The great pensions cock-up

It must be nearly 30 years now since my boss asked me to review all the company’s standard HR letters to make sure they complied with the law and company policy. It’s the sort of project you give to a recent graduate who hasn’t the experience to do much else.

As an example, my boss showed me the standard early retirement letter. Whoever had written it had simply copied over the standard ‘congratulations on your retirement’ letter and inserted the word ‘early’. The trouble with this, my boss said, was that early retirement counted as a dismissal, even though the employee had agreed to it. “People don’t early retire,” she explained, “the company early retires them.” Therefore the letter had to contain all the usual caveats about unfair dismissal claims that would go in a normal redundancy letter.

This set me thinking. At the time, lots of people were being early retired. I began to realise that what I had at first assumed was a generous company benefit for long-serving employees was actually a way for managers to sack those they considered to be dead wood without having a difficult conversation about performance. Then I had another aha moment. Under early retirement, at least some of the payment was covered by the pension scheme, so the cost of getting rid of people didn’t hit a manager’s budget in the way that standard redundancies would. He could therefore cut his headcount and still make his numbers.

Eventually, an embarrassingly long time later I’m ashamed to say, the penny dropped. The company had been keen to push up its share price and wanted to show that it was becoming lean and mean. At that time the pension fund was fat with surplus wealth. By using some of it to cover redundancy costs, the company could make impressive cuts to its workforce without hitting its profits.

I don’t remember anyone kicking up much of a fuss about this at the time. Perhaps the unions were happy to see their members get decent payoffs and didn’t think much about the longer-term consequences. Maybe they did complain but it wasn’t considered newsworthy.

The company I worked for was far from unique though. Raiding the pension scheme to finance downsizing was not unusual during the 80s and 90s. A 1999 Cambridge University paper by Michael Pollitt noted that the headcount reductions during the privatisations of this period were achieved almost entirely through voluntarily redundancies and early retirement:

[The government] was able to compensate most of the early losers – there were very few compulsory redundancies and generous early retirement and there were voluntary severance packages for those who left privatised firms as they downsized.

Workers do not seem to have got lower salaries as a result of privatisation if they remained with the company while those who left were re-employed elsewhere in the economy (unemployment fell from 1986) or went to early retirement.

Outgoing pensions minister Ros Altman cited this as one of the reasons for the dire state of occupational pensions in a recent article on her blog:

Then we come to the role of employers. They too could not resist getting their hands on the tempting pool of assets sitting in the pension funds. They used these to hide the costs of industrial restructuring in the 1980’s and 1990’s, by giving people generous early retirement benefits (paid for by the pension scheme).

As if that wasn’t enough, companies also started taking pensions holidays, claiming that the surpluses in their schemes would be more than enough to cover the retirement costs of the future. To make things that bit worse, Nigel Lawson decided to tax pension scheme surpluses just at the point when companies should have been building them up. As  Matt Hitchens of the Intergenerational Foundation says, the term ‘pensions surplus’ was a misnomer:

What looked like surpluses were actually necessary buffers for the increased costs of scheme maturity, when there would be fewer people paying in and more taking out.

Companies were instantly disincentivised from buttressing their funding position, exactly the opposite of what should have been happening. Companies were also buoyed by the appearance of surpluses, and took contribution holidays (when they didn’t add to the pension pots) throughout the 1980s and 1990s, believing that their funding position was so strong that they could afford to do so. As it turns out, they could not.

This has left companies with huge pension deficits. According to Oxford University’s Brian Bell, it is costing employers £42 billion a year to shore up underfunded pension schemes. The amount they are having to pay to keep their pensions afloat has almost doubled since 2003. This, he says, accounts for much of the decoupling of wages from productivity and overall employee compensation. While the amount of total compensation may be keeping pace with productivity, once the pension schemes have taken their cut there is precious little left for pay increases.

