. Schemes could choose whether to calculate pensionable salary on a final- salary or revalued career average basis. The government believes that overall this change would reduce funding costs by up to 30%.

The government also adopts Alan Pickering's idea that some method should be found of converting pre-1997 guaranteed minimum pensions (GMPs) to benefits on the RST basis, although it has not, as yet, come up with an appropriate way of doing this.

Pickering's ideas rejected

The Pickering report attracted much controversy by suggesting that there should be no requirement for contracted-out schemes to provide spouses' benefits. In addition it advocated the abolition of compulsory limited price revaluation (LPI), which applies to all schemes.

Unsurprisingly, the government more or less rejects these proposals out right. It argues that it would not introduce these changes unless it had good reason to believe that the coverage of, and contributions to, occupational schemes would increase as a result. It is also concerned that abolition of these benefits would have a disproportionate effect on women. However, it is seeking views on whether LPI should only be provided on pensions up to £30,000 a year.

Other contracting-out issues on which the government is seeking comments include:

The government also used the Green Paper to announce that the implementation of the sections of the Child Support, Pension and Social Security Act 2000 that replaced anti-franking provisions with a minimum benefits test (OP, February 2000) has been postponed indefinitely.

Amending s.67

Section 67 of the Pensions Act 1995 was introduced to protect scheme members against changes that retrospectively affect pensions rights already accrued. However, in practice, while its intention was laudable, it has proved cumbersome to apply. Every conceivable right has to be protected and the rationalisation of past rights is prevented (see OP, November 2002 for a feature discussing the problems). The section only allows accrued rights to be modified if each member consents or an actuary certifies that rights will not be detrimentally affected. As a result few retrospective changes are ever made.

The Pickering report recommended that s.67 should be replaced with a test that allowed changes to be made if replacement benefits were of equivalent value. The DWP says that this goes too far, as DB rights could be replaced by DC rights assessed as equivalent. Its technical paper proposes that rights could be changed provided that the actuarial value of the rights being replaced (or the value of any reduction) did not exceed 5% of the member's total accrued rights, and these would have to be replaced with rights of equivalent value.

The technical paper gives as an example two schemes that are merged, one offering dependants' pensions to children aged under 18 and the other offering the same right for children aged under 16. Under the proposal, the merged scheme would be able to harmonise the provision, without members' consent, by offering pensions only to children aged under 16 because the actuarial value of the reduction would be less than 5% of the total accrued rights. However, members of the scheme that previously enjoyed the more generous provision would have to be offered other benefits of equivalent value, possibly by providing added service. The paper asks for examples of changes that schemes would like to make that would be assisted by this proposal, and examples of those that would not.

MNTs for all

The Green Paper restates the government's intention to require one-third of a scheme's trustees to be member-nominated (a requirement included in the Child Support, Pensions and Social Security Act 2000, but not yet implemented). Most large schemes secured an opt-out when the existing Member-Nominated Trustee (MNT) Regulations became effective, and this will no longer be possible.

The government wants to reduce the level of prescription on the selection process for MNTs, and to focus on the outcome. The DWP technical paper proposes that the pensions regulator would issue guidance on good practice for nomination and selection procedures. Legislation would require that MNTs could not be removed without the unanimous approval of all the other trustees. This requirement is contained in the existing MNT Regulations and is one of the principal differences between MNTs appointed under the Pensions Act 1995 and other "member" trustees.

Two options are being considered. One would involve a simple requirement that one-third of the trustees are MNTs. The second option would also require the procedures for nominating and selecting trustees to be "fair and open" and give the regulator a supervisory role.

IDR procedure revision

The government is proposing to improve the procedures schemes must have for dealing with disputes internally by allowing more flexibility and seeking to shorten the timescale for the process to be completed.

The DWP technical paper is proposing two changes. First that schemes can choose whether to have a one or, as now, a two-stage internal disputes resolution (IDR) procedure. Secondly, that there should be an overall time limit (six months is suggested) for completing the process and either resolving the dispute or referring it to OPAS, the Pensions Advisory Service.

SECURITY FOR MEMBERS

The Green Paper recognises that members will only save for their retirement if they have confidence in the savings vehicle concerned. It proposes a number of changes in this area, described below. The DWP is also proposing to introduce a requirement that employers consult their employees or employee representatives before making changes to pension schemes.

A proactive regulator

The report of the quinquennial review of OPRA was published with the Green Paper (see box). It concludes that, although the regulator has performed well, it needs to adopt a more proactive approach and to focus more clearly on the risks associated with particular breaches. This conclusion reflects the view taken by the Pickering report, which called for a "New Kind of Regulator", and the very recent report from the National Audit Office (OP, December 2002).

The Green Paper accepts the analyses set out in these reports and proposes a new pensions regulator separate from, but operating alongside and complementing, the FSA. It says the body would focus on schemes where there is a higher risk of fraud, bad governance or maladministration.

