Issue 9 January 2006
The Pensions Commission Publishes its Second Report

On 30 November, the Pensions Commission (chaired by Lord Turner) published its second report setting out its detailed recommendations for reforming the UK pensions system. The report including appendices weighs in at 760 pages – the Executive Summary alone is 40 pages long! Whereas the recent reforms introduced by the Pensions Act 2004 were aimed at addressing some of the specific concerns about occupational pension schemes, the Pensions Commission’s report looks at UK pensions as a whole. It makes two key recommendations: the reform of the state pension system and the introduction of a new National Pension Savings Scheme (NPSS).

The Commission considered the possibility of introducing a single unified state pension, but has decided to retain a two-tier model (i.e. Basic State Pension (BSP) plus State Second Pension (S2P)). The idea is that the two-tier model will enable a gradual evolution of a higher state pension for all and will allow greater flexibility, but it does mean that the state system will remain complex. The Commission proposes that future BSP accrual is based on a residency test rather than on an individual’s National Insurance contributions, but that past accruals of BSP and both past and future accruals of S2P should continue to be based on contribution records. The BSP will rise in line with earnings rather than price inflation so that over time it will provide a higher pension. The intention is that the two tiers of the state pension scheme should aim to provide 30% of average earnings in retirement for an employee on average earnings.

This rise in state pension will be funded partly by an increase in public expenditure and partly by an increase in state pension ages. The report sets out two basic principles: that the proportion of life spent in retirement relative to the time spent in work should be preserved by raising retirement ages and that any increase in state pension age should be announced at least 15 years in advance. The report suggests an increase in state pension age to 68 by 2050.

The proposals for the NPSS are for a centrally run national scheme into which all employees would be automatically enrolled (unless they choose to opt out or unless their employer offers a scheme of at least equivalent value). Members will contribute 4% of their salary between the Primary Threshold (currently £4,888) and the Upper Earnings Limit (currently £32,760), employers 3% and tax relief will constitute another 1%. There will also be scope for members to make further contributions up to an approximate limit on total contributions of £3,000 per year. For an earner on average income, the default level of contributions will provide around 15% of average earnings in retirement and the additional permitted contributions would double that, so that a member of the NPSS who has been making additional contributions could expect a pension of 60% of average earnings (half from the state and half from the NPSS).

The report contains much detailed analysis of these proposals, and represents a significant attempt to address the potential UK pensions crisis. However, the Commission’s recommendations are still only proposals and the Government is now considering the report and is expected to publish a White Paper this spring setting out its detailed policy recommendations in the light of the report. Punter Southall hosted a session in December at which John Hills of the Pensions Commission was in conversation with David Willetts MP (Senior Advisor at Punter Southall) and he provided a unique insight into how the Commission reached some of its decisions. Please contact hati.oliver@puntersouthall.com if you would like to receive a summary of the evening.

UK Finally Implements the EU Pensions Directive

All EU countries were supposed to comply with the EU Pensions Directive by 23 September 2005. However, there have been a number of delays and the legislation implementing the directive only finally came into force on 30 December 2005. The key set of regulations is that relating to scheme funding – all valuations with an effective date on or after 22 September 2005 will now have to be carried out under the new regime, with trustees taking responsibility for the prudence of their funding basis. There are also further regulations implementing the EU requirements on investments, internal controls and cross-border schemes.

Pension Protection Fund Publishes its Third Consultation on the Levy

On 16 December, the Pension Protection Fund (PPF) published its final set of proposals for the Pension Protection Levy (see Technical Bulletins 7 and 8 for details of the earlier consultation papers). The third paper shows that the PPF have taken on board many of the criticisms of its original proposals and have modified their approach in a number of respects. They expect to finalise these proposals at the end of February 2006, with schemes receiving their invoices for 2006/7 in late summer 2006.

The PPF has announced that it aims to raise £460 million from the risk-based part of the levy and £115 million from the scheme-based part of the levy. This is around double the amount that was indicated at the time the Pensions Bill was first published in March 2004. The scheme-based part of the levy will be calculated as 0.014% of the scheme’s liabilities on a prescribed basis and the risk-based levy as ‘underfunding risk’ x ‘insolvency risk’ x 0.8 x 0.53. There will be an overall cap on the risk-based levy of 0.5% of the scheme’s liabilities – this represents a substantial change from the cap of 3% proposed in the first consultation paper.

The underfunding risk is calculated as (105% x liabilities) – assets. The PPF has proposed a few changes to the way this amount will be calculated. First, where schemes have assets of 125% of liabilities or higher, there will be no underfunding risk and hence no risk-based levy (previously all schemes were taken to have a minimum underfunding risk of 1% of liabilities). It will also be possible for schemes to include ‘contingent assets’ (assets promised to the scheme in the event of employer insolvency) in the calculation, but only if certain strict conditions are met.

Insolvency risk will be calculated by the credit scoring agency Dun and Bradstreet. The original proposal was for there to be 10 bands of insolvency risk, which would have led to major cliff-edge effects for schemes with employers on the borderline between 2 bands, but the PPF has now decided to use 100 bands, which will reduce such effects.

Finally, the PPF has indicated that it is delaying the date at which schemes must provide their first levy valuation (known as a section 179 valuation). There is now no requirement for schemes to provide a valuation until 31 March 2008 (this will be used in calculating the levy for 2008/9); however, schemes may provide section 179 valuations to be used in levy calculations for earlier years if they wish to do so (the deadline for valuations to be taken into account in calculating the 2006/7 levy is 31 March 2006).

The changes announced by the Pension Protection Fund are all welcome developments that show a body that is genuinely listening to the concerns that have been expressed. However, the fact remains that the levy will still represent a substantial cost to many schemes.

Other Recent Developments

Pre-Budget Report: In December, the Chancellor announced that Self-Invested Personal Pension Schemes (SIPPs) will not now be able to invest in residential property or ‘exotic’ investments (such as works of art, fine wines etc) when the new taxation regime comes into force on 6 April 2006 (A-Day). There has been widespread consternation at this U-Turn only 4 months from A-Day.

How to Avoid the Pensions Ombudsman: The Pensions Ombudsman recently published a handy guide based on real cases on how trustees should improve the administration of their schemes and deal more effectively with complaints, in order to minimise the risk of the case being referred to the Ombudsman.

Civil Partnerships: The first civil partnership ceremonies have now been performed and civil partners started to accrue rights to survivors’ pensions from 5 December. Although most of the legislation is overriding, schemes that have not yet changed their scheme rules to incorporate the civil partnership requirements may want to consider doing so, especially if any of their scheme members has entered a civil partnership.