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Seeking safety through defined benefits

Career patterns have changed irreversibly. Today's more fluidworkforce would seem to favour the transfer of ownership and responsibilityof pensions to the individual. So, why are companies continuing to offeremployee pension schemes at all?

Some people think the present and mounting enthusiasm for defined contribution schemes to be merely a fashionable fad sweeping through British industry. “We’ve been here before, you know,” one grizzled pensions consultant muttered wearily when quizzed on this theme. When exactly? “Oh, back before the last wave of high inflation sent everyone scurrying off in search of the safety of defined benefit schemes,” he yawned.

This is not what one tends to hear from more youthful practitioners, those still shy of their 55th birthday, let us say. Instead, what they point to is not a single similarity in the underlying economic conditions between now and when defined contribution schemes were last in vogue, (ie low inflation), but rather, the marked differences between life now and life even a decade back. Today’s workforce is on the move. No young person joining a company today expects to stay with the same company until retirement.

Defined benefit schemes, the experts say, are under pressure because, among other things, career patterns have changed irreversibly. This change becomes even more starkly visible the further back one goes, so the argument that the present rise in the popularity of defined contribution schemes is merely another slow revolution of the wheel of fashion misses the point, they say.

Perhaps, but the point in question is not a simple one. Frequent career changes may seem to favour transferring the ownership of and the responsibility for the pension fund from the employer to the employee – since individual ownership tends to favour pension portability among other things. But if that is the case, why is the trend not for a general move away from companies offering pensions at all? Why not let every man and woman look to their own pension through private personal pension plans and have done with it?

The answer appears to lie in a combination of factors. Two of the more obvious are: first, that UK companies still retain something of a paternalistic attitude towards their employees and would rather not adopt a completely hands off role, leaving staff to sink or swim unaided in their provision for their twilight years.

Second, employee pensions still form a part of the traditional reward package and, as such, employers would like to gain credit for their organisation for some degree of pension provision – even if that provision is more in the nature of an enabling gesture that leaves all the risk with the employee.

Switching to a group personal pension (GPP) scheme still leaves the employer with a role to play. Not only does the employer contract to contribute a fixed amount to the scheme, they can also retain some control over the administration of the scheme and they can set limits – by way of their enabling arrangement with the provider – on the rights of employees to manage their investments in the scheme.

Many feel, however, that all other factors aside, it is the concept of a fixed contribution that goes to the heart of the present popularity of defined benefit schemes. There is a growing belief now among some financial directors that traditional occupational pension schemes have been rendered too costly by legislation. For example, see the introductory discussion of the minimum funding requirements (MFR) introduced by the 1995 Pensions Act.

Although many aspects of the new legislation have cost implications, the MFR provisions are probably the most unsettling, bringing with them the possibility of long-term (and unpredictable) costs for the enterprise – even though most UK funds today are well inside the MFR requirements.

The problem is that the provisions of the MFR are likely to bite hardest precisely when companies are likely to be most strapped for cash – right in the middle of a general economic downturn when the equity markets are performing poorly. No FD can be entirely comfortable at the idea of his or her fund’s actuary demanding a substantial cash top-up for the fund when times are tight.

Coopers & Lybrand partner Neville McKay has recently completed a research project on corporate attitudes to final salary schemes versus defined contribution schemes. “What we found was real concern about compliance costs on the part of smaller companies,” he says. In general, he points out, there is a view that defined contribution schemes are less onerous for the employer.

FDs were also interested in the idea of transferring the risks associated with the fund’s ability to meet its obligations away from the company and onto the employees. According to McKay, there is mounting evidence to show that today very few smaller companies would consider implementing a final salary scheme.

At the larger end of the corporate scale, McKay says, the picture is a good deal more complicated. Experience to date seems to show that larger companies are looking to implement a mixture of the two strategies, with some companies looking to run both schemes side by side, leaving it to employees to pick the one that in their own view best suits their circumstances.

“The view now is that just going for a defined benefit or a defined contribution scheme is too simplistic. Big companies such as Zeneca and WH Smith are now looking at some very sophisticated and complex benefit structures,” he says. All of which takes us on to the rather complicated issue of just how best to structure defined contribution schemes.

Arthur Andersen human capital services consultant Carol Woodley is the author of a substantial study on “The switch to defined contribution”.

She, too, points out that the design of defined contribution schemes is “becoming more imaginative as these types of schemes grow in popularity”.

Woodley lists six types of scheme – and her list is by no means designed to be conclusive.

