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Income
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Britain’s pension system: the 10-minute history

On this page we describe what a pension is. Then we explain how the pensions landscape has changed dramatically in recent years, with millions of people now able to manage their own pension savings to generate a retirement income.

We explain the conditions that led to the demise of Britain’s generous employer-funded pensions and how these same conditions affect a new generation of people managing their own pensions.

It is important that you understand this background because problems that would previously have been resolved by employers are now going to become problems that individuals need to resolve on their own. We explain how and why this has come about.

However, we appreciate that some will already be aware of this background and will want to get straight down to the job. If this is you, you can safely skip this chapter and turn to Step 1 of our five-step guide to generating retirement income.

What is a pension?

Simple: a pension is the money you live on when you’ve retired. Beyond that, there are some other definitions.

Sometimes the word pension is used to mean a regular income, similar to a weekly or monthly wage; the state pension, for example. When someone is already retired, they are likely to be describing a regular income when they use the word pension. “I can just manage on a pension of £250 per week,” someone might say.

But at other times a pension describes a sum of money, or an investment portfolio that is earmarked for retirement. This is what people mean when they use the term ‘pension pot’.

The pot is what’s been accumulated over the decades of a working life, made up of your own savings out of your income, plus tax breaks from the government and probably some contributions from your employer.

This pot is not an income in itself; it’s a pool of money that you have saved while you were working and that will need, somehow, to be turned into an income at the point of your retirement from work. The process of generating an income from this pot of money is the subject matter of this website.

Another use of the word pension is in referring to pension income entitlements, or benefits that you have built up through work that won’t be paid until you reach a set retirement age. These guaranteed entitlements usually apply only to older, and now less common, ‘final salary’ work pensions.

• The world of pensions is full of awkward jargon: read our glossary of pension terms here

How pensions used to be

Older generations will recognise the concept of giving a gold watch to long-serving staffers on the day of their retirement. Younger generations will never have heard of such a thing.

The gold watch was a tradition. If someone retired after, say, 25 or 30 years’ work with the same firm, the watch would be presented to the retiree by way of thanks. “You have given the company years of your life, now your time will be your own.”

The pension of the past was very much tied up with this paternalistic style of employment. If you worked for a big firm in the sixties, seventies or eighties, the chances are you belonged to the company’s pension scheme. And by today’s standards, the pension would probably be extremely generous.

What’s more, it was the firm’s responsibility to pay you the promised income for life when you retired. Individual employees faced no difficult decisions about where, when or how to invest money. It was all taken care of on their behalf. Come the end of your career, you collected the watch, went home, and what had been your earned wage in one month became your pension payment the next month.

This was called a ‘defined benefit’ company pension, as the pension you received on retirement was defined by the company. These are also known as final salary pensions.

For example, say you worked for 25 years with the same company and at retirement you were earning £55,000. Your pension would be linked to both your final salary and your length of service. A typical formula might grant one fortieth of final salary towards your pension for every year served. In that case your pension in this example would be £34,375 (25 years x 1/40 x £55,000).

Not everyone benefited to the same degree. But for millions this was the process by which comfortable retirement incomes were built. Many older people today – those in their 70s and 80s – are still benefiting from these generous, guaranteed arrangements, and as they look at how their children are faring in relation to pension saving they are realising how lucky they were.

When it is said that “the British pension system is the envy of the world”, it is generally this era of pension provision that’s being referred to. And sadly that era is no more.

Why the good days came to an end – and why it matters

What killed off the generous work pensions of yesteryear? This may sound like an academic question, but the answers have direct relevance to those who will need to look after their own pension income today. You can boil it down to just two factors.

The first is that people’s lifespans have mushroomed.

While today we generally expect our parents and grandparents to live into their 80s and 90s, reaching such ages is a surprisingly recent phenomenon. On average, anyone born before 1940 did not make it to 70. Today, a man who has reached the age of 65 is expected to live another 19 years. A woman of 65 today will live another 21 years.