Protection on winding up

Under the heading of "Protection in the case of wind-up" in the Green Paper, the government says it is concerned that members should have confidence that they will receive the pension they were promised. Its first proposal is to change the priority order for dividing up available scheme assets when a scheme is underfunded on winding up. While this may be desirable, it will not increase the size of the cake - it merely ensures available assets are shared more fairly.

Currently, pensioner members are ranked more highly than active members and deferred pensioners, who are both treated equally. One option put forward is to give people approaching retirement, who therefore have little time in which to make alternative provision for themselves, a higher priority than younger members. A second option would be to base the level of protection afforded on the number years a member has belonged to a scheme.

Another idea would be to recoup part of any pension awarded to those (often directors) who have taken early retirement (with no reduction in benefits) just prior to a company becoming insolvent and its pension scheme winding up in deficit. The paper also floats the idea of moving underfunded schemes higher up the creditor order, in line with preferential or secured creditors. However, it points out that this could have the effect of making it harder for employers with DB schemes to obtain secured loans. It seems the DWP favours creating a new level of creditor, below preferential or secured creditors, but above other unsecured creditors.

Other initiatives explored in the report are the establishment of a "clearing house" into which members of DB schemes could pay their pension rights when a scheme winds up, or an insurance arrangement. It is envisaged that the clearing house would be able to secure the best deferred annuity for members, which would be better than they could obtain individually. The insurance option could be in the form of a central discontinuance fund - not a new idea (OP, March 1993 and March 1995).

The Green Paper proposes to increase the level of compensation paid from the current compensation scheme so that all liabilities for all members are covered. However, the scheme only applies in those rare situations where the deficit is due to dishonesty, not where funding has been insufficient or investment returns poor. So far only three schemes have benefited.

Wind-ups where employer continues in business

The government is clearly dismayed that some employers choose to wind up their schemes when the company is continuing yet do not secure the pension rights of members in full. This has the effect of undermining confidence in occupational schemes generally.

Currently, employers have to fund schemes so that annuities are purchased for all pensioners, securing their pension in full, and so that transfer values can be provided for other members. The Green Paper contemplates requiring employers to provide sufficient funds to buy deferred annuities for all members, or alternatively just for those nearing retirement.

The government says it wants greater protection for members, but does not want to increase the overall burden on employers. It is hard to see how it can square that circle.

Business transfers

The government has consulted previously on changes to the TUPE Regulations, which currently protect employees' terms and conditions on a business transfer, but which exclude occupational pensions. It has proposed removing the exclusion, but has so far not acted.

The Green Paper says there is a wide range of views on the issue and if the law were to cover the pensions of staff transferred from one private sector business to another the protection would need to be simple, flexible and worthwhile. The government is clearly anxious not to require the new company to provide pensions in the same form necessarily, and seems to be backing away from its earlier commitment.

BUILDING UP BIGGER PENSIONS

The reliability of assessments made of the size of the savings gap - the gap between how much people are actually saving for their retirement and the amount they need to save to ensure against a substantial fall in income during retirement - is queried in the Green Paper. Nonetheless, it estimates that three million people are "seriously under-providing" by saving too little to provide a pension of half their income prior to retirement. Between five million and 10 million more "may want to consider saving more or working longer".

The government has considered several initiatives to overcome this problem in addition to the simplification of the tax and other rules which may act as a barrier to saving. There is also reference to ensuring that stakeholder pensions fit in with the recommendation of the Sandler report (OP, September 2002) for a suite of regulated products that consumers can safely buy with little or no financial advice. This might simply mean requiring stakeholder schemes to have a default investment option.

Compulsory contributions

Prior to publication of the Green Paper there was a good deal of pressure for compulsory employer contributions to private pensions. The government has shied away from this, referring often to its preferred voluntarist approach.

However, the government has not ruled out compulsion in the future. Recognising the number of individuals that are, by its own calculations, under providing, it has set up a commission to monitor the desired growth in private pension coverage.

The commission is to be led by Adair Turner, vice-chair of Merrill Lynch Holdings Ltd, a director of Business Media plc and chair of the Low Pay Commission. The other members are Jeannie Drake, deputy general secretary of the Communication Workers Union and a member of the Equal Opportunities Commission, and Professor John Hills of the London School of Economics. The commission's terms of reference are set out in the accompanying box. It is to report "regularly" and the period of its work seems to be open-ended.

On the question of enabling employers to make membership of an occupational scheme compulsory, as they could do up to 1988, the government is considering options for allowing scheme membership to be made a condition of employment for new employees, if an employer so chooses. However, even if permitted, employees would be given the right to opt out in certain circumstances, for example if they were already contributing to a stakeholder pension.

Immediate vesting

The Pickering report recommended immediate vesting, with all employees who have belonged to an occupational scheme retaining a deferred pension when they leave and refunds of member contributions, therefore, not being permitted. This is intended to ensure that those who change jobs frequently are not thereby prevented from building up pension rights. Currently those leaving with under two years' service have no right to a deferred pension under the law, though some schemes offer this option and, indeed, scheme rules can insist that pension rights are preserved.

