Like in the United States – and for many of the same reasons – there has been a shift in the United Kingdom in the provision of retirement benefits to workers by private-sector employers from defined benefit (DB) to defined contribution (DC) plans. The change has unfolded differently, however, in the two countries.
In the United Kingdom, most plans are closed only to new entrants – current participants continue accruing benefits under the old plan. In the United States, many DB plans have frozen accruals for all workers, and some are closed to new entrants. The overall rate of plan change is higher in the United Kingdom, and, most recently, there have been a few complete freezes.
While U.K. DC plans are generally less generous than the DB plans they replace, they function more like true retirement income programs. There is a legal bar against loans or complete distribution through a lump sum or a few payments, which are allowed in U.S. 401(k) plans. In the United Kingdom, the life annuity is the most common form of distribution from DC plans at retirement (although there are some concerns about the fairness of prices in, and plan participant acceptance of, the annuity market).
Another significant difference between the United States and the United Kingdom is in the area of government retirement income programs and policies. The United States, with an inadequately financed but somewhat generous Social Security system, has conducted many, thus far unfruitful, analytical investigations and political debates about ways to reform the system. Reform ideas include more cutting of scheduled benefits for some workers, further raising retirement ages and again raising taxes, as well as new approaches such as introducing personal accounts to replace part of, or on top of, system benefits.
By contrast, the United Kingdom, whose adequately financed system pays quite modest benefits, has decided recently to increase income benefits for lower-paid workers and for those with shorter work histories. To offset the costs, the system will eventually reduce relative benefits for middle- and higher-income workers and increase the retirement age for all workers, while maintaining the current level of taxation. At the same time, the United Kingdom will implement a state-directed and centrally administered system of add-on, personal 401(k)-like accounts. Employers that don’t sponsor their own retirement plan will have to match partially employee contributions (unless the employee opts out of the account). These accounts are intended particularly to help lower-paid employees and those working for small companies that are unlikely to sponsor retirement plans to accumulate resources to finance retirement. The new approach may also increase the overall national savings rate in the face of an aging population.
The remainder of this article provides more background and details about these and other related developments. While some aspects of the complex U.K. retirement income system are inherently and uniquely appropriate to that country’s politics, laws, financial markets and culture, other characteristics are similar to those of the United States or offer interesting ideas for evaluation and perhaps even emulation.
Employer-Sponsored Retirement Plans
Through the late 1990s, the majority of U.K. workers in large- and medium-size private companies were covered by DB plans. (Government workers were and still are almost universally covered by DB plans.) Moreover, these private DB plans were well funded, owing to munificent asset returns and high discount rates. In fact, this ample funding likely eased, politically, the imposition around that time by the government of requirements for price indexing of accrued benefits, thereby increasing plan liabilities.
As in the United States, however, the plunge in the stock market in the early 2000s, the rapid and deep drops in interest rates and the recognition of greater anticipated life expectancy caused U.K. employers to consider these plans costly and risky, as funding ratios fell noticeably and indicated contributions rose. Moreover, the imposition of stricter accounting standards (FRS 17) around this time, as well as some plan failures, made financial market participants, workers, sponsors and government policymakers especially aware of, and concerned about, the worsening funding situation. Over a relatively short period of time, sponsors closed a substantial majority of U.K. private DB plans to new entrants and replaced them with generally less generous DC plans. Indeed, in some senses, the shift in the United Kingdom has been even more dramatic than in the United States, which has had a better, larger and longer-established 401(k) regime, and a higher percentage of U.S. DB plans remain intact and open to all or were converted to hybrid plans (a form of DB plan where benefits are expressed as lump sum amounts rather than income annuities).
Around this time, the U.K. government reacted to plan underfunding by creating new regulatory institutions and rules for DB pensions that were simultaneously tougher and more flexible than in the past. The government established a new pension regulator (TPR) and a pension protection fund (PPF) (like the Pension Benefit Guaranty Corporation (PBGC) in the United States) in 2005. Plan funding became a central focus, as the formulaic minimum funding requirements were replaced with a more flexible, but considerably more vigilant, regime.