These are averages, based on statistics crunched by the government and other institutions. In reality, of course, your own longevity is unlikely to exactly match the average.

But what these average figures show is a dramatic, and largely unexpected, lengthening in lifespans. That has generally meant longer retirements – which cost more.

When companies promised to pay staff a pension for life after they retired, say, at age 62, those companies may not have imagined that they might still be paying that pension 30 or even 40 years later. Because companies are under strict obligations to regularly recalculate the likely cost of pension promises, based on up-to-date longevity statistics, we are now very familiar with gloomy news regarding pensions and big business.

Business deals have fallen through because past pension promises have been deemed to be unaffordable. Some businesses have failed entirely because of such promises and the government has had to step in with a range of rescue arrangements.

The second factor is falling investment returns.

The assumptions about returns on investments change over the years. People whose main working and investing lives were in the 1970s, 1980s and 1990s would have a very different idea of normal rates of return from investments from, say, someone in their mid-30s today, whose only experience of saving and investing has been in the past decade.

Experience of the past forms our expectations of the future. And investment returns in the past were very different – and much higher. While the early 1970s were difficult, the stock market did very well in general throughout most of the second half of the 20th century. Annual returns averaging 9% for the period 1986–1996 are, for example, far higher than the returns we have become used to in recent decades.

Returns on cash have suffered a similar decline to that seen for shares: over the period 2006–2016 cash deposits lost value if inflation is taken into account and cash still produces very low returns today.

As companies were crippled with rising pension costs associated with their former employees living longer, they were also hit with lower returns on the investments they made to meet those costs. It was a fatal double whammy. While companies are bound by law to deliver pension promises made in the past, they do not have to offer similarly generous pensions to current workers and future retirees. And so they don’t.

In the past, the thorny issues of how long you might live, and how much it would cost to provide income for that indefinite period, was your employer’s problem. They paid your pension, so they had to find the money, somehow. But, as explained below in relation to the rise of the pension pot, now those problems have become yours.

You don’t know how long you are going to live. You don’t know how many years of income you are going to need. And you are going to have to make your own investment choices and other financial decisions about how best to make your retirement money last.

It’s not the purpose of this book to explain why investment returns have fallen in recent decades. But you need to choose your investments now (our suggestions are set out in Step 3) on the basis that returns may continue to be low for some time to come.

Longer lives and lower returns – the very things that put an end to the great company pensions of yesteryear – will also be the two big factors that shape the decisions people take with their retirement money in the years and decades to come.

The rise and rise of the pension pot

The death of the old-style, generous company pensions where your employer paid you a retirement income for life has given rise instead to the pension pot method of retirement saving. Apart from teachers, NHS employees and others in certain civil service roles, virtually no one who is working today has any other type of pension arrangement. For most people, it’s all about building a pension pot.

The technical term for the pension pot type of retirement funding is ‘defined contribution’. It’s something of a laboured term, typical of actuaries and insurance companies. It means your company pays a set amount towards your eventual pension each month: a defined contribution.

For example, each month at the same time as paying your salary, your employer automatically puts a part of your salary – say 2% – into a pension. Your employer also makes its own additional contribution to the pension – which may be the same percentage as that taken from your salary, or it may be more or less than that percentage. It is these percentages that are the defined contribution.

What happens to the pension contributions after that is down to where the money is invested by the pension provider, how those investments perform and a good dollop of luck.

When you come to retire, the total amount of money in the pot is your pension. At that point of retirement, the owner of the pension pot – that is you, the retiree – has a big decision to make about what to do with the money. Unlike with the old schemes, which as we saw were known as defined benefit, with the pension pot arrangement your company makes no promises about what income you will receive in your retirement; only the contribution made to the pension pot is defined.

That distinction is crucial. This is how the burden for providing income during retirement has shifted from the employer to the employee; from business to the individual.

If you have made monthly pension contributions from your salary with your current employer or past employers – which will have been shown on your payslip – then you will have one or more of these defined contribution pension pots. We describe how to get them organised in Step 1.

