The move to a defined contribution pension plan can be costly

Closing a defined benefit scheme is often about risk but don’t assume your defined contribution alternative will reduce costs

One certainty, though, is that predicting how costs will flex and move is extremely difficult. Aon Consulting principal in benefit solutions, Helen Dowsey, comments: “It is so scheme-specific; every single DB scheme is different. The costs of closing a DB scheme will depend on the funding, the size of membership and what sort of new plan they want to set up. We struggle at the tender stage to give costs because we don’t have enough knowledge of what the client wants.”

Nevertheless, in many cases the rising costs and unacceptable risk profile of the DB scheme will lead inexorably to action. Barnett Waddingham partner Clive Grimley says: “There is usually a fierce debate between the FD, human resources, trustees and shareholders. All this happens before a scheme closure can occur.”

An early consideration for FDs facing pressure to cap DB costs and risks, is the question of what can be done with the old DB scheme. Here, it is vital for the FD to be aware of any powers the trustees have in the trust deed and rules. “Very often the trustee has the power to wind up the scheme if the company wants to cease future accrual,” Grimley comments. This can sharply raise funding costs, particularly if the scheme is in deficit.

Even if the FD is happy that trustees do not have the power to trigger a wind-up, he should be careful, as they may argue the closure is to the detriment of scheme members and that they want something in return. This shows the importance of preparing the ground before a DB closure, in order to get trustees, unions and other interested parties onside. This is particularly important given the higher profile of pension issues and the possibility of an industrial dispute arising. Dowsey says: “Even if existing employees are not affected by the DB closure, as it is only closed to new members, they may regard the closure as a starting point.”

At the same time, only closing the scheme to future accrual may not do enough to address DB costs. One feature of DB schemes is that younger staff subsidise the costs of older workers and Pinsent Masons partner Robin Ellison says: “If you don’t have young people coming in, contributions don’t go down, they go up. But if you close to all future accrual, it does upset people.”

Mercer principal Kevin Painter adds that DB schemes are normally closed in stages: “Closing the scheme to new hires is stage one. The employee contributions are increased, LPI (limited price indexation) is reduced or the accrual rate falls for future service. The final stage is ceasing DB accrual for all active members.”Painter says that closure to new hires and all future accruals in one fell swoop is quite unusual and often raises significant industrial relations issues. However, Grimley warns that closing to new members only may not be sufficient to reduce costs significantly. “We’ve had clients who have closed a DB plan to new members and come back a couple of years later and said it has not fixed their problems. It may be better to solve things once and for all.”

In any event, involving any trade unions at the company at an early stage is seen as a good idea. Jardine Lloyd Thompson consulting director Craig Rodger says: “You have to explain what you are doing and what the potential impact is. If you get the unions onside early, they will be your best sales people.”

Once the DB closure programme is agreed in principle and key stakeholders are briefed, more detailed cost issues can be considered. One element of this relates to DB costs, another to the costs of a replacement pension scheme, which is likely to be defined contribution (DC). Preparing a cash flow schedule may help FDs get a handle on costs here and the scheme actuary should be able to do this.

On a topical note, DB costs could be affected by the credit crunch. The economic downturn is likely to lead to more corporate failures and this will raise the Pension Protection Fund (PPF) levy for the surviving companies. In turn, this could lead to more DB closures. Grimley comments: “A lot of small and medium-sized companies are closing DB schemes as quickly as they can.”

A second issue is that the difference in the method for valuing schemes for funding and accounting purposes are likely to be exacerbated by the credit crunch. Hewitt Associates scheme actuary Lynda Whitney says: “The funding and accounting rules don’t clash directly but the FD and the trustees may have different expectations.” This is because the accounting basis discounts scheme liabilities using corporate bonds, whereas the funding rules use a risk-free rate as the starting point, with a risk premium added to reflect the scheme investment strategy. Whitney says: “If the two rates started at the same point, they could have now diverged by up to 15%, as the yield on corporate bonds has got bigger, [in the wake of] the credit crunch.”

If DB costs are not immediately reduced, or even raised by closing the scheme, the temptation may be to save money on the cost of a new DC scheme, although this could be a mistake.

