The UK Pensions misselling saga and market conduct

The recent rise of Market Conduct regulation is probably due to the so-called UK pension fund misselling saga.

Regulators’ obsession with advice, intermediaries and the Retail Distribution Review (RDR) can be traced back largely to the UK misselling saga.

Understanding the transition

To correctly understand the whole saga, the provisions of pensions in general and the UK pension system in particular must be understood.

The transition to the modern industrial society from the largely agricultural society which started in 1760 brought with it a number of fundamental problems.

A system of welfare schemes

Firstly, the new economy was a wage economy. People could only survive if they had employment which was not always possible. Once they became old they could not work and thus could not earn an income. If they were injured at work, they could not work and could not earn an income. If they became sick they could not work and then also could not earn an income. These problems presented massive concerns to society which was “solved” by the brilliant German Chancellor Otto von Bismarck through state insurance schemes.

Bismarck introduced the world to systems such as worker’s compensation and state pensions. These are usually regarded as part of the welfare state but, as envisaged by Bismarck, they are not. These were not paid out of taxes. These are funded schemes, state insurance schemes, paid for by the beneficiaries by way of a pay roll tax.

Individuals were paying for their own benefits but, in the German example, administered by the state. These schemes spread throughout the world.

Top ups and augmentation

The UK introduced workers compensation but did not introduce a state fund. South Africa did. The UK also introduced a state pension scheme in 1908, and then after the Beveridge Report in 1947, introduced a more widespread welfare system. On the pension front the UK introduced a Basic State Pension (BSP). Unlike other countries the BSP was a flat rate system, not linked to salaries. The pension was also very modest. In short, for the average person the pension needed to be augmented, or topped up. And so as time progressed ways of topping up the BSP were sought.

As a result of this the Graduated Retirement Benefit (GRB) was introduced in 1959 which offered modest earnings related benefits. It was not a success as the benefits were meagre. Then, in 1978, the State Earnings Related Pensions Scheme (SERPS) was introduced which gave second tier earnings related benefits.

Employers and employees contributed to SERPS but could contract out of the scheme. Many employers also offered their own second tier top up schemes in the form of Occupations Pension Schemes. Employers included both public and private sector employers. Historically pensions were defined benefit schemes, benefits were earnings related based on the number of years’ membership.

Unsustainable systems

As society changed, people lived longer, families decreased in size and the proportion of old to young increased. It became clear that earnings related schemes, the defined benefit schemes, were building up massive deficits. This was referred as the Pensions Black Hole. In the private sector these were completely unsustainable.

In March 2016 the UK Pensions Black Hole was estimated to be £800 Billion. The promises made by these pension schemes could never be kept. The system would have to change and in terms of the new system pensioners would be much worse off. The Black Hole would not be funded but rather transferred to pensioners as lower benefits.

This would be the outcome with whatever new system replaced the old system. Thesereplacement schemes could not produce the same outcomes which had become unsustainable.

The private sector set about abandoning defined benefit schemes replacing these with defined contribution schemes. In the US, for example, by 2011, defined benefit schemes were only offered by 10% of private companies. In contrast virtually all government establishments continued to offer defined benefit pension plans covering 78% of the public sector workforce.

The public sector black hole is transferred to future taxpayers. An ever increasing proportion of current taxes would be devoted to paying retired former employees.

The important point to realise is whatever scheme replaced the private sector defined benefit occupational pension scheme, and the government SERPS would on the average, have to be, right from inception, be far inferior to theexisting schemes. They were designed to shift the financial burden away from the current schemes to the pensioners themselves. These would have to offer far lower benefits. The pensioners would, by design, be worse off.

A new pension dispensation

In 1985 and 1986 the Government then designed and promoted a new pension dispensation – the age of the Personal Pension (PP) scheme; designed specifically to reduce the government’s liabilities in terms of SERPS. Pensioners would be worse off – . Obviously they could never be better off. This is not what government marketing projected. Government advertising celebrated the new personal pension plan era unreservedly. Leaflets, newspapers, television commercials depicted workers in chains, gags, straight jackets or locked in boxes all now being liberated by the PP plan, and so individual pensioners were encouraged by the government to transfer to their very own PP plans.

The private financial market was encouraged to open and administer these new PP plans, and the market rose to the challenge. Some six million employees took to the new system switching to PP plans. At no time was it a condition that the returns had to be equal or superior to the existing defined benefit schemes. This was never built into the scheme. The private financial market was not required to guarantee equal performance.

The truth is uncovered

After a few years the truth was uncovered. Pensioners were, on average, far worse off under the new PP scheme. This was inevitable but instead of the government pointing this inevitability out, the private financial market became the scapegoat. The private sector was accused of misspelling the PP plans. The deliberate plan to reduce costs by reducing benefits to pensioners was repacked as misspelling by the financial market. The inevitable loss suffered by pensioners was then sifted onto the unsuspecting financial market as claims for compensation arising from misselling. The private financial sector could create, operate and manage the new private pensions but they could not make them more beneficial than the defined benefit scheme, . The private financial market never said it could.

The essence of the misselling problem was stated as, “the pensioner was sold a product which meant that he or she would be placed at an actual or potential disadvantage and the pensioner neither knew of, nor wanted, that disadvantage or the risk of it occurring.”

The defined contribution scheme places the pensioner at a disadvantage compared to the defined benefit. It is designed to do that since the defined benefit is now known to be economically unsustainable in the private sector.

The source of the pensioner’s loss was not bad advice. It was the move to a deliberately designed inferior system of necessity to reduce and ultimately get rid of the Pension Black Hole.