4.2 Pension funds

retiring in mid-1999 would have received 50 per cent more than a person with the

same contribution record, working for the same rm and retiring at the same age

in mid-2001. Given the problems (for rms) caused in recent years by schemes based

on dened benets, it is not surprising that many rms have begun to switch from

DB to DC arrangements.

The at-rate state pension in the UK is intended to provide only a minimum level

of retirement income. Most people wish therefore to make additional provision and

for many, as we have seen, this is provided by an occupational pension based upon

an accumulated fund of investments. However, not all employers operate such a

scheme. For this reason, the government introduced a state earnings-related pension

scheme (SERPS) in 1978. This too was to be funded from general taxation on a PAYG

basis. By 1988, however, there were fears that taxation (at levels which people were

prepared to pay) was unlikely to be sufcient to pay for these pensions. The main

reasons for this were that average life expectancy was increasing (meaning that people

would have a longer retirement during which to draw their pension) and that the birth

rate was declining (meaning that the number of working people paying the taxes to

pay the pensions would eventually fall). Indeed, at the time of writing, there are some

doubts that the core, at-rate state scheme can continue to be nanced by taxation in

its present form. This is an even larger problem for a number of continental countries

where PAYG arrangements are much more widespread than in the UK.

In April 1988, therefore, the decision was taken to encourage the private provision

of pensions, not linked to employment. The desirability of such a move was rein-

forced by arguments that existing occupational schemes were too rigid. Typically, an

employee who moved jobs, in the private sector, would be forced to terminate his

existing occupational scheme and begin another with the new employer. Like most

contractual investment schemes, pension funds pay the biggest rewards to those who

contribute for a long period. Thus, it was argued, people were deterred from moving

jobs because of the difculty in building up a long-term pension fund. Existing

pension arrangements, in other words, reduced labour market mobility. The desirable

alternative, it was felt, was for people to build up their own pension fund (a personal

rather than occupational pension) which they could take with them every time they

moved. As a further step towards the ‘privatising’ of pensions it was also made possible

for workers in an occupational scheme to make additional voluntary contributions,

with the customary tax advantages, into a private scheme operating alongside that

offered by the employer.

‘Encouraging’ such provision amounted to opening up the pension market to a wide

range of institutions, including banks and building societies, as well as life assurance

and traditional pension funds. (This provides another example of what we said at the

beginning of Chapter 3 – a pension fund is a nancial activity, not a distinctive type of

nancial rm.) Inevitably, perhaps, a great deal of effort went into the sale of pensions,

many of which were sold on commission, and what began as a sensible project to

provide certain groups of people with more exible pension arrangements and higher

levels of retirement income soon developed a reputation for the unscrupulous selling

of personal pensions to those for whom they were not suitable. The main examples

were cases where people with many years of contributions to an occupational scheme

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were persuaded to switch to private provision. It was always unlikely that personal

pension products could provide larger benets than occupational schemes, since

an employee in an occupational scheme beneted from the fact that the employer

also contributed. Furthermore, using the terms that we have explained above, these

private pensions were all funded schemes based on dened contributions. Inevitably,

therefore, some of those who switched to a private pension scheme gave up not only

their employer’s contribution to their retirement income but also his willingness

to bear the risk that the fund might not be large enough to pay the target income.

Fortunately, it is possible to establish retrospectively those cases where personal pen-

sions were ‘missold’. In 1995, the Personal Investment Authority (see Chapter 13)

insisted that pension funds should do precisely that and it estimated that there were

more than 300,000 ‘priority’ cases where compensation was urgently required.

As with other intermediaries, the nature of pension fund liabilities inuences the

composition of the asset portfolio. If the purpose of the fund is to collect ‘lifetime’

contributions in order to pay a pension that is related to nal salary or earnings, it

is obviously a fundamental requirement that an employee’s contributions be invested

in a manner which keeps their value at least in line with rising real earnings. As

we saw with long-term insurance funds, this inevitably means an emphasis upon

company securities.