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This means that very little of the rise in overall compensation goes to those currently employed:

[T]he increase in non-wage compensation may provide no, or few, benefits to the currently employed. Because a substantial part of these payments are to cover deficits in pension schemes for past workers and those already in retirement, current workers benefit little from these payments.

He uses British Airways as an example:

BA spent £55 million funding a deficit in a scheme that provided a benefit to only 2.5% of their UK employees. If this money had not been required and had instead been distributed across the entire workforce as a pay increase, it would have represented a 3.8% rise. Some have ironically described the airline as ‘a pension deficit with wings’.

As the Resolution Foundation remarked, in its Intergenerational Commission report published yesterday:

The fact that younger workers have very limited access to the generous ‘defined benefit’ occupational pensions that were standard for many workers in previous generations may feel unfair in itself. But the impact runs deeper still. The circumstances that led to these schemes closing – consistent underestimates of rising life expectancy; low stock market returns; a long-term decline in interest rates; and overconfidence on the part of both companies and the government (meaning that both raided pension funds for other projects in the 1980s and 1990s) – resulted in large funding gaps. As a consequence, many firms now have to set aside large sums of money from today’s revenues to fund yesterday’s promises.

Importantly, a substantial amount of this money will form the retirement income of past workers and those already in retirement. In other words, billions of pounds each year is being extracted from the productivity (and therefore the potential earnings pots) of today’s workers to pay the retirement incomes of yesterday’s. While a similar principle underpins the State Pension – each generation’s taxes pay for the retirement of previous generations – the fact that younger workers are much less likely to hold defined benefit pensions means that this private sector generational transfer won’t be repeated.

Pension raids and contribution holidays, together with some bad planning and short-sighted tax policy, have left pension funds with a massive gap. Companies are now trying to cover this using money that might otherwise go towards pay rises. Those they employ are working to cover the cost of benefits they are unlikely to see themselves while seeing their own pay stagnate. The FT reported earlier this week that, because of the hit share prices have taken, Brexit will only make this worse.

The gains from the pension raids mostly went to swell the bonuses and share options of senior executives who have long since retired. Even the later baby boomers who came after them may not be so lucky. There is already talk of cuts to retirement incomes. According to the FT, one sixth of private pension schemes are close to insolvency and “will almost certainly end up in the Pension Protection Fund.” In other words, the liabilities will end up with the state and the pension incomes will be reduced. For those younger still, the likelihood of retiring with any sort of defined benefit scheme looks remote. Some of the middle managers who were sending out those early retirement letters in the late 80s will be coming up for retirement around now. Little did they know that every one was drilling a tiny hole in their own pension pot through which the funds would eventually leak away.

To call this the Retirement Heist, as one US journalist has described similar happenings over there, makes it sound more coherent and planned than it was, or, at least, than the British version was. What happened in Britain was as much cock-up as conspiracy, a mix of a bit of greed and a lot of short-sightedness. A few people did very well out of it. Many more benefitted from comfortable retirements, rightly because that is what they were promised. The rest of us won’t be so lucky.

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16 Responses to The great pensions cock-up

  1. Person_XYZ says:

    It’s a good job we are assured of young, skilled immigrants from the EU that will at least alleviate this problem, eh? Also, wasn’t it great the government engaged in blatant fraud on working people to give disproportionately wealthy pensioners the extortionate Pensioner Bonds?!?

  2. Metatone says:

    Perhaps we need to print some money and formally bail these schemes out. (Would be more humane to do it fully than just pushing them into PPF.) That would free up British industry more than any trade agreement. Of course, question remains, how do you create a sustainable but generous system for the future of retirement? (Obvious first step is raise retirement age, but is that enough?)

  3. duncan brown says:

    Agree with most of this. But you also need to mention change in the GAAP pensions valuation methodology and also reaction to Maxwell geuninely raiding his fund. And bit emotive, exec bonuses much more modest then

  4. Robin Stafford says:

    Yet another piece of the jigsaw of that complex set of factors that has brought us to the pensions mess we are in.
    So many articles just pick out one factor, preferably the one that suits a particular political agenda. Has anyone written a comprehensive analysis of all the various actions and factors over the last 20 years, and how each of them has affected pensions?

