Brown and pensions: putting the record straight

HARVEY COLE finds sympathy for the Prime Minister and suggests that there may be another angle to the ‘pension raid’ story.

As Gordon Brown shifts across from 11 Downing Street next door to No. 10 (where, of course, he has already been living for the past 10 years), a concerted attack has been mounted on his so-called ‘raid’ on private-sector pension funds in his very first budget of 1997.

It is now an almost universally accepted folk-myth that Brown flouted the advice of Treasury mandarins and deliberately struck a damaging blow against the country’s personal pension schemes, impoverishing millions of people by billions when they came to retire. Strangely enough, no motive for such behaviour seems to have been suggested.

An annual loss of £5bn is laid at his door, and it is asserted that the consequence of Brown’s Budget was the collapse in company pension schemes in recent years, and, in particular, the abandonment of defined benefit versions.

While the 1997 Budget clearly had repercussions on pensions, it is best to start by putting it into context alongside other changes made by previous Chancellors, and looking at the impact of events, before rushing to judgement on Brown’s own contribution.

Company contributions and tax exemption

It is now more than twenty years since Nigel Lawson applied an embargo to c’ompanies paying further contributions into their pension plans for employees where they were already more than able to meet their prospective commitments on actuarial valuations. He threatened to disallow further payments by making them liable to tax as if they remained part of reported profits. Over the intervening period, this has deprived pension funds of money that would by now have grown to well over £100bn. Lawson was also clever enough to ensure that any discontent was levelled at the companies. The media accused them of meanly taking ‘pension fund holidays’ at the expense of their workers.

While Norman Lamont was at the Treasury, he actually made the first breach in the policy of exempting dividends paid to pension funds from tax. He cut the rate of credit from 25 to 20 per cent. Logically, this would have caused a quarter of the amount of damage subsequently put at Gordon Brown’s door – a very large sum according to the wilder estimates of the 1997 effect. Unlike Brown’s, Lamont’s cut was a simple revenue-raising operation, and not part of a wider-ranging package of reform of corporate taxation.

As Brown took office, pension schemes were having to take account of legislation passed in 1995, when Kenneth Clarke was at the Treasury. This provided that pension funds would have to build in an allowance 27 up to five per cent a year to give their beneficiaries a degree of protection against inflation. While the cost cannot be precisely quantified, it is likely to have been at least £3bn a year.

Brown was put under siege for failing to heed the advice he received from his officials. Not merely was that advice conflicting (as is usually the case when major decisions are under consideration), but important parts of it were simply wrong.

Thus, he was told that withdrawal of the tax exemption could be expected to lead to a collapse of share prices of up to 20 per cent in the immediate aftermath. That would have cut around £130bn from pension funds’ portfolios. In the events between the Budget and the end of 1997, share prices rose by 18 per cent – worth £110m or so to funds. In 1998 they went up by a further £85bn and another £150bn was added during 1999 – a cumulative total of almost £400bn.

Of course, the boom came to an end, starting with the collapse of the dot.com boom in 2000, followed by 9/11 the next year. Nobody seems to have detected the Brown hand behind either of these events.The level of share prices in London is still, seven years later, around five per cent below the peak of 2000 – and more like 20 per cent down if inflation over the intervening period is taken into account. That dwarfs any effect of reductions in net income from dividends. In any case, the size of its capital is far more important to the health of most funds than immediate income.

However, it is an over-simplification to regard the change in tax treatment of dividends as amounting to an annual loss of £5bn. Dividends paid in the four years following 1996 rose by a cumulative £20bn or so, of which approaching half went to pension funds. So, by 2000, they were getting almost the same net income. More important, many companies started buying back their own shares and distributing the proceeds instead of, or as well as, making conventional dividend payments. This money was tax-free and much of it ended up in pension funds.

Life expectancy

Apart from external events, pension funds were affected by changes in their own position. Undetected by the army of actuaries retained to advise them, life expectancy was continuing to grow – at the rate of two months for each year of a pensioner’s life. This severely affected the financial position of funds, which found themselves having to pay out pensions from their accumulated resources for longer than had been factored in.

This led to strict new rules to determine whether a fund was solvent or not. To a large extent, these were unrealistically theoretical, basically requiring funds to show they could meet all their obligations should they arise within the immediate future (instead of recognising that they were spread over long periods). This is rather like regarding an individual as bankrupt if he cannot show he has enough money in the bank today to pay all of next year’s bills tomorrow.

A very large part of the higher contributions and lower payments being made by pension funds is due to these elements rather than to the Chancellor’s activities. Ironically, the much reduced rates on annuities of which Brown’s critics complain as another example of his attack on company pensioners, is actually a reflection of the sustained low level of inflation (and therefore of interest rates). In real terms, a smaller pension pot eroded much more slowly by rising prices is to be preferred to a larger initial annuity slashed in half by soaring prices within six or seven years.

The final point about the 1997 Budget is that the ending of the tax credit was part of a package for reforming corporate taxation (an interesting example of simplification on the part of the great complicator living at No. 11). Company profits were taxed under what was known as Advance Corporation Tax. Shareholders then received a tax credit for the amounts already paid by companies to be set against their own bills (an issue against which the CBI had been campaigning for several years). Brown’s package ended ACT – and therefore the need for tax credits with it – but also cut the rate of corporation tax from 33 to 30 per cent. This should have enabled companies to pay out dividends on much the same scale as previously. (If they had retained part of the money, that would have tended to increase the value of the shares).

Equities carry more risk than gilt-edged and other fixed-interest stocks. By taxing income from neither in pension funds’ hands, the risk element in equities was artificially reduced, tempting pension funds to allocate too high a share of their funds to that class of investment. In 1997, the typical fund had well over 60 per cent of its money in equities, and the proportion was tending to rise. Had it reached, say, 75 per cent by the time markets collapsed, that would have added another £25-30bn to the capital losses which have still to be fully recovered. Brown may well have induced a degree of his beloved prudence in the minds of pension fund management.

All in all, it is very doubtful if the ‘hit’ from the 1997 Budget on pension funds amounts to anything like £5bn a year when all relevant factors are taken into account. Its impact certainly pales into relative insignificance compared with other events and changes in the past ten years. Put another way, without the rout of share prices between 2000 and 2003, or the undermining of solvency by rising life expectancy, Brown’s ‘pension raid’ would not have attracted any attention at all.

Harvey Cole is ECA’s economic and development consultant. He can be contacted on 01962 865930.