Setting employer contributions for defined contribution schemes

Setting employer contributions for defined contribution schemes is a complex business, and organisations will need to consider a range of factors, says Vicki Taylor

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On average, medium-to-large organisations make contributions of 6% to defined contribution (DC) schemes.

Factors to consider when setting contribution levels include affordability, comparison with competitors and an organisation’s attitude to employees’ retirement savings.

Employers replacing a defined benefit scheme may come under pressure to make higher-than-average DC contributions, particularly from unions.

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Setting suitable employer contribution levels for a defined contribution (DC) scheme is a complex business. The factors for employers to take into account include: what is affordable, what competitors in the market pay and the organisation’s attitude towards employees’ retirement savings.

Other factors such as the involvement of unions, particularly if an organisation is introducing a DC scheme to replace a defined benefit (DB) arrangement, might also have an influence.

Ben McDonald, a director in the pensions team at accountancy firm KPMG, says: “In theory, [employers] would like to make contributions at a level that provides employees with enough retirement income. In practice, organisations might carry out those theoretical calculations and find that the contribution rate is much higher than they want to pay.”

On average, employers with a workforce of more than 250 staff make average contributions of 6% into their employees’ DC schemes. In reality, however, staff need 15% of salary to be paid into their pension to retire in comfort.

John Foster, DC consultant at Hewitt Associates, says employers moving from a DB to a DC scheme might come under pressure to pay more than the average 6% contribution. But he adds: “In reality, many employers look at defined contribution schemes as a means of controlling and containing costs [so DB] is not a sensible benchmark in terms of setting contribution levels for the future.”

Ensuring contributions stay within the realms of affordability will also be a key consideration for employers. Ian Martin, head of pensions and retirement income at HSBC, points out: “Clearly, there is no point in an employer putting 20% of payroll into a pension and then going bust. There is a very real-world consideration of what the company can afford.” In addition, employees are likely to appreciate their employer’s contribution more if they have also paid into the scheme.

Darren Laverty, benefits consultant at Secondsight, explains that employers should also look at the sector they operate in when setting or reviewing DC contribution levels. He believes that if an organisation is only prepared to offer a lower contribution than its competitors then it might as well not bother. “I met an employer paying a 2.5% matched contribution and the average in the sector was just short of 6%. I said they should put it up [because it was] highlighting they were a bit mean.”

Paternalistic employers might want to start with the level of benefits staff will need to retire in comfort and work backwards. Factors to consider include likely investment returns for the plan, the predicted cost of an annuity on retirement and state benefits. Employers may also want to take account of employee contributions to drive down the organisational burden.

The white paper on pensions reform published earlier this year could also have an effect on employers’ contribution levels. Under the current proposals, it will be compulsory for employers to make a minimum contribution of 3%.

There are fears that employers which currently offer above this amount may scale it back to the minimum level. Those that already make contributions of around 3% may have to increase these for staff to continue to value the pension as a benefit.

Possible take-up rates may also need to be taken into account. While it is unlikely 100% of the workforce will choose to join the scheme, this eventuality should be factored into calculations to ensure it remains affordable