Pensions governance: Contribution levels must be right

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• The average employer contribution to a defined contribution pension scheme is 8%.
• Most DC schemes now offer matched contributions and this trend is likely to increase.
• Most employers are not expected to level down contributions for existing employees as a result of the 2012 pension reforms, although this may be unavoidable in certain industries.
• A greater emphasis on communication by employers can help to increase employees’ contributions levels.

Case study: Arup engineers matching pension contributions

When engineering firm Arup set up a new group personal pension (GPP) plan last June, it decided to offer a matched contribution to staff.

The matches on offer range from a minimum 2% employee contribution which attracts 4% from the employer, up to a maximum 6% employee contribution which attracts a 12% employer contribution.

Of the firm’s 3,000 staff, 93% have taken up the benefit, with 83% on the maximum contribution level.

This contrasts with Arup’s previous trust-based scheme, which offered a choice of defined benefit (DB) or defined contribution (DC) provision and achieved a take-up of just 63%, with most people opting for DB.

Despite the high take-up, group pensions manager Rosemary Mounce says Arup will be affected by autoenrolment. “For a majority, it is just a process that will bring in the 7% that have not joined. But there is another quite significant group – some on quite decent salaries – who are on a fixed-term or consultancy basis and will be brought in for the first time.”

Discussions are currently taking place to decide whether this group should be included in the existing scheme,
whether a new lower-level scheme should be set up for them, or whether they could be accommodated through
the national employment savings trust (Nest).

Mounce explains: “We are not expecting existing scheme contributions to be levelled down, although there is always the question of affordability.”

The firm’s existing scheme will also have to be adapted to remove the lowest permitted contribution level, which will fall below the statutory minimum. Mounce says Arup will probably wait until the last moment to do this.

“There may be people who genuinely cannot afford more, and we do not want to frighten them off before we
have to,” she explains.

Contribution levels are under scrutiny as pension schemes adapt to change, and employers and employees must make sure their input is adequate, says Peta Hodge

The question of how much employers should pay into their defined contribution (DC) pension schemes for staff is under the spotlight. A tough economic climate, combined with legislative changes and the continued migration from defined benefit (DB) to DC schemes are all factors affecting contribution rates.

There are also the 2012 pension changes to consider, in particular the introduction of auto-enrolment and phasing in of minimum contribution levels of 8% (3% from employers, 4% from employees, plus 1% in the form of tax relief).

Tom McPhail, head of pensions research at Hargreaves Lansdown, says: “Just about every employer is going to reflect on the benefits structure they offer their employees even if they end up persisting with the status quo.”

No doubt employers will be interested in discovering what the status quo is for pension contributions. The National Association of Pension Fund’s (NAPF) Annual Survey 2010, published in March this year, shows its members are paying an average of 8% into DC schemes and employees are paying an average of 4%. This employee average has increased from five years ago, when it stood at 6.2%.

Towers Watson’s survey FTSE 100 Defined Contribution Pension Schemes 2011, also published in March, shows a similar upward trend. Will Aitken, a senior consultant at Towers Watson, says this is because of a gradual ratcheting-up of contributions after organisations have closed DB schemes and replaced them with DC plans.

Lower interest rates

He explains that every time an employer closes a DB scheme, it looks at the contributions needed to provide a reasonable pension for employees and, because of lower interest rates, it comes up with a higher figure than it would have done five years ago.†

“Overall, I would predict that contributions will continue to trend upwards,” says Aitken. “There may be a bit of a slowdown at the moment, but I think the trend will generally be to increase.”

The findings of the NAPF’s survey certainly support this theory. These show that 9% of respondents are planning to increase their employer contributions. However, Richard Wilson, senior policy adviser at the NAPF, says this may be due to the 2012 pension changes rather than anything else. “Those with lower pension contributions are perhaps looking to increase them to make sure they meet the requirements,” he says.

This view appears to fly in the face of concerns that employers will level down contributions once auto-enrolment comes into play in 2012. But Wilson thinks the 4% of NAPF members that are planning to reduce their employer contributions are probably doing so for exactly this reason. “This is probably under-reported because people do
not want to admit it yet,” he says.

Many pension consultants do not predict a widespread levelling down of employer contributions for existing members. Jamie Clark, business development manager for corporate pensions at Scottish Life, says: “Employers that have set up these schemes have done so for a reason. For example, they understand the value of a pension in the recruitment and retention of quality staff, or they may have a paternalistic attitude towards staff. For these reasons, it will be less likely these employers will level down.”

Take-up of existing schemes

The key factors affecting contribution levels will be the coverage and take-up of existing schemes. If a scheme is already available to all, or almost all, employees and the vast majority have chosen to join, auto-enrolment will not make much difference. But where eligibility is severely limited and/or take-up is low, levelling down of employers’ contributions is much more likely. Staff brought into pension provision for the first time may, therefore, get a less generous deal. John Foster, DC consultant at Aon Hewitt, says: “In the main, employers are not looking to reduce employer contributions for staff who are already participating. What they are considering is the rate they will offer for those who have not previously joined.”

