defined contribution. Archives - Financial Planning in Surrey

Golden handcuffs

Dominic Thomas
Jan 2023 • 6 min read

Golden handcuffs…

For many employees, a key reason to remain with their employer is because of pension benefits, however the playing field of employer pension schemes is far from level and the cynic in me questions whether Government tax policy is deliberately attempting to reduce the cost of pensions to employers, particularly the State employers such as the NHS.

Firstly, it’s important to understand the two basic types of pension. The clue to what they are is in the unusually straight-forward name.

1 – Defined Benefit (DB) or Final Salary Scheme

Your pension (benefit) is based on your final salary when you leave the scheme, whenever that is at the scheme normal retirement date (NRD).

The amount you get is a fraction of your final salary, your membership of the scheme and work for the employer builds your entitlement. So a scheme with a 1/60th rate of “Accrual” 25 years of membership would provide 25/60ths (41.6%) of your final salary. This will be inflation-linked within parameters set by the scheme.

The amount you receive has nothing to do with how much you contribute, that can be any amount (sometimes nothing). It is your employers duty to honour the agreement not simply for the remainder of your life but likely the remainder of your spouse’s life as well.

According to ONS data to 2019 (the most recent at the time of writing) there are about 7.6m active members (people still building benefits) of DB schemes, of these 6.6m are in Public Sector schemes.

2 – Defined Contribution (DC) or Money Purchase Scheme

These schemes are more straightforward in that they are investment-based schemes and the only guaranteed definitions are how much the employer is going to contribute as a percentage of pensionable salary (and the employee). How much this is ultimately worth will depend on how well the money is invested and the charges applied. Many employers use fairly cautious investment strategies in the misguided belief that this is better, yet as most people will save for their retirement for three or four decades, this will be rather like driving with the handbrake on.

The Auto Enrolment pensions that were introduced to automatically add staff to a pension rather than ask them if they wanted to join are essentially defined contribution schemes. They have been a success in the sense that more people are now saving into a pension.

The majority of employers do not offer a DB scheme, in fact hundreds have been closed over the years. There are barely any open DB schemes in the private sector, because they cost an awful lot to run and provide. There are roughly 10.4m people drawing a pension from a DB scheme and it’s fairly evenly split between private and public sector pensions. Remember that these are pensions payable for many years with a degree of inflation-proofing. Back in 2006 there were about 3m members of private sector DB schemes, half of them were closed, but by 2019 only 0.6m members were actively building benefits due to the number of closed schemes, deemed too expensive. Contrast this to the 0.9m members of open private sector DC schemes in 2006 which has risen to a whopping 10.6m.

To put a little more ‘flesh on the bones’ of the open private sector DB schemes, employers contribute a weighted average of 19.1% with employees adding a further 6.5%. Compare this to the weighted average private sector DC scheme where employers contribute 3.5% and employees just 1.6%. It doesn’t take a maths genius to work out that its much cheaper (by a country mile) for employers to provide a DC scheme, for which they pay annual contributions when their member of staff works for them and not a penny more thereafter.

Stating the obvious, if you are running any business, profit is what sustains a future; reducing costs increases profits (or should). The Public Sector cannot generally make quick and substantial changes like this. Generally the approach has been to alter existing DB schemes, with pensions starting later (65, 67, 68 as opposed to 60). Member employee contribution rates have increased – doubling in many cases. Finally, the rate of accrual has also been changed, often dressed up as better, but invariably forfeiting other benefits such as a lump sum. This is where most Union and legal challenges have been directed.

So taking a typical doctor who began their career paying 6% into a 1/80th pension scheme that would provide a pension for life from age 60 and a one-off tax-free lump sum. If they started working without any career breaks they might build 36 years of service (36/80ths) providing a 45% pension of their final salary (say £130,000) of £58,500 a year and a one off lump sum of £175,500.

