Expert View: Pensions on the road to perdition

The unions are right: closing a defined benefit pension plan imposes the biggest cut in real incomes since the Second World War. Make no mistake, a pension is no more than deferred income. When defined benefit plans are closed and replaced with so-called defined contribution (DC) plans, not only is the investment risk transferred to the individual, contribution rates are usually cut as well.

The unions are right: closing a defined benefit pension plan imposes the biggest cut in real incomes since the Second World War. Make no mistake, a pension is no more than deferred income. When defined benefit plans are closed and replaced with so-called defined contribution (DC) plans, not only is the investment risk transferred to the individual, contribution rates are usually cut as well.

To fund a two-thirds final salary benefit typically requires contributions of around 16 per cent of salary over a working lifetime. More often than not, DC plan contribution rates are around 8 per cent. In the future, members may retire on something like one-third of final salary, provided they don't end up stopping work at the bottom of a bear market and when annuity rates are historically low. Should that happen, the result could be much worse.

This is a problem that all who are stakeholders in our pension system need to face up to together. But just who are the stakeholders?

First, and most obviously, they are those workers who are deferring their income, hoping for a dignified retirement. Second, they are the sponsoring companies which pick up much of the bill. Third is the Government, which has a real interest in a viable pension system, combining both state and private sector elements. Fourth is the next generation; they are the ones who through taxation or higher interest rates will pay the price if we get this wrong. And last are all those who work in the pensions industry.

Many factors have conspired to undermine our private sector pension system. The cost of providing pensions has gone through the roof, not necessarily for "bad" reasons, but they have to be paid for. In the last 20 years we have seen:

* Transfer rules for early leavers "improved".

* The introduction of limited indexation for transfer values.

* An increased regulatory burden after the Maxwell scandal.

* The coming imposition of a new accounting standard, FRS17, disliked by many as it will lead to volatility in company earnings.

In most parts of the world, governments provide a favourable tax environment to encourage pension savings, the so-called EET system. This means contributions into pension funds are exempt from tax, and so are earnings while the fund builds. Taxes get paid only when pensions are finally collected. In its first term, the Labour government started to tax the earnings of pension plans. It changed the rules governing advanced corporation tax, costing pension funds some £5bn a year.

Another problem is that we have all started to live longer. Don't apologise, but when state pensions were first introduced by Bismarck in Germany, few lived long enough to collect. Now a couple retiring at age 60 can look forward to 20 years plus of retirement.

Finally, many sponsoring companies, encouraged partly by the Inland Revenue rules on surpluses, and partly by the pressure to produce ever higher profits, stopped or cut back their contributions when equity markets were roaring. Now that equity markets have collapsed, they are faced with a very big bill indeed to cover unfunded liabilities.

Maybe the idea of growing up for 20 years, working for 40 and retiring for another 20 is an impossible dream for all but a few. Possibly the only way out of the bind that we find ourselves in will be for everyone to work longer. What is certain is that unless we face up to reality now, many of us will not be able to retire when we had hoped, and when we do, it will not be with the income we had been led to expect.

Alan Brown is group chief investment officer with State Street Global Advisors.