The great British pensions debacle

published 12 December 2005

The Government has created a hidden pensions trap that will catch millions of us. Here's how to avoid it and retire rich.

We two things about pensions: they're complicated, but it's in everyone's interest to save for one. Right? Wrong. They're certainly complicated, but Government tinkering over the past few years means that even some of our large pension firms find themselves in the extraordinary position of recommending that most private-sector employees shouldn't contribute to a pension plan at all - it turns out that it is not in our interest to get a pension after all. Indeed, Steve Bee, head of pensions strategy at Scottish Life, goes so far as to say that most pensions plans should now be thought of not as tax breaks, but as "voluntary tax takes".

This is partly due to the fiendishly complicated system of pension credits introduced last year. The credit has two elements: the Guarantee Credit and Savings Credit. The Savings Credit is intended to reward' pensioners who have a second pension or modest savings. But, as it turns out, it rewards only people who have very modest incomes. This is all very complicated to explain, but the upshot is simple: if you are going to save more than £16,000 but (as a couple) less than £180,000, the means testing will penalise you to such a degree that you might has well not have bothered - you will effectively be taxed on your savings at the higher rate. This is clearly absurd, as even most of the professional press is beginning to grasp. "Last week the PPI (Pensions Policy Institute) said the credit was too complicated, too costly and its take-up was too low," writes Samantha Downes in Financial Adviser, the trade paper for IFAs. In a mini-masterpiece of understatement, the PPI also added that "the credit could disincentivise saving". And a leader in the Daily Express argues that the message to the electorate is "don't bother to save for retirement". The fact is that up to five million of those people sweating to save for their old age may end up no better off than those who have saved nothing. A 20-year-old Briton starting now would have to save at least £280 a month for his or her entire working live to escape the disincentive of means-testing altogether, according to research by Mercer Human Resource Consulting, featured in the Express. The research also shows that a 30-year-old worker would have to save £330 a month, while a worker aged 40 would have to save £420 a month to avoid the pension trap. Who on the UK's average salary is going to save that much? Not many of us, it seems: the Institute of Fiscal Studies has estimated that, on current trends, around 73% of people currently aged 45 and older will depend on state assistance in the form of pension credits in 2025, rising to 82% in 2050.

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"If it ain't broke don't fix it" is a maxim this Government seems to have wilfully ignored when it comes to pensions (as indeed with much else). Whenever any government decides to "simplify" something as complex as pensions, theoretically we should all cheer. However, that's before we get to look at exactly what the government means by "simplify". The PPI's report, for example, says the new pension "savings credit [is] notoriously difficult for pension experts to understand", according to Downes. However one thing she is sure of: "It cannot be said with certainty that it always pays to save - except for people so far up the income distribution that they will remain clear of means testing and pension credit throughout their life", as the PPI report puts it. Roughly translated, any "tax-free" savings you make in your pension fund will effectively be taxed at 40% when you retire once you've been means tested for the "minimum" state pension, currently £105.45 a week, or £160.95 for couples. Why would anyone want to save now to be voluntarily taxed later? If you aren't going to save a lot, don't save at all.

It's clearly unfair that those who have saved all their lives end up no better off than those who have not. And that will surely actively encourage cheating. The Government's current bug-bear of benefit fraud can soon be expected to be an almost population-wide pastime as the prudent look for ways to deceive the Government about how much they're really worth. How long until every pensioner in the land is claiming to have only £15,900 in their savings accounts?

But what if you are one of those people who will "remain clear of pension credit throughout their life"? You should still think very carefully before you get a pension. According to James Brooke of Anand Associates, even if you ignore the iniquities of the new pensions-credit system altogether, it is not worth most people's while buying into a basic pension plan. This is mainly because of the small-print surrounding the compulsory annuity purchase you have to spend most of your pension "pot" on.

An annuity pays you interest, but it also pays back some of your capital each year too to boost the annual income stream. Effectively it works just like a repayment mortgage, but in reverse. However, all the income you receive from a compulsory purchase annuity is treated as taxable income by the Revenue. Thus the tax breaks the Government gave you with one hand to encourage you to save for your pension merely lead to an increase in your tax rate once you're actually receiving it. If you were to buy an annuity on the open market - ie, not with your pension pot - the capital part of the pay out would not be taxed.

