Pensions Supplement 2002 – Theory: In search of a pensions solution

The papers have gone crazy over pensions. Tabloids that once dismissed pensions as dull are now packed with headlines screaming: ‘Death Knell for Final Salary Pensions’, and ‘Greedy Companies Will See You Starve in Old Age’. And it’s hardly surprising, after-all pensions are undergoing one of the biggest transformations since Lloyd George suggested old people shouldn’t have to die in the workhouse. According to the National Association of Pension Funds (NAPF), in the last year, 46 defined benefit (DB) schemes closed their doors to new entrants, and 13 switched from DB to occupational defined contribution (DC). This is starting to look like a fundamental change in pensions. It’s standing room only on the bandwagon pulling out of DB, but before you climb aboard you need to think whether it’s right for you, and if it is, where you want to go. The most compelling reason to drop DB over the last five years has been increasing costs – driven by a mixture of political and environmental changes. The economic climate hasn’t been kind to DB. Lower inflation and low interest rates have meant poor investment returns, so pension schemes have had to invest more to get the same returns. At the same time, schemes are struggling with the effects of increased longevity. Pat Wynne, director of UK operations at Entegria, explains: “Updating the typical mortality table from 1998-9 adds 8% to pension costs.” You can’t blame anyone for these changes – except doctors and nutritionists for making people live longer. But you can blame the government for the growing legislative burden. They pulled off the double-whammy of abolishing advanced corporation tax relief and introducing the minimum funding requirement (MFR). The removal of tax relief on corporate pension investments meant that HM Treasury swallowed a chunk of any surplus. At the same time, MFR rules meant deficits had to be made up quickly, adding short-term volatility to pension costs. This volatility was bad enough, but the phasing in of FRS 17 will be even worse, because it puts these varying costs on the balance sheet. As the pension payments change, the profit and loss will fluctuate, the company accounts will wobble, and shareholders may start to panic. So it’s not surprising that financial directors are demanding change. David Bird, consultant with Towers Perrin, says: “The tolerance level has been reached. Companies are saying ‘we can’t fund pensions like this any more’.” But the financial director isn’t always the best driver for human resources decisions. Wynne explains: “Decisions driven by finance directors are going to keep the company afloat, but they may also alienate employees. Often they are saying ‘this is how much we’re going to pay – make the most of it’, rather than ‘we want this benefit, what must we pay?’.” But while the human resources department may have little power over whether pensions change, it can ensure that the changes match the human resources strategy. Bird advises: “Go back to first principles, ask why you have a pension, what you want from it, what your employees need, and place it within the context of the employment deal.” Many employers still prefer the philosophy of DB pensions. It may suit the culture of the organisation, particularly if you have a business where skills and training are developed over time and are highly valued, or where the organisation has a strong paternalistic culture. It may also be integral to your retention strategy. Wynne warns against leaving DB if it’s right for you: “You have to be careful you don’t just jump away from a tried and tested formula to something that will hurt employees in the future.” Retaining DB means the risks of investment volatility are still borne by the employer. The only way to make this palatable is to reduce costs, and introduce a cushion to absorb the impact of volatility. This can mean reducing benefits, or moving to a hybrid scheme somewhere between DB and DC. Hybrids include career average DB schemes, which base pensions on an average of salary over an individual’s career rather than their final salary. Ian Walker, manager of technical services at Buck Consultants, welcomes this idea because, “the employee isn’t left at the mercy of the investment markets”. Colin Singer, a partner at Watson Wyatt, also recommends a middle way, and although career average is the most common type of hybrid, he highlights other options such as self-insuring the annuity on a DC scheme, and providing cash balance pensions. These are average salary arrangements, which provide a lump sum at retirement rather than a pension – overcoming the risks associated with longevity. But although Singer recommends broader options, he recognises that most companies will simply move to DC. He says: “Decisions are taken by the board. They hear about the risks of DB and they want out. They don’t have alot of time to think about pensions, so they see DC as the way.” Fortunately this doesn’t have to damage employees. It will worry them because they have fewer guarantees, but DC has some advantages – especially for those who change jobs regularly. If you leave a DB (final salary) scheme your pension is frozen. So after 10 years in a 60ths scheme you’ll get a sixth of what your salary was when you left, which is likely to be considerably lower than your final salary. This will be indexed to prices, but salaries rise 2% faster than prices, so it will gradually lose its value. And as staff start to move around more, this will become increasingly pronounced. DC also works well with performance-based reward structures. DB (final salary) schemes don’t fit easily within bonus cultures, because employees may not earn their biggest bonus in their last year. And even if your benefits structure puts DB at the heart of reward, it’s worth considering why. Is it the best way to motivate people, or is it because the DB scheme