If a triennial review uncovers a funding deficit relative to the plan’s chosen liability measure, a plan of recovery must be filed with the regulator by the trustees. The regulator then reviews the assumptions chosen for calculating the liabilities (regulations require that these be prudent) and the method by which, and period over which, the deficit is targeted to be recovered. TPR has stated that the liability measure and recovery plan should take into account the strength of the plan sponsor. A financially stronger sponsor may allow relatively less cautious assumptions in the liability calculation, whilst a weaker sponsor should be reflected in more cautious assumptions and a higher liability. In addition, TPR has stated that sponsors should be paying off deficits as quickly as they can reasonably afford. From data published by TPR, it is understood that an amortization period of around 10 years is most commonly targeted, although there are no specific rules or even guidelines, and the results of individual reviews are not published by the regulator. The discount rate for the postretirement liability of the plan is generally set to be lower than the rate for the liability for preretirement accrued benefits. For different reasons, this practice echoes broadly the new U.S. requirement under the Pension Protection Act of 2006 (PPA) to use three segment rates, based on a usually upward-sloping corporate bond yield curve (at similar rate levels currently) to measure pension liability for funding and lump sum calculation purposes.
The PPF bases its new insurance premiums on a combination of a scheme-based levy, which is proportional to the plan’s liabilities, and a risk-based levy, which takes into account the level of underfunding in the plan and annual insolvency risk of the sponsor. The probability of insolvency is based on the Dun and Bradstreet failure scores, with the current relative range of premium charges, from financially strongest to weakest, being roughly 1 to 500. Overall premium levels may be changed by the PPF in response to its own developing financial situation; it also has an ability to reduce guaranteed benefits if circumstances warrant.1 It is interesting to note that the Bush Administration in 2005 proposed a similar reflection of the risk of the plan sponsor in new funding rules and PBGC premiums, as well as PBGC board-determined premium levels, but Congress decided not to include these provisions in the PPA.
There have been many market developments more recently in the United Kingdom in response to the closing of DB plans and the expansion of DC plans. TPR has taken a generally favorable attitude toward the use of contingent assets and escrow accounts in recovery plans. Some companies have chosen to secure the liabilities of their closed schemes with deferred and immediate annuities from insurance companies. Also, TPR has generally not taken any action (after careful scrutiny) following the assumption of plan liabilities by hedge fund organizations. (By contrast, in the United States, these innovations have been slower to emerge, reportedly because of skepticism expressed by the regulatory and political authorities.) There is an intense focus on an increasing rate of longevity improvement among the Interwar Generation of recent retirees and the creation of mortality bonds for hedging the risk of changes in mortality trends. This focus on mortality may be greater in the United Kingdom than in the United States because calculated inflation-indexed pension liabilities in the United Kingdom are more sensitive to changes in mortality rates than U.S. nominal pension liabilities, especially considering the very low level of interest rates on long-dated, inflation-indexed bonds in the United Kingdom (an inverted real yield curve) appropriate for duration-matching. Indeed, both countries exhibit much interest in the employment of liability-duration investing, as well as in asset-liability modeling. In the United Kingdom, this has apparently caused a perceptible reduction in the exposure to equities and an increase in international diversification of assets.
Owing to the existence of plan trustees, DC plans for larger employers in the United Kingdom are more likely to offer trust investments to plan participants than those in the United States. The obverse, of course, is also true: U.S. 401(k) plans, even those sponsored by large companies, are more likely to offer mutual funds and insurance contracts than are U.K. DC plans. This is despite broadly consistent international evidence that these “contract” investments are more expensive and may give lower returns than trust assets. Default investments are more widespread in the United Kingdom as the culture of investing is not as well established as in the United States.
While there has been considerable curiosity in the United States about using life annuities in 401(k) plans and there are interesting new product developments in annuity markets here, such interest is heightened in the United Kingdom because the use of annuities is essentially mandated by law. It is understood that this mandate arises from the existence of a widely accessible means-tested welfare program for retiree income in the United Kingdom; a similar program in the United States does not exist. Another policy reason is similar to the imposition of minimum distribution requirements in the United States – tax-advantaged savings should not cascade down the generations. Nevertheless, as in the United States, annuities are not well liked in the United Kingdom owing to their lack of flexibility and inheritability, and general lack of fairness to those with expectations of short lives. In response to the latter concern, however, an active “impaired lives” annuity market has developed in the United Kingdom. However, the likely consequence of this splitting of the general risk pool will be higher annuity prices to better-educated and higher-income retirees.
