A NEW category of pensions has been outlined by the government as part of its attempts to find a compromise between defined benefit (DB) schemes, in which the employer takes all the risk, and defined contribution (DC) schemes, in which the employee bears all the risks.
Originally put forward in 2012 by pensions minister Steve Webb, this half-way house has yet to be fully defined. The principle involved has been dubbed “defined ambition”, or DA, to go along with DB and DC. The idea is that there should be a fairer sharing of risk between the employer and the employee, and the hope is that a fair arrangement will, as it says on the tin, “reinvigorate workplace pensions”.
The government wants to reach a point where companies stop bankrupting themselves through having made promises to pensioners which they can no longer afford to keep and employees don’t end up in poverty after a lifetime of work because their DC pension pots are woefully small.
The problem with current DC schemes delivering only rudimentary pension cover can be addressed in a multitude of ways. Contract schemes, where the deal is between the insurer and employee and where the employee is solely responsible for monitoring a fund’s performance over time, carry huge risks. Along with the risk of inertia, there is the risk of employees being overactive and switching in order to chase fashions in investing, which is usually a proven way of destroying value. Providing for a trustee board oversight of group pensions offers a better alternative, suggests Karen Tasker, associate director at Baker Tilly.
“The contract-based route to DC pensions is the cheapest and the least invasive, and is the least risk for employers. You simply put the members into an insured product and apart from administering payments and enrolment, the job is done. These schemes are regulated, but they are also pretty opaque to members,” she says.
Peter McDonald, chief actuary and head of human resources in PwC’s north of England business, points out that one of the compelling reasons for moving to a half-way house – of the kind being explored in defined ambition – is that DC schemes shift too much risk onto the employee and fail to use the company’s bulk buying power sufficiently.
“A company is in business to take risks in order to make a profit, so the question is to what extent there is value for the business in taking risks in terms of the benefits to be provided to employees,” he says.
Whether employees are aware of it in their younger days or not, they run a risk throughout their career that they will have insufficient pension to support them in retirement. It follows, then, that companies should be able to look to get a better performance from their employees by shouldering some of that risk themselves.
The problem is that the middle ground between DB schemes and DC schemes risks being neither one thing nor the other. For this reason, McDonald argues that the government should start again with pensions legislation if it is serious about DA, and existing DB and DC schemes would need to be moved to a new legislative framework that would allow them to run alongside each other.
“There are structures elsewhere in the world that could be used as a template for this, so redrafting the legislation is not like going to Mars – it is more akin to saying we need a new railway line. You know in advance that you won’t please everyone and that getting consensus will be tough,” he says.
But McDonald doubts that DA in any shape or form will make it into law this side of an election, though he says that, as growth returns, it will become more of a pressing issue. “This is something we need to build towards. Some form of DA has been spoken about for some time, but in the downturn it was a good idea at the wrong time,” he says.
One note of caution he sounds for employers is that the cost of running even standard DC schemes is likely to rise sharply in the years ahead. “At the moment, the minimum contribution the company has to make to a DC scheme is 1% of an employee’s salary. However, I expect this to increase rapidly to about 10%, which is a significant cost,” he comments.
In its submission to the consultation document, PwC warned the minister that, as there is a need to protect the current rights and expectations of employees regarding their existing pensions, any new DA scheme “creates overwhelming risk that change will result in further complexity and more regimes of retirement provision, which remain discrete and perhaps still incompatible (with each other)”.
According to Tasker’s reading of the consultation paper’s findings – published at the end of last year – it looks as if the pensions minister favours the Dutch system of collective pensions.
“You need to look abroad to see what works well and what doesn’t. There has to be an alternative to DC and DB schemes but everything has risks. The Dutch collective DC schemes had poor investment returns in 2013 and benefits were cut as a result. I am not convinced that DA as discussed so far is the right focus. The government should be encouraging people to veer away from contract DC schemes where there is no trustee oversight of performance,” she says.
David Fairs, a partner in KPMG’s pensions team, does not share the view that the UK is probably moving towards a Dutch collective model.
“From what I have heard, Steve Webb wants a more open and honest conversation. The problem with the Dutch model is that you are promised a level of benefit that will not happen if there is not enough money in the pot. I would say that we are more likely to go for the Danish model, which puts a big chunk of the fund into safe, low-return investments and a smaller chunk into higher returns in order to add a hedge against inflation,” he says.
The other huge point to be resolved concerns whether, and how much, the government will change the present annuity requirement if it moves to introduce DA.
“It would make sense for a DA fund to allow an employee approaching or at retirement to opt for draw-down instead of an annuity. That way, they could keep their pension pot invested in growth assets, instead of having to crystallise them into very low-growth assets like bonds,” says Fairs. This would enhance pensions and make it a much more effective vehicle.
Unlike McDonald, Fairs believes that it is possible that the government could bring forward legislation, with cross-party support, before the next election. ?