In the first post of this series explaining the history of UK pensions, we discussed the concept of a retirement income and the evolution of the state pension.
Unlike other European countries, the UK state pension was conceived as a basic income to keep people from becoming impoverished in old age rather than a way to replace a salary.
In addition, the state pension did not keep pace with the growth in earnings so it would not match inflation. This prompted the growth of a parallel source of occupational pensions.
According to the Institute for Fiscal Studies report The history of state pensions in the UK: 1948 to 2010, although workplace schemes had existed before WWII, they became good tool to attract talent in the tight labour market of the post-war years.
These pension plans are known as ‘defined benefit’ schemes. During the staff member’s lifetime their employer paid contributions into a separate pension fund. On retirement the employee would receive a ‘defined benefit’ – that is a specified income for life, which is linked to inflation.
Defined benefit pensions are the gold standard. There are three elements which make these benefits so valuable – they provide a specified income, you receive payment at long as you live and the benefits keep pace with inflation.
Even though defined pension benefits are such a valuable pension benefit, the number of people receiving this pension has declined rapidly over the last two decades.
There was no one change which made companies start to see defined benefit schemes as an expensive liability rather than a useful recruiting tool; it was instead the accumulation of a number of modifications which drove this reversal.
A decade of change
The first step in this chain reaction was The Financial Services Act in 1986 which stopped membership of occupational pension schemes from being compulsory. That made easier for companies to turn their backs on this employee benefit.
But it wasn’t until pressure on finance directors accelerated during the 1990s that companies really fell out of love with these schemes.
The decade started with the UK’s most significant pension scandal. After Robert Maxwell’s death in 1991, it emerged he had stolen millions from his own company’s pension funds.
This crisis led to The Goode Review in 1993, with most of its recommendations implemented in the 1995 Pensions Act.
The key outcomes of the Act was to establish an occupational pensions regulator, as well as a minimum funding requirement (MFR) to ensure pensions had a certain amount of cash and a compensation fund for pension schemes in the event of fraud.
Of these changes, the MFR created the biggest headache for finance directors. If a scheme’s assets were less than 90% of its promised benefits, this short fall had to be paid back in three years. If it was more than 90%, the scheme had 10 years.
In theory a pension scheme can make up a short fall by choosing assets with higher returns. But higher returning assets tend to also be those with higher risk so there is a good chance the scheme could be in even worse position at the end of those three years.
When assets cannot be relied on to generate returns, the responsibility for making up the shortfall falls to the company. And so MFR became an expensive headache for finance directors.
The added expense of the MFR was then compounded by changes to advance corporation tax. This was introduced in 1973 and required companies to withhold tax on dividends before they were paid to shareholders.
As pension schemes were not tax payers, they were allowed to reclaim the withheld tax thus increasing their dividend income. In 1993, the amount was reduced and in 1997 it was scrapped altogether.
In the 1990s actuaries were using a dividend-discount model to value equities. These two changes saw reductions in valuations of schemes’ equity portfolios.
The accumulation of these changes meant by the end of the decade many companies viewed these benefits as expensive and chose to close their defined benefit pension schemes to new members.
In the next chapter we will discuss how accounting standards sounded the final death knell for private sector defined benefit schemes.