  5. ChrisA says:

    No – companies are not paying into pensions rather than into salaries. This is a rather fundamental misunderstanding of how economies work. If a company decides to do this and ends up offering a lower salary than the market as a result, then their employees are not likely to stick around, are they? And if your model is that companies are basically colluding monopolies, that can pay what they like and the employees have to lump it (a not very sensible model) then what sets their wages? The generosity or not of the boss?

    Reality – lots of people like pensions because of the tax efficiencies (even with many of these advantages taken). So companies into their pension funds because it is a cheap way of paying high income people, like the managers who set pension policy.

  6. P Hearn says:

    Thank goodness that before he saved the world, one of Gordon Brown’s first acts as Chancellor was to massively reduce taxes on pension funds by £5bn a year to avert future funding problems.

    Combining that huge reduction in tax with his radical reforms on pensions administration that ensured companies had no say over the funds themselves, and we’re in a great position today.

    Thanks Gordon – you’re the best.

  7. Simon Jones says:

    I too administered many of these early retirements in the public sector from the mid 1980s/early 90s.But I’m not sure you could call it a cock up or even short-sightedness by employers. The prevailing view was that your pension was deferred salary – in the public sector it was a compulsory deduction from your salary. Many staff – including middle/senior managers – saw their pension benefits, including early retirement enhancements, as their right for having had 5-6% of their wages taken from them for their entire career.

    The real issue is that the system could have continued – with modifications – had the Thatcher Government not created abolished the requirement for employers to put employees into a pension. This created the whole private pension scam and effectively left a generation without any pension provision. It’s a situation that auto-enrolment may correct somewhat in the future, but it’s clear to me that it was government policy in the 1980s that is the root cause of today’s problems.

  8. exIT says:

    What I remeber noticing in the 1990s was that companies with pensions funds which were substantially invested in equities and ‘in surplus’ were both unloading unproductive staff as a cost on the pension funds and taking contribution holidays. Gross profits thus improved, they were able to pay larger dividends which drove up share prices and caused pension funds to become yet more ‘in surplus’.

  9. lbc says:

    good luck to UK pensioners, who on top of all this, are about to lose the right to automatically reside in cheaper France/Spain where healthcare is good, and free…

  10. Dipper says:

    another top post and a subject I have clearly less knowledge about than both the author and some commentators.

    Surely the idea of a company final salary scheme is nuts, because of the results we are now seeing. It loads up some seriously large financial risks in the future over which the company has no control.

    I had assumed that companies funded their pensions according to the industry view of the time on matching liabilities and assets, and what has caught companies out is the double-whammy of pensioners living a lot longer than expected and yields from investments dropping much more than expected. The companies are in a real bind here because as ChrisA says in a free market you cannot just take it off the employees, and you can’t over-charge customers either, so the obvious thing to do is to go bust, walk away, and set up a company without these overheads.

  11. Dipper says:

    … and as someone with most of their pension in a money purchase scheme, I have often wondered about the true value of the public sector final salary scheme. Particularly in years such as 2008 when the massive drop in share prices and reduction in interest rates saw many public sector employees gain tens of thousands of pounds in net asset value over their private sector counterparts.

    I worked for Options businesses in the city, and have always liked the idea that a financial instrument is an instrument designed to provide an experimental measure of something. A share price is a measure of the worth of a company. A share option price is a measure of how risky the current price is in the view of the market. The instrument for the value of a final salary scheme would be the right of someone in a private company to opt out of their money purchase scheme and instead buy a final salary pension for the year’s salary they have just earned. This would have to have some assumptions in it for expected growth or inflation just as proper final salary schemes do. I expect that the money you would have to spend to buy this pension would be enormous, hence indicating the true value of a government backed final salary pension.

  12. Carnagey says:

    No mention of BoE’s role in this mess?

    The low rates and QE damage our economy in the medium/long term..

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