The government has picked up this recommendation and is proposing that pension rights should vest from day one. However, like the Pickering report, it is proposing to allow trustees to transfer small pensions to a stakeholder scheme after members leave, unless the member objects or asks for the rights to be transferred elsewhere. This is very like the existing law governing preserved pensions for service of less than five years, although this option is rarely if ever used.

Pension planning

Given the government's view on compulsion, providing individuals with the information they need to make informed choices is especially important. The government proposes to step up its pensions awareness campaign and move the emphasis from simple awareness towards information that will prompt people to take action. It plans a telephone and website information service as a first point of call for answers to basic questions and is evaluating its existing digital television service launched last year. It wants to build on the pensions ready reckoner launched recently by the Association of British Insurers and the FSA, so as to introduce a web-based retirement planning tool by 2004. An FSA-approved pensions information pack for employers to use in communicating with their employees is also envisaged.

The paper recognises that information specific to the individual will be even more useful. In consequence, the DWP wants to broaden the coverage of combined pension forecasts (covering occupational and state pensions) and is seeking views on whether to do this on a voluntary or compulsory basis.

The DWP also intends to send out forecasts of individuals' state pensions automatically, starting with self-employed people that have not received a combined pension forecast from their pension provider, and extending this to everyone within five years.

According to the Pickering report, the current disclosure of information requirements are complex and result in members receiving too much, poorly targeted information which they tend to ignore. Accordingly, the Green Paper is seeking ideas on how the current legislation can be rationalised. It suggests replacing the current time limits with a "within a reasonable time" approach. It also wants to know what, if any, of the information that presently has to be provided automatically, could be given on request.

Employer task force

The Green Paper confirms the government's plan to set up a task force to help employers share experiences and ideas to increase and extend pension provision. The task force is expected to act "as a catalyst in the development and promulgation of best practice".

The task force will be made up primarily of employers, but with trade union representation. It seems a worthy proposal, but reminiscent of the ill-fated Best Practice Guidelines Working Group, which was set up in 1999 (when the Quality in Pensions Administration initiative ran into difficulty) and which was quietly dropped two years later.

THE NEXT STEP?

There has been a mixed response so far to the Green Paper, as the selection of comments shows. The tax simplification proposals have been broadly welcomed, if nothing else for being a genuine attempt to achieve radical change. One of the main criticisms of the other Green Paper proposals is that on key issues, such as replacing MFR or compulsory membership of pension plans, little has been done to progress matters. The fact that the government is consulting further on many points, or setting up committees to look at specific topics, suggests either that it is short of ideas or that it lacks the political will to carry out major reforms.

The government estimates that its simplification plans, taken as a whole and including the tax proposals, would save employers between £150 million and £200 million. Of this, it appears that £80 million will be saved just by the introduction of the new tax regime. In addition, it believes that the abolition of the MFR will result in savings to schemes of £10 million a year, and that £70 million a year will be saved from the impact of the removal of MFR on schemes' investment strategies. Therefore it is not quite clear how the government reaches its total savings figure. In particular the paper does not say whether these sums take account of large one-off costs that will probably be incurred when schemes switch to the new regime.

The government has given an indication of the legislative timetable for the tax simplification proposals only. It intends to include these changes in the 2004 Finance Bill, which would mean they could be implemented as early as 6 April 2004. Given the consultation period for the other Green Paper recommendations, it is unlikely that a Pensions Bill would be laid before Parliament until the 2003/04 session at the earliest. The government is also proposing that, once this raft of changes has been introduced, pensions legislation will be consolidated, a task for which the Law Commission would be responsible.

The government has also taken this opportunity to make announcements on some issues resulting from the Myners report and a subsequent consultation paper (OP, May 2001 and March 2002). Following advice from the Law Commission, there is now no intention to legislate on pension fund surpluses. Also, following publication of the Institutional Shareholders Committee code (OP, January 2003), it plans to reassess the need for legislation on shareholder activism in two years' time. However, the Green Paper says there will be legislation to ensure that trustees have the expertise they need to take investment decisions.

Source: Simplicity, security and choice: working and saving for retirement, chapter 2.

¹"Simplicity, security and choice: working and saving for retirement", Cm 5677, and a summary, available by telephoning 08457 023474, free, and from the website of the DWP (at www.dwp.gov.uk/consultations/consult/2002/pensions/index.htm ).

²"Simplifying the taxation of pensions: increasing choice and flexibility for all", available by telephoning the Treasury public enquiry unit on 020 7270 4558, free, and from the Treasury and Inland Revenue websites (www.hm-treasury.gov.uk and www.ir.gov.uk ).

³"Report of the quinquennial review of the Occupational Pensions Regulatory Authority", available from the DWP website (see above).

⁴"Simplicity, security and choice: technical paper", available from the DWP website (see above).

⁵See the Civil Service pension website (www.civilservice-pensions.gov.uk) and the Local Government Pension Scheme website (www.xoq83.dial.pipex.com).

⁶"Report of the quinquennial review of the Occupational Pensions Regulatory Authority", December 2002, by the DWP and Dr Brian Davis, independent reviewer, available from the DWP website (www.dwp.gov.uk).