Figure 4.2 shows the composition of pension funds’ portfolios in 2004. Notice

rstly that at £761bn the market value of pension fund assets at the end of 2004 was

second only to that of long-term insurance funds. Of this total, UK company secur-

ities accounted for over 29 per cent, and overseas securities, by far the greater part

of which are also company shares, accounted for nearly 23 per cent. UK government

Figure 4.2Pension fund asset holdings at end 2004 (£bn)

Source: Adapted from ONS, Financial Statistics, April 2006. Table 5.1B

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Table 4.1	4.2 Pension fundsNDTIs – some comparative features, end 2001
	Insurance companiesPension fundsUnit trustsInvestment trusts GeneralLong-term

Assets	109.7	967.3	760.9	279.2	48.1
Growth
2000–04 % p.a.
(compound)	1.2	0.3	0.4	1.7	6.0

UK co. securities
– holdings	18.5	392	223.6	161.2	25
– acquisitions	2.1	3.3	10.9	7.4	2.5

UK govt securities
– holdings	19.7	157	87.6	9.8	0.5
– acquisitions	0.2	15.4	0.5	0.9	0.1

Overseas securities
– holdings	18.2	150	171	98.1	21
– acquisitions	0.9	6.7	9.4	5.0	0.9

Net inow of funds

7.7

25.3

11.7

16.2

3.4

Notes and sources: All gures in £bn except growth rates. Holdings at end 2004, acquisitions and net inows during

2004. Figures taken or calculated from ONS, Financial Statistics, April 2006, section 5.

securities also formed a signicant proportion at 11.5 per cent. The rate of acquisi-

tion of these various classes of assets has varied from year to year. Since 1980, the

proportion of overseas securities in pension fund portfolios has tended to rise, inviting

the same criticism – that pension funds have hindered the nancing of UK industry

– that we saw levelled at life assurance companies. What Table 4.1 shows is that 2004

saw a marked shift out of UK company securities. Total net investment in 2004 was

£11.7bn. Much of this, and the funds switched out of UK shares, went into unit trusts

and ‘other’ assets.

Most of the funds owing into pension fund schemes are contractual; employees

have had little choice about contributing to such schemes. Contributions have also

been comparatively favoured by tax treatment. Successive governments have been

very careful to ensure that the benets bought from a pension fund are taxed only

once and strictly as deferred earned income. Contributions up to 17.5 per cent of

annual income are exempt from income tax and pension funds pay no capital gains

or income tax on their investments. The benets paid from the fund are taxed at the

rate appropriate to the pensioner’s circumstances.

Just as the tax position of pension funds is straightforward, so too, comparatively

speaking, is the regulatory framework. Most pension funds are strictly speaking trusts.

Their activities are therefore circumscribed by the terms of a trust deed and this deed

itself must comply with legislation governing the conduct of trusts. Any member of

the scheme who feels that the terms of the trust are being abused can seek redress

under trust law. To be exempt from taxation the trust must meet Inland Revenue

conditions relating to contributions and benet entitlement.

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This leaves pension funds with a wide range of powers over the selection and

management of investments, and this has attracted a degree of adverse attention

in recent years. The rst worry was noted by the Wilson Committee (1980). This was

that pension funds, like life insurance companies, were too willing to invest in over-

seas companies, by implication ‘starving’ British industry of capital. The Wilson

Committee found the case unproven, but the Labour Party and the trade union move-

ment suggested at the time that tax concessions available to pension funds should be

made conditional upon the repatriation of some of their overseas investment. More

recently, concern has grown in many quarters about the ethics of certain types of

investment. With hindsight, the beginnings can be seen with the British Rail Pension

Fund’s purchase of paintings in the mid-1970s. Although their capital appreciation

might eventually benet pensioners, it was felt inappropriate by some that a fund

should invest in ‘unproductive’ assets. In 1984, the National Union of Mineworkers

fought an unsuccessful legal battle to prevent their pension fund managers from

investing in alternative, i.e. competing, energy sources. More recently, investments

in tobacco, drug and oil companies and in rms using animals for experimentation

have been the subject of protest and workers have tried to inuence their pension

fund managers away from these.