The first type she calls variations on conventional schemes. The “variations” all explore ways of counteracting the fact that pension schemes cost more for each pound at retirement as the age of individual fund members increases.

As she points out, level contributions therefore do not allow new entrants at different ages to achieve the same level of target pension. Ways of overcoming this include introducing age-related contribution rates, introducing service-related rates, or combinations of age and length of service rates – with a fourth option being contribution matching. The latter is simple enough and involves the employer in matching, or more usually, doubling, additional contributions made by employees, within pre-arranged limits.

Aside from contribution matching, the other three options have varying degrees of downside, which illustrates how tricky defined contribution schemes can be to set up. To start with, while the employer can, of course, offset the increased cost to the fund as members near retirement by paying more into the fund, it is not clear what business benefits the employer gets in return for this generosity.

Setting things up so that the contribution increase is service-related does have the merit of rewarding long service, which provides a clear business benefit in most circumstances. However, Woodley identifies a shortcoming here too, in that older entrants will not have large enough contributions to provide a reasonable level of pension. This is a point that can and has been made quite loudly in the press about defined contribution schemes in general and we will return to it shortly. The third answer, combining age and service related options caters for the older, new arrival by allowing for the appropriate, pre-defined, steep increase in contribution that will be required. However, you can only implement this type of scheme by building in a complex matrix, which takes away from the clarity of the reward structure. One of the themes emerging with defined contribution schemes – and money purchase schemes too, for that matter – is a concern that employees should be able to understand the schemes that they are signing up for.

So much for variations on conventional schemes. Next up is the hybrid already discussed above, where the employer offers a mix of defined benefits and defined contributions. The defined benefit element of these schemes acts as an “underpin”, protecting the member against investment risk.

Woodley gives the example of a scheme where a flat contribution of 10% of salary is paid by the employer together with 5% by the employee – and the whole is underpinned by the employer agreeing to pay a pension of, say, 1/80th of final salary for each year worked. This type of hybrid should be attractive to employees, since it offers them the best of all possible worlds, but this is achieved at a high cost to the employer in both cash and administrative complexity.

This can be made even more complex by applying a minimum and maximum annual interest rate to the member’s fund. Excessive returns in the good years could be creamed off to build up a fund to offset the costs to the employer of the guaranteed minimum return in bad years. Alternatively, Woodley points out, the employer can opt for a “with-profits” approach, which provides the same guaranteed minimum, with no upper limit. Here the scheme’s trustees (assuming it was operated within the framework of an occupational pension scheme) would look to hold back some surplus in excellent years in order to supplement the earnings in poor years, in order to meet the minimum level. Again, this kind of flexibility can only be achieved at the price of additional administrative complexity.

For something different, there is the option of drawing on the US experience.

Here Woodley picks up on the US “cash balance” approach, which has a lot more to do with defined benefits than it does with defined contributions, since the benefit is guaranteed to the member (increasing with time).

Each member, on joining this sort of scheme, gets a notional cash balance account set up for them and this is credited, according to some agreed formula, with a notional annual cash increment, which can be added to by pre-arranged levels of employee contributions. The general feeling in the US seems to be that the value of these schemes lies in the fact that members can identify the cash value to them of their accruing pensionable benefits – the point being to foster greater levels of appreciation for the overall reward package.

One of the reasons hybrid schemes are attractive to larger companies looking to take advantage of some of the benefits of defined contribution schemes is the fact that swapping existing members out of a defined benefit scheme can be a legal nightmare. Rather than renegotiating every member’s contract of employment it can be far simpler just to close the defined benefit scheme to new entrants, and steer them instead into a new defined contribution scheme. An additional level of flexibility can be gained through the company specifying points – relating to age or length of service – at which members could opt to switch between schemes. Setting contractual matters is not the only legal issue to be overcome. Woodley points out that early leavers have, by law, to receive benefits that are an “equitable portion” of what would have been received had the member stayed on to retirement. Any of the more complex schemes outlined above could carry with them the need to adjust the portable benefits to reflect the implications for the value of the member’s fund of all these additional parameters.

Since GPP defined contribution schemes shift the onus of responsibility for the ultimate solvency of the scheme from the employer to the individual member, they raise an interesting question as to how that responsibility can best be exercised. Companies setting up group personal pension plans (GPPs) by and large do not expect to administer such schemes themselves.

They almost certainly will not be in a position to offer personal pensions, of course, since that is a regulated activity. Therefore the administrative burden, together with the need to keep each employee appraised of what was happening to his or her fund at reasonable intervals, is being outsourced.

