Additional voluntary contribution pension schemes and alternatives

Enabling staff to make additional voluntary contributions is a good way of helping them boost their pensions savings, but with traditional schemes becoming outmoded, Ceri Jones looks at alternative options

Providing a scheme for employees who are minded to boost their retirement savings should, in theory, be perceived as a valuable staff benefit and retention tool.

Under an additional voluntary contribution (AVC) scheme an employee can put in either £3,600 per annum or 100% of their earnings to benefit from tax relief at their marginal rate of tax, subject to the maximum total annual allowance for pension contributions, which is £225,000 for the 2007/2008 tax year.

However, traditional AVC pension schemes are beginning to look somewhat outmoded. Managed by insurance companies, often using antiquated legacy computer systems, their administration can be poor. In addition, many traditional AVC schemes offer only a limited choice of investment options.

New structures for collecting additional employee premiums are starting to evolve. Under the pensions simplification rules introduced in April 2006, it is now possible for employees to concurrently be a member of both an employer’s defined benefit scheme and a group personal pension, if perhaps one has been set up for new staff. Allowing a scheme member to pay AVCs into the employer’s GPP can deliver economies of scale for the sponsor as it will only have to deal with one set of defined contribution scheme processes and reconciliations.

For the member, there is likely to be a wider choice of funds. The sponsor may also wish to pass administration costs on to the member under a GPP, rather than stick with the usual practice of assimilating the charges involved in AVC schemes.

Actuary Simon Jagger of investment consultancy Jagger & Associates, says: “We have seen occasions where employers and trustees are concluding that they no longer want to run their old AVC scheme unless they absolutely have to. They may only have a handful of employees with AVC policies but the knock-on effect of some of these archaic systems can be very difficult.”

Another consequence of pensions simplification is that members are now able to use up to 25% of their AVC fund as tax-free cash, with the result that less of the main scheme is taken as a cash lump sum. This will impact costs as converting pension to cash is perhaps 20% cheaper for the scheme than providing the pension. So these can rise by around 5% overall in respect of any member who, prior to the new rules, would have taken the full tax-free cash allowed from the main scheme. Some sponsors may, therefore, seek to restrict the cash allowed under the AVC scheme.

Following A-Day rule changes, pension scheme trustees must inform members of their right to shop around for the best annuity (the income paid at a fixed rate for the rest of their lifetime), a right often referred to as an Open Market Option. However, this obligation is frequently not met by trustees. Hewitt Associates’ latest annual AVC survey revealed that almost one-third of companies are flouting the rule, costing scheme members up to 20% of their pension income as a result. For example, a man aged 65 years with an AVC fund of £100,000 buying a level annuity would receive £1,140 a year less from the provider with the poorest terms than he would from the best one.

Another issue is the regularity with which trustees monitor the providers’ performance. Paul McGlone, head of employer advice at Aon Consulting, says there should be a plan of action if the investment performance falters. “The obvious example is Equitable Life. Trustees often don’t review their AVC provider in the same way as they monitor their defined benefit manager, just looking at them every now and then, rather than continuously. AVCs are the poor relation to the main scheme, and that is understandable given the amount of money involved but, at the very least, the scheme adviser should have a standing brief so any newsworthy event will be brought to the trustees’ attention,” says McGlone.

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Given that some employers are taking steps to restrict future accruals to their main pension schemes, this should, in theory, boost the need for additional savings mechanisms. Salary sacrifice is one solution offering employees a way of boosting pension savings voluntarily, but the employee should be made aware that payments made to a pension arrangement through this method will be classified as employer, not employee, contributions.

If you read nothing else read this…

  • Traditional additional voluntary contribution (AVC) schemes tend to be run by insurance companies on legacy systems and their administration can, therefore, be poor. But new structures for collecting AVCs are evolving partly due to April 2006 pensions simplification rules.
  • The rule change allowing members to take 25% in cash from an AVC can have a big impact on the main scheme’s costs because there will be less call on it to provide cash, which is a cheaper option than providing a pension.
  • Trustees have a duty to inform members about their option to shop around for an annuity at retirement, but many are failing to do so.