“The trend in the last three to five years is for employers to really think about designing the DC arrangements, whereas five years ago it was more of a knee-jerk reaction, ‘we have got to get out of this DB plan’. Now they are saying ‘let’s plan this properly’,” Dowsey says.

DB contribution rates can vary from 10%-12% to 25%-30% of salary depending on various factors and rates can vary widely, from as high as an employer contribution rate of 20% down to 5% if the employer sees DC as a cost-cutting opportunity.

Grimley said that former DB members often get higher DC contribution rates, to make up for the loss of DB benefits, but warned that care needs to be taken over age discrimination rules, if contribution rates vary with age, or factors relating to age.

Others warn that moving from DB to DC should be seen as being about reducing risk, rather than reducing cost. SEI DC product specialist Ashish Kapur says: “If you do DC properly, [it] is about the same cost as DB. If you want to buy the same amount of benefits it will cost the same.” Kapur adds that DB costs in recent years have been raised by the cost of deficits and other costs, such as actuarial expenses and valuation costs, but otherwise the pure cost of each type of pension is the same.

At the same time, moving to a DC structure will probably affect the NI rate paid, as most DC plans are now contracted in and once the state second pension (S2P) starts in 2012, it will not be possible to contract out with DC. Moving from a contracted-out DB scheme to a DC scheme which is contracted in will increase the NI rate paid by 3.7% from 9.1% to 12.8% between the lower and upper earnings limits. Furthermore, with a DC scheme, the cost of death-in-service benefits and risk benefits needs to be taken into account. Against this, a salary sacrifice arrangement introduced with a new DC scheme could save the employer NI.

Mercer principal Kevin Painter says that care needs to be taken when using salary sacrifice for DC members earning less than the upper earnings limit, as future S2P benefits could be reduced by more than the increase in take-home pay. “The number of potential losers will increase in the next two years when the upper earnings limit is raised,” Painter says.

Two other issues for FDs to remember when looking at moving from DB to DC are the costs of a communication exercise to publicise the changes and the possible impact of the introduction of personal accounts in 2012. With auto-enrolment of all employees, this could raise costs and FDs should ensure that their assumptions over scheme take-up rates reflect the future changes.

Overall, FDs should look at moving from DB to DC about reducing risks not costs. Acting in haste may mean reviewing DC plans or revisiting DB arrangements in a couple of year’s time, further disenchanting employees. Do it properly and do it once should be the FD’s aim when moving from DB to DC.

For more information on employer-provided pensions go to: www.employeebenefits.co.uk/benefits/occupational-pensions.html

Funding basis v Accounting basis

Comment: If an FD is monitoring funding using corporate bond yields (the red line), funding will be higher than if it is based on gilts plus a fixed spread (the blue line). The gap between the two can be as much as 20% and can lead of a difficult conversation if the FD thinks the scheme is approaching surplus on an accounting basis, while the trustees think the scheme is more heavily in deficit on a funding basis.†

Source: Hewitt Associates

Executive summary

• Closing a defined benefit (DB) scheme often increases overall pension costs. It should be seen as reducing risk, rather than reducing cost.†

• FDs need to be aware of any powers the trustees have in the trust deed, and rules that can sharply raise funding costs.†

• Only closing schemes to future accrual may not do enough to reduce DB costs because younger employees subsidise the costs of older employees. But closure to new hires and all future accruals in one fell swoop is unusual and raises industrial relations issues.†

• The economic downturn is likely to lead to more corporate failures and this will raise the Pension Protection Fund (PPF) levy for the surviving employers.†

• The difference in the method for valuing schemes for funding and accounting purposes are likely to be exacerbated by the credit crunch.†

• Former DB members often get higher DC contribution rates, but this could fall foul of age discrimination rules, if contribution rates vary with age, or there are other factors that relate to age.†

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• Moving from a contracted-out DB scheme to a DC scheme which is contracted in will increase the NI rate paid by 3.7% from 9.1% to 12.8% between the lower and upper earnings limits.

Back to ‘Employee Benefits Report For Financial Directors – June 2008’