The killer blow, though, comes from the price of the compulsory annuity. Compulsory annuities for men of 65 pay about 7%, all of which will be taxed, remember. But the actual interest rate you'd be getting right now is below 3%. I'm getting 5% on my bank savings account, for example. The rest of the payout would come from the capital. If you had a pension pot of £750,000, for example, your net annuity income would be £36,000 a year, or just 4.8% of your fund. Yet long-term savings products like guaranteed bonds, if wrapped inside an Isa with your capital gains allowance taken out of growth, can return a good 7% virtually tax-free, reckons Brooke. What's more, stick with an Isa and you haven't forgone your capital as you have to when you buy an annuity. This would enable you to leave a capital sum to your dependents when you die, not something you can do with your pension. In short, Brooke reckons you'd need to live to almost a hundred to break even on the compulsory annuity.

Still, there is some good news on the pension front. According to Adair Turner's Pensions Commission report, the UK has an enormous £1,300bn in funded (private sector) pension rights. That's more than the other 24 countries in Europe put together. On the downside, most of this money is in large company defined benefit (final salary) schemes, and most of these have now been closed to new entrants. And worse, even that is nowhere near enough. Contrary to many press reports, the Pensions Commission calculates that the country's pension liabilities are under-funded to the tune of not just £57bn (although that would be bad enough), but £57bn a year. That implies every worker should be saving nearly £2,000 extra a year. If they don't - and they won't - comfortable old ages will be a distant dream for most of us.

Turner's report also revealed that the Government has given pension rights to public-sector employees, which are totally unfunded (and so must come out of future tax receipts), worth £500bn. This is what Jeremy Clarkson, writing in The Sunday Times, called - with good reason - "the I'm All Right Jack Civil Service Pension Fund". Steve Bee of Scottish Life estimates that even though public-sector employees' rights are unfunded, they represent nearly 40% of the nation's pension liability while accounting for less than 15% of the working population. In 2002, unfunded pension payments to ex-public sector employees, over and above their state pensions, already totalled 25% of the entire state pension payout.

Apparently concerned about the lack of pension saving by the rest of the private-sector working population, the Government introduced stakeholder pensions in early 2001. Research by ABI suggests that 82% of all schemes are "empty boxes with no members and sales of stakeholder are falling", reports Bruce Love in the IFAs' trade paper Money Marketing. Turner revealed that although 65% of companies with five to 12 employees have nominated a stakeholder provider, only 4% of those firms actually have employees who are bothering to make any contributions. Pensions Minister, Malcolm Wicks, told the recent Labour party conference "that stakeholder was a resounding success", reports Love. "All you have to do is look at the amount of money that has gone into stakeholder schemes," opines Wicks, who like so many of his ilk turns out to be guilty of looking only at the numbers he wants to look at. There may be some money going into stakeholder pensions, but the majority of it has simply been transferred out of existing schemes into stakeholders because they're cheaper to manage. The rest? It's going in as a rich man's tax dodge.

TUC General Secretary Brendan Barber says that company employees using stakeholders are putting an average of only £720 a year into stakeholder. Yet the average contribution is £2,000 a year. Where's the rest coming from? Mainly wealthy parents and grandparents starting private stakeholders to invest on behalf of their children. That makes stakeholders "a bigger failure than we thought", concludes Barber.

If you're in the lucky position of having a pension pot that's likely to exceed £1.5m in value by "A Day", then you can ring-fence' it now, but you can't add any more. This is, of course, what our captains of industry will all now be doing. So they won't be in the same kind of pension plans we are. And senior civil servants and MPs don't need to bother because, amazingly, they're not subject to the same restrictive cap anyway. This is terrifying: it means that within a couple of years, none of society's decision makers will be in a pension's plan that bears any resemblance at all to those of the man in the street. As Steve Bee points out, this could have enormous ramifications for the future of our pensions industry. What will they think of pension provision once it becomes a cost from which they get no further benefit?

Bear this in mind and your path becomes clearer. Don't expect the pension system ever to work in your favour - it probably never will. Instead, use your full Isa allowance every year. This is currently £7,000, but it is soon to fall to £5,000. If you start at 35, put in £5,000 a year (£416 a month) and earn a compound growth rate of 5% a year (this sounds modest, but it is realistic). This will allow you to build up a tide pot of £370, 413. That's not bad. And you can do with it whatever you want. But best of all, you'll be outside the pensions system and you will never have to read about pensions again in your entire life.

James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.