It is the institutions who now have to wrestle with the question of how much freedom they should be offering to individual members.

The problem, as Johnny Campbell, investment director with Scottish Widows, points out, is empowerment without knowledge can have disastrous consequences for members when they retire. One of the beauties of GPP schemes, he says, is that the employer does not have to do anything except collect the contributions.

There is no board of trustees, no one at all except the individual member and the provider – and of course the PIA. “One consequence of this direct relationship with members is that we as the provider, in common with every other institution offering GPPs, have to see that UK employees move up at least one level in their understanding of pensions,” he says. Campbell points out that while it is not necessary for employees to become investment experts, they do need to understand the basic difference between cash and equities. “We do not want to see up to 40% of people’s pensions being in money market instruments, for instance!” he observes.

The problem is that unless the scheme is set up from the outset to mandate a particular spread of funds, each member is, in effect, in control of his or her own pension and is, in the ordinary course of things, free to contact the provider and call the tune between various funds. It has occurred to many senior figures in the industry that the average UK employee is not exactly in possession of all the skills that such hands-on management might require. As Campbell puts it: “With GPPs, there is often nothing stopping any individual from pulling themselves out of something good and into something bad at any point.” At the heart of this debate is the long standing cultural divide between the US and Europe over pensions.

In the US ordinary working folk tend to have amassed a reasonable amount of experience in investment matters. A reasonably high percentage of the US population is accustomed, for example, to putting its surplus cash into equity-based mutual funds. By contrast, the British are more likely to pop their money directly into the local friendly building society-cum-bank for 20 years – something an investment-wise US worker would probably regard as more than a touch simple-minded. The provider’s ability and willingness to educate the workforce into an appropriate attitude to the range of fund options inside the GPP structure, then, is an increasingly important part of the overall package of services on offer to large companies.

It is, in other words, a key selling point.

Already there are strong stylistic differences between those providers who are enthusiastic proponents of the US model and those who favour the more paternalistic, traditional approach. What US pensions experts like to call “empowering the individual”, UK consultants tend to think of as abandoning the individual to his or her fate. This difference in attitude goes deep. Coopers & Lybrand partner Neville McKay recalls, for example, a meeting with his US counterpart who had trouble crediting the anxiety being felt by his European colleagues over the precise degree of control that it would be appropriate to allow to individual fund members in a GPP.

However, the predominant UK feeling appears to be that if UK finance directors are going to use GPPs and defined contribution schemes as a way of reducing the overall corporate contribution, which reduces the total pot available to the fund, then it is even more important to see that the fund’s assets are working hard. And there is a strong belief that whatever management of the fund there is, should not be misguided.

As Campbell puts it, “we need to make sure that a 25-year-old member does not have all his fund’s assets in cash, while a 59-year-old has all her assets committed to emerging markets”.

As the complexity and sophistication of the various options being deployed demonstrates, it is difficult to dismiss defined contribution schemes as “merely” a collective corporate retreat from the costs and responsibilities associated with the traditional occupational pension – as has been alleged from time to time recently in the press. However, this is not to say that everyone in the industry is committed to the idea that defined contributions are an advance over defined benefit schemes.

Andrew Waddingham, a director of consultants Barnett Waddingham, makes the point that one of the advantages of a final salary scheme is, as he puts it, the member can see from day one whether the end result is going to be good or not. “Tell an employee that you will contribute 5% of his salary to a defined contribution scheme and he hasn’t got a clue what the outcome will be,” he notes. This visibility of outcome is one of the reasons why surveys tend to show employers are more willing to pay substantially more into final salary schemes than they are into defined contribution schemes. John Williams, client strategy director of the WM Company which specialises in measuring fund performance, agrees there is a danger that many in the industry will be seen by the press and the public to be pursuing a vested interest in promoting defined contribution schemes – namely, lower costs on the part of the client organisations, new business opportunities on the part of the suppliers.

“The risk is that defined contribution scheme funds will both save less than would have been saved in traditional funds and that they will also not save in the best investments – so causing their members to lose out on two counts,” he says. Whether things will actually come to this pass or not will not be tested for a few decades yet – long enough for the current management in both providers and client organisations to be long gone.

Waddingham takes a still gloomier view. Employees are far from aware of just how much they will need to invest in order to secure themselves a reasonable old age. “People complain now about the level of the State pension. In the years to come the recipients of today’s State pension will turn out to be the lucky ones. Private pension schemes are peaking and they and the state schemes are going downhill,” he observes.

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