Unknown cost of DC pension schemes

WHEN IT COMES to budgeting, finance directors prize certainty, and this prize seemed at hand when companies introduced defined contribution (DC). The advent of DC promised control of pension costs through the careful planning and management of future budgetary requirements.

But the comfort of that certainty has given way, perhaps inevitably, to change, owing to the UK’s 2008 Pension Act and its soft compulsion regulations that require auto-enrolment of eligible employees into a qualifying pension scheme. It begins in October 2012 with compulsory 1% employer contributions, rising to 3% by 2017.

For finance directors, that once firm grip on DC costs stands to loosen even further in the coming years, as employer contributions could potentially rise to nine or 12% if the experience of the Australian market is a fair reflection.

This leaves UK companies with the difficult challenge of devising strategies to deal with escalating costs, unless they choose to simply incur them and suffer them as an additional tax. Instead, will they reduce employee salaries as a means to offset them? Or will they embrace a Total Reward approach to communicating salary and benefits as they adjust their pay schemes?

Variables abound

Complicating matters are a number of variables to consider in addition to cost-control issues. Typically in the UK, pension schemes have worked on a basic salary calculation when calculating employer and employee contributions to a scheme. However, personal accounts earning bands are more complicated; they grow from £5,000 to £33,000, and include all income, including that above and beyond basic salary.

In addition, companies must take into account such variables as:
• The number of existing scheme non-members
• Employees who become eligible by age or income before or after 2012
• Members who already qualify under their existing scheme
• Existing categories or schemes that might fall short of compliance
• Employees who opt out of auto-enrolment.

Employers who seek help with this planning can turn to existing tools to compare their position pre-auto-enrolment with their post-auto-enrolment situation from a cost perspective. With a good idea of the financial impact, organisations then have the opportunity to look at what the very minimum cost might be and at scenario planning. They can find out what the cost will be, for example, if they level down contributions or decrease pay to compensate.

However, companies should consider that enrolling what might be a large proportion of the workforce into a pension scheme overnight is more than just a matter of financial cost – it’s a benefit strategy and design challenge. For instance, many employers will have to start thinking about how this will impact on their administration, payroll and HR systems.

Tools and total rewards

Thus, a strategic approach calls for other strategic tools, such as Total Reward statements that help companies communicate the value of their overall benefits package, an important approach to managing the cost of auto-enrolment.

In Australia, for example, the total reward emphasis has been a major help in dealing with the cost realities of rising employer contribution levels. Indeed, prior to its era of compulsory contribution, salary in Australia was communicated much the same as in the UK – that is, the pound value of salary with any and all benefits considered separately. But more recently, companies in Australia have begun to communicate salary on a Total Reward basis, by which pay includes superannuation contributions.

For UK companies facing the auto-enrolment requirement of increased pension contributions spread over a period of years, an employee earning £10,000 for whom a 1 percent pension plan employer contribution is required can be said to be earning £10,100 on a total reward basis, with subsequent increases in total salary as the compulsory employer pension contribution rises each year. The pay rise may not be reflected as additional take-home cash, but it does represent a real increase.

Therefore, as employers go through the process of having to increase their pension contributions, lesser (or no) salary increases are accompanied by larger pension contribution increases, so total remuneration is increasing. The communication challenge is to make employees understand this through total reward statements and a strong HR emphasis on the value of things like pension contributions and auto-enrolment.

Employers may well view the total reward approach as an appropriate solution if it goes hand in hand with salary sacrifice – both methods can be used to good effect in controlling employer cost on the one hand, and clarifying that something is indeed being given back to the employee on the other.

For younger employee generations and those just joining the workforce, the total reward emphasis is the beginning of a new and different way of valuing their compensation. The emphasis on the full value of a salary and benefit programmes, as opposed to the sole focus on cash reward, could even bring about a cultural shift in how UK employees view their benefits, so that when they reach the point of changing jobs they may focus on total compensation rather than on just the cash element.

Ultimately, organisations that offer higher pay, but less in the way of benefits and employer pension contributions, may well be at a competitive disadvantage. Indeed, as the era of soft compulsion gets under way, it’s time for employers to view the cost implications as an opportunity every bit as much as it may be a challenge.

Steve Charlton is a principal and member of the Mercer workplace savings team