swallows so much money you have nothing left to spend on bonuses, flexible benefits, or anything else? In this instance, a move to DC could free up cash to spend on the package. And DC doesn’t have to be inferior. Tim Webb, divisional director of the employee benefits department at Gissings, says: “DC schemes aren’t necessarily second-rate. If you put 3% into the scheme it probably is, but if you contribute 15% it’s another matter.” Unfortunately, not every employer takes this approach. Damian Stancombe, senior consultant at Punter Southall Financial Management (PFSM), admits: “Some companies are looking at it as a way to save money.” Once you do this you’ll be offering an inferior product, which will exaggerate the drawbacks of DC. A cheap DC scheme can cause recruitment problems. At Towers Perrin, Bird recommends that before you tighten your belt you consider your competitive position: “This is about attraction and recruitment. If your competitors are very generous with pensions it’s difficult if you’re not doing the same.” If you replace a DB scheme with a poor quality DC this will hit retention too. At Gissings, Webb says: “It’s a question of what your current employees think of it. If you’re trying to palm them off with a second rate scheme you can expect problems.” Entegria’s Wynne explains: “If you’re an existing member who will see an expectation or a promise watered down it’s a clear demotivator.” This is part of the reason why most companies changing schemes have only done so for new recruits. But while this limits negative reactions, it also limits the effectiveness of the move. At Buck Consultants, Walker explains: “Closing a scheme to new entrants is not an immediate panacea. It takes a long while for the liabilities to run off.” He warns it could also be storing problems up for the future: “If you provide DB to a closed group then the cost per person keeps increasing. So people will start to ask why you’re doing so much for a small group when you’re not doing it for everyone else.” If you decided to move to DC, you’ll need to weigh up the attractions of an occupational DC scheme, a group personal pension (GPP) or a stakeholder. Most companies chose stakeholder or GPP, especially if they have no history of running a well-funded DB scheme. This avoids the need for trustees which can save considerable sums in administration – but means a loss of control.Because individuals make their own investment decisions, employees can pick failing funds. Under the regulations the employer can’t encourage staff to move their investment, they can only inform them of its performance. Walker says: “An employer can say it’s down to the employee how he invests, and what he gets is down to him. But what happens to the workforce if someone who has worked for you for 30 years retires with far less than they were hoping for?” This is the drawback of giving people choices, but it’s easier for staff to tackle if DC fits within a broader culture of employee empowerment.This has meant an increasing number of companies are considering introducing flexible benefits packages when they move to DC. Instead of putting 20% of salary into pensions, companies can put 20% into the flexible benefits pot. At Gissings, Webb says: “The company has fixed costs and the employee can spend money on what they want, so they get a greater perceived value. It’s a win-win situation.” But while consultants recognise it’s a great way to get more out of spending the same money, the real challenge is to stop those holding the purse strings from seeing it as a great way to get away with spending less. Pensions speak Defined benefit (DB): Pensions with a guaranteed benefit pay out. Employer contributions vary to ensure the scheme is fully funded. Defined contribution (DC): Pensions with fixed contributions. Payouts depend on how investments have fared. Group personal pension (GPP): Personal pensions bought on a group basis. DC-style investments. Stakeholder: A DC-style scheme introduced by the government. Like a portable GPP which charges under 1%. Minimum funding requirement (MFR): Test to ensure employers have enough money in a DB scheme to meet liabilities. If the fund falls 1 – 10% below this level you have 10 years to top it up. If it falls further you have three years. FRS 17: Accounting standard which means that by the financial year 2003/04 pension fund investment levels will show on company accounts. Closing DB? Before you decide whether or not to close a defined benefit (final salary) (DB) scheme consider the following questions: – Can you handle fluctuating DB costs? – Will your shareholders cope with volatility on the balance sheet? – Do your employees value DB enough to make it worthwhile? – Are they likely to stay to retirement age? – Can you recruit in your market with a defined contribution pension? – Which sounds most like your business? a) Long-service, paternalistic culture with low staff turnover, and little performance-related pay or bonuses. b) High-turnover, empowered culture with performance linked to reward and a strong bonus culture. Opening DC? If you’re leaving DB and wondering where to go next, it’s worth considering the following questions before you start: – Is the problem with defined benefit (DB) cost rather than volatility? – Is a DB pension fundamental to your recruitment strategy? Yes: consider a hybrid DB pension scheme. No: Ask yourself: – Are current pensions fundamental to your employee relations? – Would taking away a defined benefit pension have a devastating effect on morale? Yes: Consider closing a DB scheme to new entrants only and opening some kind of defined contribution (DC) scheme. No: Consider closing DB to all members and opening a DC scheme. – Are you happy retaining the administration of trusteeship? – Do you want involvement in the investment decisions members make? Yes: Consider an occupational DC scheme. No: Consider a stakeholder or group personal pension.