A new alternative in the middle ground

For companies torn between occupational pension schemes of the traditional final salary variety, and the laissez faire world of group personal pension (GPP) plans, money purchase schemes offer an interesting half-way house.

(See the article on defined contribution schemes for a discussion of GPP schemes.)

This is because while money purchase schemes have many of the features of GPPs, including defined contributions, they nevertheless operate inside the same legal framework as final salary schemes. What this means, among other things, is that unlike GPPs, money purchase schemes require the appointment of trustees. If this sounds as if the money purchase alternative presents an additional layer of complexity, it’s because it does.

However, one of the features that give such schemes an appeal not possessed by the out and out defined contribution route presented by GPPs, is that they are relatively easy for companies with pre-existing final salary schemes to set up. Moving employees from final salary schemes to money purchase schemes is technically somewhat easier and moving surpluses from the one scheme to the other is a great deal easier.

Duncan Buchanan, a lawyer specialising in pensions with the legal firm Garratt and Co, says one of the major advantages of a money purchase scheme for organisations whose final salary scheme is in surplus, is that the company is able to use the proceeds from the traditional scheme to fund the money purchase scheme which would not be permissible if the organisation had set up a GPP instead. “It is much more tax efficient for the organisation to use the excess in the fund in this way than to claim the surplus for itself,” he says.

The reason for this, he explains, is that under pensions legislation introduced in 1990, if the employer reclaims a fund’s surplus the employer has to ensure members’ funds are indexed so they are guaranteed to increase each year at the lower of 5% or the RPI. The employer also has to face a 40% self-standing tax charge on the reclaimed surplus that cannot be offset against any losses incurred by the company. It follows that there is far more benefit to be had by using the surplus in the traditional fund to finance the employer’s contribution commitments to any money purchase scheme, while the employer enjoys a contributions holiday.

That said, the fact that money purchase schemes require trustees is something client organisations need to think about carefully. Whereas in a GPP defined contribution scheme the employer can leave the responsibility for the investment policy to fall upon the provider and the member, in a money purchase scheme the trustees face the same responsibilities for overseeing the performance of the fund they do in a final salary context. This presents trustees with a peculiar dilemma, since in other respects the management of each member’s “fund” is much as with GPPs and will almost certainly be outsourced.

Johnny Campbell, investment director with Scottish Widows, says boards of trustees will want to define the investment practice to be followed by the scheme provider in a manner that will leave employees a reasonable level of choice. While there may be discussion and room for differences of opinion at the level of detail, as John Williams, client services director of the WM Company, explains, this will generally mean providing a portfolio of funds of varying levels of risk/reward ratios. Typically this might involve a bond fund, an equity-only fund, a mixed fund and so forth with movement between the funds varying as the fund matures.

A sensible pattern for orchestrating this movement between funds is the “lifestyle” approach adopted in GPPs, though here it is conducted at the level of the fund itself. As the fund itself matures, more of its assets are switched into low risk or interest bearing investments (whereas in a GPP this switch takes place on a graduated basis as the member approaches retirement). For a performance measurement organisation such as the WM Company, the consequent high rate of churn between funds has to be good news. For the providers of money purchase schemes, together with the attendant outsourced administrative services, it represents a real opportunity to “add value”.

While money purchase schemes can involve considerably more administrative overhead than final salary schemes, one of their attractions for companies with a high staff turnover rate is that it is, administratively, much simpler to identify the value of that employee’s holding on their departure from the company. Under a final salary scheme, by contrast, the company has to get the fund administrator to agree the amount to be transferred.

Opinions differ as to whether money purchase schemes have really taken off yet in the UK.

According to Williams, while they have been big news in the US for a long while, they are only just starting to show signs of taking off in the UK. However, Julias Persale, senior consultant with Mercury Asset Management, points out MAM already manages u1bn worth of money purchase schemes from a zero start base in 1989. “Over the last year alone we doubled the number of clients for whom we manage such schemes, taking our total client base in this area to around the 200 mark,” he says. The range of companies introducing such schemes has also broadened considerably. “In the early 1990s, our typical client company would have been a high tech or financial company, usually a subsidiary of a US parent. During the last year, however, the fastest growing business sector for us has been UK industrials.”

Like everyone working in this area, Persale recognises the fact that schemes which empower the members to make investment decisions between various funds have an educational responsibility. However, his concern is not so much that members will invest wildly, but rather that if they are left without guidance, they will err too far on the side of caution.

“If you give most UK employees the choice between investing their pension funds in the risky stockmarket or placing them in a building society, they’d all choose the society. But unless you get members investing in equities, they are not going to enjoy adequate pensions – it is a syndrome we call reckless conservatism,” he says. Making the transition from the world of final salary schemes, where they never had to give a thought to risk/reward ratios, to the very different conditions of the new money purchase regime, is tough and asks a lot of employees. “If you offer members ten different investment links, give them a fistful of brochures and tell them to get on with it, you are heading for disaster,” he says.

Around three quarters of MAM’s clients have opted to solve the “balancing” problem by adopting the “lifestyle” approach. As Persale notes, this satisfies the fiduciary responsibilities of trustees, since it can be shown to be both sensible and prudent as an investment strategy, and holds out the promise of reasonable returns for the fund in the long term.

More importantly, as Persale explains, a “lifestyle” scheme does away with what the pensions industry calls “interest rate or annuity rate risk”.

Sharp movements in annuity rates, predicated on base rate fluctuations, can be much more devastating to retiring members than a stockmarket crash.

With “lifestyle”, the slow drift over time of a member’s holding from equities to gilts does away with the crash-bang-wallop approach of shovelling the whole value of the fund into gilts on a single day. “If it is not counteracted, the effect can be really dramatic,” Persale says. “For example, someone retiring at the end of 1990 would have received, say, a pension of x. Someone retiring at the end of 1993 on an equivalent fund value would have received a pension of half x, thanks to the dramatic drop in annuity rates during that period.”

Another way for trustees to ensure their fiduciary responsibilities are being discharged is for them to choose a predominantly passive, index tracking strategy rather than an active management approach. This line has proved highly successful for Legal & General, among others. Bob Bridges, head of the company’s business development, says of the 200 new clients won by the company through 1996, over 60 of these opted for Legal & General’s passive money purchase schemes.

“We’re not against active management – far from it. We have a number of actively managed funds ourselves. But the fact is that active fund managers find a long-term competition against the index very challenging, so though passive funds by definition cannot outperform the market, they offer a very solid middle ground,” he says. Just as important, the costs associated with passive funds are typically a half to a third those associated with actively managed funds. This is a key point in money purchase where members bear most, if not all of the costs. As Bridges puts it, “active fund managers have to run a great deal faster just to keep up”, so index tracking funds often look better to trustees both from a risk/reward perspective and in pure cost terms.

Both money purchase and group personal pension schemes still have some distance to go by way of winning converts before they could be regarded as having overtaken the final salary scheme as the preferred way of securing the future of employees in their mature years. However, as both Bridges and Persale point out, anecdotal evidence – as opposed to hard market research – seems to show they are both very much on the increase.

Whether their onward and upward rise could survive another prolonged burst of high inflation, when minds tend to be focused more on defined benefit than leaky numbers, is perhaps more doubtful. But then who is to say whether or when high inflation will once again slip the leash and rule the land?