The 2008-09 credit crunch / banking crisis is of significant concern to almost all of us. Is our job secure? Are our savings safe? What will tax rates be next year? Am I now in negative equity on the house? By how much have my pension expectations been crushed?
To those of us in our 20s or 30s and not working in finance, pension expectations may seem rather less pressing an issue than losing our job next week. However if you really think that pensions are something you can sit back and ignore till your 50s, you're wrong.
Types of pension plan
There are two broad categories of pension plan: defined benefit (or "final salary") and defined contribution (or "money purchase").
In a defined benefit plan, the employer provides a guarantee of a post-retirement income for former employees. This is usually based on salary and length of service and typically will be of the form "X% of final salary multiplied by years of service". If, for example, X% is 2%, then a staff member retiring after 30 years of service will receive 60% of their final salary as a pension.
The plan will have assets and liabilities: the assets are the investments (shares, bonds, property, etc), while the liabilities are today's estimate of future pension payments.
More and more defined benefit plans have now closed, as they can prove rather expensive. Pension plans are often bigger than the company itself: the British Airways pension fund has liabilities some 6.5 times bigger than BA's market value.
The benefits of such plans vary widely, ranging typically between one-eightieth and one-fiftieth of final salary per year. For instance, 40 years of service on a one-eightieth multiple will get 40/80 or half of final salary as a pension income.
A defined contribution plan is rather simpler to describe: the employee and/or employer pay a fixed amount, usually a percentage of salary, and this is invested on the markets. The pensioner's income will then depend on how the investments perform.
The key difference between the plan types is who takes on the risk: for defined benefit, the employer bears the risks; while members of a defined contribution plan take on the risk of poor market performance themselves.
How big is my pension pot?
Quite likely, not as big as it needs to be. Let's do a simple example.
Consider each £1000 of annual salary. Ignoring who bears the risk, suppose an employee wishes to build up a pension income of 60% of final salary after thirty years of contributions - i.e. one-fiftieth per year. This means that the £1000 income this year will provide an annual income of £20 per year (£1000 ÷ 50) after retirement. At today's rates you'll need investments of at least £500 to achieve £20 of income. In other words, for each £1000 of your current salary, you need to save £500.
Go on - hands up if you pay 50% of your salary into your pension?
Exactly, I didn't think so.
What about the public sector?
A close family member retired a few years ago from a career in one of the government departments. He is now receiving a comfortable index-linked pension. After 30 years at Her Majesty's service, how big is the pension fund that pays his monthly income? Precisely zero.
Most public sector pensions are unfunded, meaning that they are paid from current budgets. In other words, today's taxpayers are paying today's pensions. With current employees not receiving their pension until later this century, their future pensions are certainly not this government's problem!
Let's get the scale right: we're looking at somewhat over £650 billion of public sector pension liabilities according to the BBC's Robert Peston, or around £25,000 per person paying UK income tax. Newspapers have bandied around various eye-popping headlines over how much debt we're all in now - the £25,000 per taxpayer is not the national debt, nor the impact of the credit crunch. It is the amount that each taxpayer - public and private sector - owes just for public sector pensions.
The Ponzi time bomb
Bernie Madoff, eat your heart out. The government has created the Ponzi scheme of all Ponzi schemes, too big even to shake a stick at.
Named after the 1920s fraudster Charles Ponzi, such a pyramid scheme promises unrealistic returns, with early investors being paid out from subsequent investments rather than from profits. In order to survive, the scheme must continue to grow exponentially, though it is destined to collapse eventually.
Typifying the short-termism of the current government's budgetary control is the Royal Mail pension plan. This scheme has serious problems: assets of £20 billion, but liabilities some £9 billion higher. Such a shortfall would cause problems for any pension fund manager. However the government has created what seems like a much neater solution. The assets will be absorbed into today's deficit, reducing national debt. In other words, "We've already spent it". The near £30 billion of liabilities will be added to the £650 billion, leaving the problem for the next generation and certainly the next government.
The UK's public sector pension mountain is not unique - in fact Schwarzenegger's problems with Californian police and firefighter pensions are well reported. European pension imbalances are considered by some a threat to the euro currency itself. In fact most developed countries (Singapore being the shining exception, with a fully funded scheme for all eligible citizens) must come to grips with the fact that (1) people are living longer, (2) people are reluctant to retire later, and (3) stock market returns are not predictable.
A solution?
Sadly, the only solution that would have a real impact is politically and socially impossible.
Private sector pensions can be modified or reduced without much political backlash. Towards one end of the spectrum are Enron and Equitable Life. But other radical changes have taken place, even very recently: in just the last week we have seen BP close its defined benefit scheme to new employees, as well as Barclays moving existing employees from DB to DC. Such changes are politically unpalatable in the public sector.
Should a government have the willpower, new civil servants should move to a defined contribution plan, at the very least. This is the "BP solution". This will cost more (yes, payments will be needed today, not when today's new recruits retire), but the impact is gradual. In fact so gradual that the benefits will only be realised in the second half of the century.
Somewhat more radical would be the "Barclays solution", changing benefits for existing employees, keeping the defined benefits they have already earned, but using a defined contribution plan from now onwards. This would mean changing employment contracts and would cause a legal minefield. Again, most budgetary benefits would be decades away.
Most radical of all would be to backdate a reduction in benefits. Although this would have an immediate reward for the chancellor's books, it would represent political suicide for any government attempting such a move.
There are no easy or palatable solutions. As public sector pension liabilities continue to grow, it will take a strong government to prevent them from ballooning even further out of control.
Whoever is in power next year, they have a tough job ahead.
For the rest of us: invest wisely, don't believe financial forecasts, and, above all, sit tight.
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