If we exclude inflation, a same salary doctor will need to work an extra 7 years to get their pension at 67. They pay closer to 13.5% of salary to the pension and build it as 43/54ths of 79% of their salary (no lump sum)… but the Government was smarter than that, the maths isn’t really 1/54th of final salary, it’s of each year … the term ‘career average earnings’ captures this. A doctor starting out is obviously paid substantially less than one at the peak of their expertise and career earnings – so it’s nothing like a final salary but an average salary over 43 years. Taking the midpoint as an example, 21 years into a career – or retiring on a salary that you had 21 years ago. In fairness it isn’t quite like that, there is some inflation-linking, but this is detail you don’t need to know right now. The principle is how pensions in the Public Sector have been sliced and diced to save money.

When you add in draconian Government/HMRC rules about the Lifetime Allowance (a tax charge of 25% or 55% for those with pensions valued at over £1,073,100 and the Annual Allowance formula used, (which for many triggers a substantial tax on a pension income they have not yet had), it is very hard to conclude anything other than a deliberate strategy to remove higher paid long-term employees … like doctors.

So quite apart from the awful treatment medics often get in the media and utterly fictional suggestions of Consultants barely breaking from a round of golf to turn up for work occasionally, there is little wonder that most of them feel betrayed by a nation that they chose to serve. I can certainly tell you that from three decades of working with NHS doctors, I’ve not met any that became multi-millionaires through their work within healthcare. Some are certainly more entrepreneurial than others, but most of them simply love medicine and get satisfaction making a real difference in people’s lives, more likely describing it as a ‘calling’.

The reasons for the NHS being in crisis are complex and many, but part of the reason is that many doctors are being forced to reduce the number of sessions that they work or retire early so as to avoid a scenario where they are essentially paying more tax than the income they earn … actually paying to work. It is down to the Government and policymakers to have an adult approach to pensions and scrapping many of the really very badly thought through self-defeating rules.

You can read more articles about Pensions, Wealth Management, Retirement, Investments, Financial Planning and Estate Planning on my blog which gets updated every week. If you would like to talk to me about your personal wealth planning and how we can make you stay wealthier for longer then please get in touch by calling 08000 736 273 or email info@solomonsifa.co.uk

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It happened on the way to Essex (warning: dangerous information)

I was in the car, on the way to a client listening to the radio. Possibly I should have stuck with my own music, but decided to listen to some “news”. It was Thursday (yesterday) and the media was agitated about pension charges. The panel discussion was about as badly informed as it gets and if this was designed to reduce or remove confusion about pensions, then it failed spectacularly even on explaining the difference between a Defined Benefit and a Defined Contribution pension and proving the adage “a little knowledge is a dangerous thing”. Why a sensible IFA wasn’t asked to speak I have no idea. So I had better explain.

Firstly there are broadly two types of pension. A Defined Benefit, so called because it defines what you will get. More commonly known as a final salary scheme. This sort of pension is based entirely on your service and your final salary. Each year of service in such a scheme is built up at the rate of a fraction each each. So take a doctor or nurse, 1/80th each year. So a doctor or teacher that works for 30 years, the sum is 30/80ths (37.5%) of their final salary = annual pension (for life). Ok these schemes are changing, but the principles are remaining pretty much the same.

The other type of pension is an investment based pension. If you are employed and in such a scheme it is often called a defined contribution scheme… it won’t surprise you to learn that it is aptly named, because the contribution (the amount paid in by you and/or the employer) is defined – eg 5% of salary. However as its just an investment, the value of the pot will change… daily. So the value you end up with is based on what the pot is worth.

The row is over the charges applied to investment based schemes and whether they actually offer value for money as a result. A lot of hot air on the radio resulted in my exasperation fogging my windscreen, not a good idea on the M25 when it is grey and wet. There were a lot of inaccurate statements and very little placed into a context. So at the risk of boring you, I will attempt to do so.

Back in the 1980’s investment based pensions began to take the place of final salary schemes. Why? because of the liberated stock market (big bang) and a desire for people like you and I to capitalise on capitalism. There was also a growing (albeit muted) appreciation that people are living longer and therefore the old style final salary pensions were going to have to pay out for longer, costing employers a lot more money. Divorce rates were also rising, meaning that the spouses (and ex-spouses benefits) might also last a very long time. The rise of retail investment funds (Unit Trusts) which only began life in 1931 (thanks to M&G) became more widely available. Pension companies (a considerable number back then) ran their own investment funds using their own fund managers. Financial advisers were largely sales people that worked for pension providers. They were paid to sell pensions (and other products) from commission in the same way that pretty much every other type of selling works… the more you sell the more you earn (as a salesman/person)

