Pension Simplification The Simplest Effective Pension Scheme and Ways to Make it More Complicated

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Pension SimplificationThe Simplest Effective
Pension Scheme and Ways to Make it More
Complicated

• Mike Orszag
• Head of Research, Watson Wyatt
• Chair, Research Committee, International Network
  of Pension Regulators and Supervisors (INPRS)
• Editor, Journal of Pension Economics and Finance
  (Cambridge University Press) (http//www.pensions-
  journal.com)

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In the UK we are the experts on complex pensions!

• 8 different tax regimes for pensions
• Larger number of overlapping legal regimes
• Huge pensions industry
• and sometimes high barriers to entry (and hence
  high costs)

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• Pensions are complex elsewhere too!
• US complex rules for coverage and benefits (to
  make sure less well off do well)
• Australia really complex tax system
• Finland complex partially funded system
  (funding dependent on employer size)
• Switzerland complex rules for pension guarantees

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• Outline
• What is the simplest effective pension scheme?
• Why do people want to make it more complicated?
  (There are some good reasons for complexity)
• Ideas from the UK about simplification (If it
  simplifies the UK, it will work anywhere!!)

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• What is Simplification?
• Simplicity is simplest possible way of delivering
  minimum standards but not simpler
• Simplicity is not simplifying standards or
  reducing requirements (this is called reducing
  benefits, not simplification)

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• Simplest Effective Pension Scheme (SEPS)
• Mix of insurance and savings
• Transparent benefits (so an individual can plan)
• Reasonably secure (so benefits are not at risk
  from mismanagement)
• Inexpensive to provide (so not a lot of money is
  spent on services and compliance)

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• INPRS Principles http//www.inprs.org
• 1. Adequacy. Proper assessment of adequacy of
  private schemes (risks, benefits, coverage)
  should be promoted, especially when these schemes
  play a public role.

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• 2. Rights of Beneficiaries
• Non-discriminatory access - age, salary, gender,
  period of service, terms of employment, part-time
  employment, and civil status
• Portability and Vesting
• Indexation

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• 3. Separation of Scheme and Sponsor The
  pension fund must be legally separated from the
  sponsor (or at least such separation must be
  irrevocably guaranteed through appropriate
  mechanisms).

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• 4. Funding
• Private schemes should be funded. Tax and
  prudential regulations should encourage a prudent
  level of funding.
• Private unfunded pay-as-you-go schemes at
  individual company level

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• 5. Level Playing Field
• Regulation should promote a level playing field
  between the different operators and take account
  of the usefulness of a functional approach. The
  fair competition should benefit to the consumers
  and allow for the development of adequate private
  pensions markets

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• 6. Investment
• Limits on self-investment
• Investment abroad liberalised
• Asset-Liability Modelling standards

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• 7. Disclosure.
• Appropriate disclosure and education should be
  promoted as regards respective costs and benefits
  characteristics of pensions schemes
• Disclosure of fees structure, plans performance
  and benefits modalities should be especially
  promoted in the case of pensions plans that offer
  individual choice.

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• 8. Winding Up
• Proper winding-up mechanisms should be put in
  place.
• Arrangements (including, where necessary,
  priority creditors rights for pension funds)
  should be put in place

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• Complexity Ways to Make it More Complicated (and
  Expensive).
• Governments favourite complexities
• Employer complexities
• Financial institution complexities
• Union complexities
• Individual complexities
• and finally Accidental complexities!!

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• Government complexities
• Introduce non-essential rules on discrimination
  (reason equity)
• Introduce complex tax rules (reason fiscal)
• Introduce complex rules prohibiting scheme
  modifications (reason protect members)

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• Employer (and Pension Fund) Complexities
• Discourage disclosure of underfunding (typical
  reason sponsors might discontinue because of
  costs of funding)
• Not define liabilities properly (typical reason
  so sponsors can avoid paying liabilities in cases
  of financial difficulty)
• Not define who has priority claim on liabilities
  (typical reason so sponsors do not have to bear
  full cost of pension liabilities)
• Opt out of state system (UK/Japan)

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• Other complexities
• Financial institutions and complex charging for
  individual products
• Individuals demand use of money before
  retirement for housing, unemployment, etc.

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• UK Developments
• Tax
• Benefits (Pickering)

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• UK Tax Changes Key Points
• Simplicity
• Full concurrency
• Flexible retirement
• Lifting of personal contribution limits
• Reduced compliance costs
• Framework for creative scheme design

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Controls Within the New UK Regime

• 1.4m lifetime limit (indexed with RPI)
• Personal contributions up to 100 earnings, or
  3,600 if greater
• 200k p.a. tax-free contribution/value of accrual
• 25 lump sum
• No benefits before age 55

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Lifetime Limit as Annual Income

• 1. Rates at 02/01/03 sources Annuity
  Bureau/Prudential
• 2. Bond yields (15 year) fixed 4.5. RPI (2.5
  inflation) 2.1
• 3. Guaranteed payment period Nil
• 4. Spouse benefit 50 of pensioner
• 5. Lifetime limit 1.4 million

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1.4m Lifetime Limit
Lifetime Fund
Tax
1/3 on excess over 1.4m
1.4m
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Valuing Defined Benefits

• Consultation
• Government favours simple table, which is likely
  to undervalue a defined benefit pension
• reduce need for conversion to DC
• Table kept under regular review
• Special cases

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Annual Accrual/Contributions

• 200k p.a. tax-free
• Excess taxable as benefit in kind
• Employer contributions fully relievable in year
  of payment

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Pension Requirements

• Start between 55 and 75
• Payable annually for life
• If unsecured
• maximum and minimum (1) annual income
• maximum reset regularly
• no return of capital after age 75
• Survivors pensions unlimited

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Pension in Payment Value Protection

• Minimum guaranteed period up to 10 years
• OR
• Capital protection

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Value protection

• Guarantee period
• benefit must continue as pension for duration of
  period (i.e. non-commutable)
• Capital protection
• cannot exceed initial value of benefit, less lump
  sum and pension paid
• any lump sum return is taxable at 35
• no lump sum return from age 75

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Death Before Drawing Benefits

• Test value of benefits against lifetime limit
• Apply recovery charge on excess over 1.4m
• Net value payable as
• lump sum (tax-free)
• income (taxable)

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Transition

• Consultation
• Benefits greater than 1.4m at A-day can be
  protected
• 3 years for member to register protection
• Protected value indexed (RPI)

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• Pickering Review
• Make scheme changes easier
• Eliminate or reduce indexation requirements on
  benefits

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• SIMPLIFICATION
• Simple as possible but not simpler.
• KEY IDEAS
• 1. Tax simplicity lifetime limit
• 2. Level playing field
• 3. Information simplicity Importance of
  disclosure