Wednesday, February 21, 2007


Tories like to claim that the abolition of ACT is the reason for the disappearance of final-salary pension schemes, but is this really the case?

The main reason for the abolition of ACT was tax-simplification (which Tories claim they are in favour of). ACT was a convoluted nightmare for companies to calculate, and they welcomed abolition. However because ACT was abolished, pensions schemes could no longer reclaim the ACT that the company had paid. To compensate and make this revenue-neutral, the Treasury slashed corporation tax from 33% to 30% for large companies and from 23% to 19% for small companies. Cutting corporation tax increases a company's profits after tax, which the company can choose to either distribute as an increased dividend, (to make up for the inability to reclaim ACT) or retain within the company for future investment. As share prices are based on profits after tax (which are used to calculate Earnings Per Share), cutting corporation tax would have increased share prices, everything else remaining equal, which should have benefitted the pension schemes that had invested in them.

Therefore the abolition of ACT cannot be the reason that final salary schemes have closed. Yet it is indisputable that final salary schemes have continued to be closed to new entrants, and in some cases closed altogether. To find the true reason for this, one must go to the pensions legislation enacted by the Major government.

The first piece of legislation of importance is the Social Security Act 1990 (which came into effect in Jan 1991), which insisted that if a member left a pension scheme, their preserved benefits in addition to GMP must be revalued from the date of leaving the scheme to the date of retirement in line with the Retail Price Index. From 6/4/1997, this was changed to Limited Price Indexation (which caps the increase to 5% p.a.).

Therefore someone who had left a scheme aged 30 in 1991, with a preserved pension of £1000 p.a. would get £2097 p.a. at aged 60 if RPI averaged 2.5% p.a. between leaving and retirement. Prior to this act he would have got just £1000 p.a. at 60. This sharply bumped up the costs of final salary schemes, as most of their members are deferred pensioners (i.e. people who've left the scheme before retirement age because they've left the company).

The next piece of legislation to hit schemes was The Pension Scheme Act 1993, which insisted that the guaranteed minimum pension (GMP) part of a contracted out schemes preserved benefits, was subject to a minimum level of revaluation that applied to both public and private sector schemes. GMP accrued from 6 April 1993 up to 5 April 1997 of preserved benefits must have a revaluation equal to the Average Earnings Index (AEI) of 7.0% and from 6 April 1997 this is reduced to the RPI or a maximum of 5.0% a year..

The 1993 Act also changed the definition of Final Salary, introducing a concept called Dynamisation. The sharing pensions website says that "dynamisation allows for the definition of final remuneration for a scheme member to take into account increases in pensionable earnings that have not kept up with the retail price index (RPI). Any use of dynamisation will still be subject to the earnings cap. The earnings of the member during the definition years, say the best three years except the final year preceeding the retirement age, will be averaged and revalued in line with the increase in the RPI to give the final remuneration. Dynamisation will usually increase the retirement benefits in the form of a pension income and any commutation to a tax free lump sum for the scheme member."

Many of the provisions of the Pension Scheme Act 1993 were brought into force on 6th April 1997, (just before the general election) and all these provisions were very expensive as they sharply increased the payouts, which in turn meant that companies had to sharply increase their contributions to pay for them.

Some pension schemes were already starting to struggle under the 1990 act provisions and realised that the 1993 act provisions were unaffordable - HSBC's final salary scheme closed to new entrants on 6/4/1996 and WH Smith Pension scheme closed to new entrants in 1995. Other schemes hoped that stock market performance would increase faster than it had in the past (a fantastic expectation not borne out historically) and bail them out. But by 2001, this hope started to look forlorn and schemes such as Marks and Spencers started to revamp their final salary schemes this year.

One way to restore the viability of final salary schemes is to repeal the pension provisions of the Social Security Act 1990 and the Pensions Act 1993. But this would be very unpopular. The public expect that their preserved pensions should be revalued in the period between leaving and retirement, (which is why the Major government enacted the legislation in the first place) and they don't accept that companies can't afford them. Therefore the only option available to companies is to switch to money-purchase schemes, which will provide similar (and in some cases less) benefits to that which the member would get in a final-salary scheme if the Social Security Act 1990 and Pensions Act 1993 were repealed.

Re-reading what I've written, I'm conscious that I have included a lot of dense detail: but it's important people realise just how generous were the benefits introduced by the Major government, and how this contributed to making final-salary schemes unaffordable. I don't think Major's intentions were bad - like most people, he felt provisions and protections should increase with time. The lesson is perhaps that you can't go on increasing the benefits people get - at some point you have to say, this is the maximum we can provide.

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