Now you and I might think it a pretty bad idea that people are paid a commission to sell financial products. The advantage of hindsight is a wonderful thing isn’t it. However, most people, even in 2013, do not wake up and think that they should start a pension, or take out life assurance and sadly some people (most) need to be “sold” the wisdom of doing so (unless it isn’t appropriate for them = very few people). So “advisers” needed an incentive to incentivise the public. Yes it was a silly system, but in January it all changed. Every adviser must charge fees – properly. Surprisingly people are not jumping up and down with enthusiasm about this (on both “sides”).

Taking a step back in time, commission was paid based on the products type, the premium and the term of the “policy”… more for more. Then factor in some pension companies thought that they could offer a bit more for the “same thing” . This led to bias (you are not surprised). Bias between financial product and also financial provider. Simple example… you have £300 a month to invest. You could do so into a variety of “products” a pension, an endowment or a PEP (old form of ISA). The commission might range from £5,000 to £9 for a PEP.

Eh? well endowments paid very large commissions, they were generally 25 year policies and if I recall paid more than a pension. A pension though has tax relief but couldn’t be touched until 50 (back then) most though retired at 65, an extra 15 years on the policy term (commission is related to policy term too). A PEP, well it doesn’t have a term, its not a policy. It was a single investment of £300 that happened to recur. 3% of £300 is £9… each month. Not many advisers were going to advise a PEP not because they thought it was bad, but you would have to sell a lot of them to make a living. Other products though were “contracts” so you were agreeing to pay for 25 years. The product provider (names you know and possibly loathe for a variety of reasons) had a separate agreement with the adviser (well the adviser firm). Rather than pay £9 a month, they paid it upfront (£9x12monthsx25years = £2,700) for example. How? (with only £300 a month going into the pot)… it would surely take 9 months before £2,700 was even in the pot right? Well thats where some very “clever” accounting and charges and types of units comes into play. The details varied from provider to provider, making it hard for even good advisers to accurately compare one with another. In short, the commission was really a loan, if the investor (you) reduced or stopped paying, the commission loan would have to be back in full or in part.

This approach led to two key things. Firstly, people took out policies that they didn’t need or couldn’t afford. As a result advisers had to pay back commissions, invariably leading to a very high rate of staff turnover. Secondly there was an obvious pressure to sell, sell, sell… which meant a focus on new business and not servicing existing clients. The regulation at the time was as divided as the industry, independent advisers regulated by FIMBRA and Tied advisers by LAUTRO. The latter working for the insurance company, the former doing your shopping. However, even being independent did not prevent bias between solution (product) and provider selected. So in 1995… that’s 18 years ago! commission disclosure was introduced and at around the same time a single regulator was introduced (the Personal Investment Authority – PIA). You (and the adviser) could both see what the adviser would be paid. However both relied on standard projected rates of returns to work out which provider was cheaper than the other. Still smoke and mirrors, but in all honesty, nothing to do with the advisers.

Stay, with me…if you can. The regulator then decided that advisers should write proper reports, “reasons why letters” and also provide better data about who they were placing business with. The profession of advice began to evolve (slowly catching up with the IFP Institute of Financial Planning, born in the UK in 1984). The PIA became the FSA in 2001 and with it decided to end polarisation (tied/IFA) and added a third option “multi-tied” which confused things even more and enabled certain high street Banks to give the impression that they weren’t only peddling their own stuff. However to be independent, you had to at least offer clients the option of paying a fee rather than a commission. In January 2013, advisers were to be defined as either Independent or restricted and with both options, if you are arranging any form of investment, a fee must be agreed and paid – not a commission. Hooray, we finally got there and with another version of regulation – the FCA. In practice the regulator has said, your advice must not be biased and your client must agree the amount they pay for it. The results are yet to be seen, but in reality, most people cannot or will not pay for financial advice, because most people’s experience has been bad, sold duff products, that didn’t deliver and weren’t serviced.