The shift towards the pension pot style of saving has been under way for decades. But developments in 2015 suddenly made it a great deal more significant.

The pensions revolution of 2015

History has still to assess the legacy of George Osborne, the chancellor under David Cameron during the latter’s term as prime minister. What is beyond doubt is that Osborne changed the landscape of personal finance more than any of his predecessors in living memory. He did this by tearing up the pension rule book.

His real objective? No one knows. Was it a political belief in freedom of choice for individuals, as Osborne said; or was it about saving money for the government at a time when the national debt was spiralling out of control?

In a nutshell, under Mr Osborne’s reforms, savers would be able to access their pension savings once they reached the age of 55. They could take as little or as much of the money as they wanted and spend it on whatever they liked. Gone were the restrictions that had previously required the money to be used to provide an income in retirement.

As Mr Osborne said so emphatically: “No one will have to buy an annuity.”

As far as you are concerned, in a practical sense these reforms mean that it has become your task to turn your pension cash into an income you can live on throughout retirement. This was viewed as a positive step in most quarters. Annuities had by then become the enemy of many pension savers.

For those who don’t know or who need reminding, an annuity is a form of insurance policy. You buy the policy with a cash lump sum at the point of your retirement. In return, the insurer pays you an income for life.

The insurance element is in the fact that no one knows how long you will live. If you live for a very long time you are protected: the income will keep on coming, and it will be the insurer’s loss. If on the other hand you die shortly after buying the annuity, you lose out and the insurer benefits from a windfall.

Before George Osborne, pension rules had made it more or less impossible to avoid using some or all of your pension pot to buy an annuity. But falling annuity rates – the amount of income insurers offered in return for a lump sum paid by someone of a certain age – had made them deeply unpopular.

By the time that Mr Osborne’s pension freedoms were announced, annuity rates had roughly halved in just ten years. In other words, you needed twice as much capital to buy the same retirement income.

The rocketing cost of an annuity

You’re 65 years old. You want to buy an inflation-linked income for life (annuity) starting at £35,000 per year.

• Cost of this annuity in 2006: £761,000

• Cost of the same annuity in 2015: £1.4m

Or, looking at this the other way around: You’re 65 years old. You want to buy an inflation-linked income for life (annuity) with your pension pot of £761,000.

• Annual income from annuity in 2006: £35,000

• Annual income from annuity in 2015: £19,000

Annuity rates express as a percentage the income you buy with your lump sum. So a 5% annuity rate would mean an annual income of £5,000 for every £100,000 spent.

It’s fair to say that annuity returns have become pretty poor. The fact that the pre-2015 pension rules virtually required you to buy an annuity was viewed as deeply unfair. Mr Osborne provided the key to freedom.

You might be reading this and wondering just why annuity rates have fallen so much and so consistently over the years. This is a technical subject and largely beyond the scope of this book, but very broadly the causes of this are the same two causes cited above for the end of defined benefit pensions: increasing life expectancies and falling investment returns.

The Lamborghini moment

George Osborne’s sudden liberalisation of the pension rules took politicians on all sides by surprise. Not everyone welcomed the move.

There were some who argued that the whole purpose of a pension system was to encourage individuals, through the provision of generous tax breaks, to build up an income that would last them through the final years of their lives. The state would thus be spared the cost of supporting them in old age.

This fundamental contract or purpose was being broken by Mr Osborne, it was argued, if now savers could do whatever they wished with the cash from age 55.

In the political debates and interviews that followed the announcement of the reforms, the pensions minister at the time, Steve Webb, raised the idea of “taking all your pension and spending it on a Lamborghini”. The concept stuck and, perversely, this Italian sports car marque has now become permanently associated with the somewhat less glamorous subject of pensions.

But the Lamborghini reference was effective: it underlined the sudden breadth of choice available to savers in their 50s and beyond. If they wanted to withdraw their entire pension savings as cash aged 55 and buy a sports car, they could do that. With that choice comes huge potential advantages – as well as dangers. This website aims to help you navigate them.