deVere Spain

A modern pension is expensive.

EMPEROR AUGUSTUS came to power with the help of a private army. So understandably he was eager to ensure the loyalty of his soldiers to the Roman State. His ingenious idea was to offer a pension for those in the army who had served for 16 years (later 20), the equivalent in cash /land to 12 times their annual salary. As Mary Beard, classical historian, explains in her history of Rome, “SPQR”, the promise was immensely expensive. All told, military wages and pensions absorbed half of all Rome’s tax revenues.

The emperor would not be the last to underestimate the burden of providing retirement benefits. Around the world a funding predicament for pension schemes is at boiling point. In Britain the pension problems of BHS scuppered attempts to save the high-street retailer; the same issue cursed both Tata Steel and Carillion.

The roots of the predicament lie in defined-benefit (DB) pensions, which guarantee a pension linked to workers’ salaries. These may provide security for the retired but have been incredibly expensive for employers. In many cases, DB pensions were offered decades ago when they seemed like a cheap alternative to awarding pay rises. Now private-sector employers are usually offered defined contribution (DC) schemes, which hand them a pot of money on retirement with no promise of the income it will generate.

The DB problem is huge in Britain this id due to the fact that many employers operate funded systems, in which contributions are put aside and invested to pay pensions. There are many reasons that funding pensions are becoming ever more troublesome. Firstly, people are living longer. In 1960 the average British 65-year-old man could expect to live for another 11-13 years, women 14-16 more years. Now it is 18-19 years for men and 20-24 years for women. Furthermore funding decent pensions is all the more difficult given that the proportion of retired workers is continuously growing. Around 600m people aged over 65 now make up around 8% of the world’s population; by 2050 there will be 1.6 billion, that’s more than 15% of the total population.

Secondly, the low level of interest rates and bond yields mean the cost of paying out pensions has gone up. In the late 1990s, £100,000 would have bought a 65-year-old British man a lifelong income of £11,170 a year; now it will earn £4,960, according to Moneyfacts, a data firm. In other words, paying out a given level of income now costs more than twice as much as it did, and as a result employers are searching for ways to limit the cost allocated to providing retirement benefits for past and present employees.

Government-bond yields are at historically low levels. This has a direct impact on your pension. Government bonds are considered “risk- free” investments where the default risk is extremely low and therefore a safe choice for companies to invest in for pensions. The problem, however, is that government bonds offer low-to-negative real returns that eat into pension funds and increase those fund’s growing deficits. With huge debt burdens and budget deficits of £1.6 trillion themselves, it is difficult to see how government is going to plug that hole.

With a deficit so large the government is in need of replenishing its losses. When you put money into your pension you are given a tax relief as an incentive to put more money aside for retirement. This costs the treasury a record £55 billion a year and the cost will only increase as auto enrolment contributions surge. Royal London Director, Steve Webb, warned that the treasury have already tinkered with tax-breaks six times since 2010 and undoubtedly has its eyes on the rising cost of tax relief. He said “my worry is that [the treasury] will be tempted to use the pension tax breaks as a ‘cash cow’ useful for dipping into whenever it is short of money.” An example of the government already dipping their sticky fingers into pensions is the life time allowance. Previously there had been no limit to the pension lifetime allowance prior to 2006 when it was set at £1.5 million, after which all further savings are heavily taxed. This rose to £1.8 million in 2010/11, and has steadily dropped in the years since. In the last three years alone, this allowance has reduced by 33 per cent, to a tax-free allowance of £1 million.

For those living abroad in the EU there could be possible repercussions as Brexit approaches. In March 2017, the British government announced it would begin charging 25 per cent exit taxation on all international pension transfers outside of the EEA or to a country without an HMRC qualifying scheme where the client is resident. Currently, those living within the EU aren't affected but it won't be long until they are. The government sees pensions as low-hanging fruit in terms of taxes, and are beginning to aggressively go for non-residents.

There is a gaping hole that is only getting bigger. In Security and Sustainability in Defined Benefit Pension scheme DWP February 2017 section 202  the government states that “apart from waiting for interest rates and gilt yields to rise, and/or for expected investment returns to follow suit, there are only four possible ways of improving the funding position of schemes: employer to pay more Deficit Repair Contributions (DRC) into the scheme; for the trustees to change their asset allocation to get better returns from investments; for the scheme to reduce liabilities by reducing benefits or restructuring exercises; and finally for the prudence in the valuation assumptions to be reduced (although this latter option would only change the perceived funding position of the scheme rather than actually change the cost of the liabilities).” The likely hood is unless markets deliver implausibly high returns, more and more companies will be forced to juggle the interests of workers and taxpayers.

What is the answer? The UK government’s response, “some individuals will request transfers out of their defined benefit pensions, and for some individuals, this may be in their best interest.” [4.11 Freedom and choice in pensions] If the UK government is suggesting for some people to move out of their DB schemes, then isn’t it worth looking into?

The essence of the problem is clear. Low rates and high taxes mean that employers and workers need to put more money aside for retirement. Many are either not contributing enough or ignoring a problem that seems a distant threat. They would do well to remember that in Augustus’s time the Roman Empire looked invincible. But the troubles that overwhelmed it were already taking firm root.

If you are interested in finding out more about your pension options, get in touch with one of deVere’s Executive Wealth Mangers, who specialise in pensions and cross border finance.