The role of the adviser has altered dramatically, for all but the dinosaurs or stupid. A financial adviser is ADVISING you what you should do. A good adviser will be doing proper cash-flow planning, working with you on your actual goals and figuring out what you need to do to get there. A great adviser will also be helping you to assess risk and the returns you need, adjusting your portfolio and minimising the number of bad decisions you would otherwise make. A brilliant adviser will also keep you disciplined and focussed on what your goals are and help you avoid the 98% of the financial media that is a complete red-herring to your goals and life story. These people tend to call themselves financial planners, wanting to emphasise the planning work and disassociate themselves from selling products.

In short the skill set has evolved. You wouldn’t believe the level of research that is done these days. This is possible because of better technology and frankly better skills and a much better context. The truth, as painful and sad as it may be is that we have all messed this up at some point. Investors in believing in “free advice” and advisers in not being clear that it wasn’t, perhaps afraid to be. The product providers are guilty of making highly complex charging structures in order to pay for sales, and they have also effectively bought and bribed business. The fund management industry has overcharged and underperformed, manipulated data and set in motion a system that rewards big bets. The regulator has invariably focussed on the wrong things and hasn’t evolved as quickly to cope with some very complex financial instruments. In fairness though, it has had to take on more and more – now it is also taking on regulation of consumer credit – everything from a washing machines to a Ferrari (or Aston to Zanussi). However, the myth that is still perpetuated is that investing is easy and it is cheap. It is neither. I don’t care what massive “discount brokers” say or “money saving experts” they have all come from the same place and are focussing on the wrong things.

So (if you are still with me) back to the radio show. Statements about charges on pensions are very flawed, as flawed and silly as the charging structures themselves. Old style pensions were very pricey by today’s standards. Sometimes it is worth getting out of them, sometimes it isn’t. This needs careful consideration. Suggesting that 25% of a fund will be wiped out by charges is a foolish thing to say. It won’t, because you cannot invest for free. The charges are projections about a future that will not even happen. Returns are unknown. You are unlikely to have the same investment in 30 years time that you have now. The real menaces to investors are these:

1. Not reviewing your portfolio at least annually (and not being disciplined)

2. Not having clearly defined goals and objectives

3. Not assessing your attitude to risk and ability to cope with market volatility and therefore figuring out what returns you can accept and therefore what it will produce.

4. Running out of time, or money.

5. Not having a proper financial plan, that tells you when you have reached your goal and have “enough” (by your definition of “enough”)

6. The utter rubbish talked,written, recorded,filmed about money and investing

7. What the FTSE does is largely irrelevant to you

8. Government policy that messes with and creates a tax regime so complex that you need to pay an expert’s expert to decipher it.

9. Inflation, inflation, inflation, inflation…

10. The myth that you can get something for nothing, falling for the latest investment fad or fear.

You can have a successful investing experience, but you also need to be realistic. There are, and always have been some good advisers, some good fund managers, some good product providers and some good regulation. Life is not as binary as many would like to suggest. Over the years I have met some thoroughly decent people from all these camps. I have met advisers that I would trust with my own money – or my widows/children’s.

What’s more, this is not new. I set up my firm 14 years ago. I created a product neutral playing field, charging the same fee structure for investing in any form, in any product. I removed commission from new protection policies (which by the way is still available to advisers). I began to develop a proper investment philosophy and service and gradually began to use proper cash-flow planning. I have evolved, grown and learned. I made mistakes along the way, taking too long to improve in some areas and doing others too soon. That’s life. However I have remained consistent to the notion that my job is to improve my clients position, not make it worse. My long-term interests are best served by serving yours. Yes the financial services industry has a lot to answer for, it is miles from perfect.

One final point, here in Britain we seem to think that someone else will pay, that things are actually without cost. The very real and difficult truth is that we don’t really want to acknowledge that things have a price. Whether this is social security, care of the elderly, good education, quality teachers, good government, protecting children on the internet, a watchdog for the police, media, government, NHS, utility companies, stock market, financial advisers…or helping refugees and decommissioning weapons. Everything has a price and pretending that it doesn’t or it can be cheap is… well its like that big river in Egypt…. denial.

Footnote: By the way, the regulator does not think investors are capable of working out charges in a percentage format. They want charges expressed in monetary terms. So what hope do we have if people cannot even calculate what 1% is?

Dominic Thomas – Solomons IFA