Is risk-sharing the way forward for occupational pensions?
We ask the experts for their answers…have your say online at: http://forumemployeebenefits.co.uk/
Tom McPhail, head of pensions research at financial services provider and asset management specialist Hargreaves Lansdown:
Can we salvage something from the wreckage of the defined benefit (DB) sector? At present, it appears that traditional final salary provision has no future at all; certainly not in the private sector and therefore, by extension, not in the public sector either. Corporate memories of the malignant effect of scheme deficits will take time to fade, so I do not think finance directors will be in any hurry to expose their employers’ business to such risks again any time soon.
So does risk-sharing have a role to play? There is certainly scope for employers to run and underpin final salary-type schemes with very modest benefit levels combined with a money purchase overlay. One potential issue I have with the Tories’ enthusiasm for such a scheme is that they seem to be looking at the issue very much from the public policy end of the telescope, focusing more on questions of how such a scheme could be used to cut means-testing, rather than on whether it would actually be workable for employers and employees. There are other alternatives, such as cash balance or conditional indexation, all of which can work.
I am concerned, though, that even with a hybrid scheme, members are still exposed to some risks. There is therefore a need to help them manage these risks effectively. The principal problems we currently face with the pensions crisis are inadequate contribution rates and the failure of members to engage with their pension. Hybrid schemes will not solve these problems.
John Reeve, a senior consultant at consultancy firm Premier Pensions Management:
Unlike the reports of Mark Twain’s death, reports of the death of DB pension schemes are not ‘greatly exaggerated’. However, the crime in modern-day pensions is not the death of DB schemes, it is the replacement of good-quality final salary schemes with totally inadequate defined contribution (DC) plans.
Some have suggested changing the law to enable employers to offer basic DB schemes in which some of the benefits (increases in payment or normal retirement age) are discretionary and based on sufficient assets being available.
Such an approach may well have benefited those who found final salary schemes too risky or expensive in the past. However, those who have already closed their DB arrangement are unlikely to reverse direction.
Increasingly, our challenge is to look at ways of encouraging employers to improve their DC offering rather than propose more manageable DB arrangements.
The adequacy of a pension in retirement depends on the level of contributions and the investment returns earned. Employers should be encouraged to pay more into their employees’ pension pots. Topping up employer contributions when times are good, which could be based on dividend payments, is already possible, but rarely done. Guarantees at retirement are more problematic, but it should be possible to develop ways of sharing the mortality and investment risk post-retirement.
Employers that offer to underwrite annuities, even if only in the early years after retirement, would be taking significant steps to help their employees. This is where our focus should be.
Nicola Bumpus, senior associate at law firm Pinsent Masons:
Current pension arrangements put the risk either on members (DC) or on employers (DB). DB schemes are too expensive and too risky for many employers, but DC schemes are often confusing for employees and offer a low pension on retirement. Cash balance schemes, which are effectively an enhanced form of DC scheme, are popular in the US but have yet to take off over here, even though they offer a way for members and employers to share the risks of paying for pension benefits. This could be a way forward for the UK.
Investment risk under these schemes is borne by employers. They give members a targeted annual investment return on their funds and top up the funding regularly to meet any shortfall in the actual investment performance. The trustees determine the investment strategy. This tends to be more effective because one of the problems with standard DC schemes is that members are often too conservative in their choice of investments or simply follow the default fund option. This is especially the case in the run-up to retirement, when members are worried about the value of their investments plummeting.
At retirement, an annuity would be purchased for the member using the assets in that member’s notional ‘pot’. The costs related to increasing life expectancy are therefore borne by the member.