Make pension schemes fairer with greater staff education

The trend towards closure of defined benefits schemes to future accrual will accelerate this year, and with distinct consequences, says Debbie Harrison, senior visiting fellow, the Pensions Institute, Cass Business School.

By the end of 2006, it was clear that the focus for corporate pensions policy in the private sector had shifted from the long-term vision of human resources (in terms of recruitment, motivation and retention) to the balance sheet – where a significant defined benefit (DB) deficit can prevent a company from raising finance, distributing dividends, and engaging in corporate activity.

Most private sector employers have already voted with their feet on DB scheme closure. In 2007, the trend towards closure for future accrual will accelerate. Inevitably, the design of the proposed system of personal accounts – the new national pension scheme scheduled for 2012 – will influence employers’ decisions. Like it or not, auto-enrolment into a defined contribution (DC) scheme that requires an employer contribution of just 3% is the new, government-endorsed benchmark.

This seismic shift in pensions policy from DB to low-cost DC begs two questions. Firstly, what is the rationale for employers to do more than offer the statutory minimum? Secondly, and more fundamentally, what is the rationale for workplace pensions?

These questions are not intended to be irresponsible or disingenuous. Many major companies have sworn fealty to an attractive benefits policy in the UK only to sack thousands of employees and move offshore to India and China, where total remuneration is a fraction of the cost.

It is essential for businesses to understand the objectives of their pensions policy and to see a tangible return on the company’s investment as represented by employer contributions. Recruitment and motivation clearly are important issues but retention – the third element of the HR mantra – should not be the last. An efficient business needs to be able to retire older, less economic members of staff in a way that is manifestly fair and reasonable. This was the rationale for the first UK pension schemes, introduced by the railway companies in the late nineteenth century.

But does a DB scheme help with retention? Definitely, to the point where employers are being forced to make very generous settlements in order to retire workers they no longer need. Another question to be addressed is: will age discrimination rules make it difficult to retire older staff with insufficient DC pensions? This is already happening in the US, so is almost certain to occur.

To make DC schemes fair, we need employee education. DB plans, assuming the promised benefits are paid, are a paternalistic benefit. It is extraordinarily complex under the lid but, from the member’s perspective, the scheme does what is says on the tin and pays a well-defined and stable income in retirement.

Uncertain outcomes
At present, contract-based DC arrangements represent a reversal of this concept. They are highly complex from the member’s point of view and the outcome is far from certain. Moreover, due to regulatory and legal constraints, it is difficult and undesirable for the employer, the life office, third party administrators and asset managers to undertake a fiduciary role.

This year, employers and service providers must address this governance vacuum and find ways to help people make sensible decisions and to review their decisions at appropriate intervals. If the outcome is uncertain, then this should be stated clearly on the tin rather than disguised behind regulatory projections that give false hope.

Above all, we need innovation in DC investment strategies. To date, most innovation has focused on DB schemes, where the money and corporate pain lies. The simple fact is that the majority of employees in DC plans are uncomfortable with stock-market volatility and would willingly give up an element of out-performance in return for being able to sleep at night. The personal accounts delivery authority, which will be established this year, is in an ideal position to accept the challenge to make DC schemes safe.

Debbie Harrison, senior visiting fellow, the Pensions Institute, Cass Business School