Big Changes in Government Retiree Income Programs
The current U.K. Social Security program includes two elements – the basic state pension and the state second pension (S2P). The basic pension is a flat benefit that is price-indexed rather than wage-indexed. Because wages generally increase faster than prices, the basic pension does a fairly poor job of replacing preretirement income. The S2P benefit is broadly dependent on the worker’s level of earnings between lower and upper limits. The system is broadly financed by an employee-paid tax of 11 percent of a worker’s earnings (up to 33,540 GB pounds annually2) and an employer-paid tax of 12.8 percent of earnings (with no limits), although some of these taxes are transferred to general support of medical, work injury and unemployment benefits.
In 2007, the U.K. government approved changes to both parts of the program. The basic pension will be wage-indexed (although applying to all workers, this change is particularly beneficial for lower-wage workers relative to higher-wage workers), and the S2P will also eventually become a flat benefit (also advantageous to lower-wage workers). These changes are expected to lessen the need to rely on means-tested welfare programs, and, of course, they make the overall program more progressive. In the United States, President Bush proposed progressive indexing in Social Security, whereby benefits of higher-income workers would be increasingly linked to prices rather than to average wages; lower-wage workers’ benefits would have continued to be linked to average wage levels.
Another important change in the United Kingdom is to shorten the number of years required to earn a full Social Security benefit – from as long as 44 years today to 30 years; also, time for child caring will be creditable for a retirement benefit. Both of these changes are advantageous to women. These moves contrast to discussions in the United States that Social Security should increase its benefit computation period from 35 years to 40 or 42 years in order to encourage labor force attachment among older workers. But the U.K. system does not allow for early retirement, as in U.S. Social Security, and indeed the pension age in the United Kingdom will be increasing, over a long horizon, from the current age 65 (60 for women) to age 68 for both genders by 2046. (In the United States, the full retirement age for Social Security is already scheduled to increase to age 67 – although the early retirement age remains at 62 – and there have been proposals to link the retirement ages with increases in life expectancy.)
While these changes in the “DB” portion of the U.K. Social Security program are important and significant, even more momentous, challenging and unpredictable is the coming system of personal accounts that will begin in 2012. This new system was proposed, in part, because of the apparent failure of an earlier reform – stakeholder pensions, to which employer contributions were voluntary – to cover most low-wage workers. Unless a U.K. employer offers a retirement plan of similar or better terms (almost all DB plans will qualify, so the “bite” applies mainly to DC plans), it must contribute 3 percent of pay into a personal account when the employee puts in 4 percent of pay and the government provides 1 percent of pay in tax relief, on annual earnings between 5,000 and 33,500 GB pounds (indexed to wages). The participation of employees is not mandatory, although because an “automatic enrollment” mechanism will be used for workers aged 22 and older, it is anticipated that participation rates will be high. (The Department for Work and Pensions (DWP) – the U.K. equivalent to the U.S. Department of Labor – is currently analyzing results from a survey of workers on exactly this issue.)
The personal accounts will be administered by an independent trustee board that will be set up in 2012. Before that, a Personal Accounts Delivery Authority is overseeing the development of the infrastructure for these accounts. Assets will be centrally managed through competitive contract bids by investment companies. The goal is for investment and administrative expenses for the accounts to range from 30 to 50 basis points; this would indeed be a notable achievement compared with other individual investment and insurance contracts available currently in the United Kingdom. The nature of the default investment given to personal account holders (similar to the Swedish experience, this is expected to be the predominant investment “choice”) is currently under discussion, although some form of “life cycle” appears most likely; indeed the DWP is currently conducting a survey of investment preferences and risk tolerance among workers.
No one knows yet whether or to what extent the personal accounts will succeed. Creating such an administrative system certainly will be challenging. Will automatic enrollment work, or will workers opt out either initially or eventually? How will employers, especially small- and medium-size ones, currently offering retirement plans react – will there be a least-common-denominator effect – a leveling down? (The DWP has conducted a survey of employers on this question and is currently analyzing the results.) And, a subject of current political debate, how will and should the eventual accumulation of resources in personal accounts interact with the extensive system of means-tested programs in the United Kingdom?
These are exciting and challenging times for U.K. retirement income programs, in both the private and the public sectors, as major changes have occurred or are being planned. The impact of these changes should be studied carefully, both to make mid-course corrections in the United Kingdom, and to help other countries, like the United States, assess their own changes and proposals.
1 Whether there would be the political will to reduce the level of protection has not yet been tested.
2 As of November 2007, 1 GB pound was worth about $2.