The impact of the forthcoming pension reforms will also vary for different industries, with certain sectors expected to be particularly affected by auto-enrolment, says Aitken. “In some industries – and retail is definitely one of them – where take-up levels are very low, employers are looking at a huge increase in the number of people going intothe pension scheme and that has got to be funded from somewhere.”

Scottish Life’s Clark adds: “We are already aware of some employers preparing now by thinking about how their remuneration strategies need to change to allow for the cost of automatic enrolment, for example freezing or limiting pay rises. If levelling down is felt to be undesirable, early planning by employers will be vital.”

Different contributions for different jobs

A number of organisations already vary contributions according to employees’ job categories or grades. This practice is likely to increase as a result of auto-enrolment. Clark sees no problem with such differentiation, but employers must make sure they do not discriminate between different groups of staff. “Employee segments within an organisation will inevitably be on different pay scales,” he says.

“One of the main issues facing pension saving is affordability. As such, if pension saving is to be encouraged, contributions should be based on the affordability factor – as long as different contribution rates do not fall foul of discrimination legislation.”

Aon Hewitt’s Foster adds: “Employers need to manage the cost of all this in a way that is commercial, but [they] must also recognise that different groups of employees have responded differently to pensions in the past and are likely to continue to respond differently.”

Matched contributions can be a useful tool to deal with such differences. This approach sees higher contributions from the employee trigger higher contributions from the employer. It is already widely used and is likely to increase once the pension changes come into force.

“What some employers might do is bring people in at the [new statutory] minimum level and have higher employer contributions if they put in more,” says the NAPF’s Wilson. But there is some concern that the minimum contribution rates are not enough to deliver a decent pension in retirement.

Mark Futcher, associate at Barnett Waddingham, says: “It worries me that employees may see this as the default or
government-endorsed rate of saving.”

Minimum contribution rate

The fact that the minimum contribution rate is being phased in over a period of five years up to October 2017, starting at just 1% of qualifying earnings from both employers and employees (until October 2016), could exacerbate this problem. “The danger is that these low starting rates could send out the wrong message,” says Scottish Life’s Clark.

There is a some scepticism in the industry over whether the minimum contribution levels as these stand will deliver adequate pensions. However, many see them as a starting point for developing the culture of pension saving in the UK.

“I think there is a potential win for everyone in using the workplace nexus to encourage financial engagement,” says Hargreaves Lansdown’s McPhail.

In this respect, he believes the introduction of the national employment savings trust (Nest) could simplify the jargon around pensions and raise awareness through the simplicity of the services it will deliver.

So how do employers go about increasing employee contributions? Futcher likes the save-more-tomorrow strategy, developed by behavioural economics experts Richard Thaler and Shlomo Benartzi, whereby members commit, on joining the scheme, to allocate a portion of future salary increases to their retirement savings. “This works because members are committing to increase their contribution levels from money that they have not yet experienced,” says Futcher. But such an approach must be backed up by education. “We believe that individuals will only commit to a course of action they understand the benefit of,” he adds.

One thing employers need to impress on staff is just how much a decent pension costs, says Futcher. “People should save half of their age as a percentage of their salary, for example, a 30-year-old should be saving 15% in total – employer, employee and tax relief.”

Foster believes communicating this kind of message to staff will be the focus of many employers’ attention in future. For existing schemes, he predicts a levelling out, but not necessarily a levelling down, of employer contribution rates.

“Greater emphasis on how important it is for people to make provision for their retirement may mean the balance between employer and employee contributions will change,” he says.

Looking at average employer contribution rates over time, Foster concludes: “There will be a tendency [for these] to drift down – if only because there will be so many new plans coming into the market in order to meet the minimum requirements.”

How to encourage staff to increase contributions

  • Employers can use matched contributions to encourage staff to save more into a pension. Higher contributions from the employee are rewarded with higher contributions from the employer.
  • The save-more-tomorrowstrategy gets pension scheme members to commit, in advance, a portion of future salary increases towards their retirement saving. The thinking is it is easier for staff to give up part of their salary they have not yet experienced.
  • Employers should use simple messages to ensure employees know how much they need to save to have a decent income at retirement. Staff should be told to save half of their age as a percentage of salary. For example, a 30-year-old should be saving 15% in total (employer and employee contributions, as well as tax relief).
  • Organisations must ensure staff do not view the minimum contribution rates stipulated under the 2012 pension reforms as the government-endorsed rate of saving. Employees need to be aware that although the minimum contributions are not enough to deliver an adequate pension, they are a good starting point.
  • Any initiative to encourage staff to save more must be backed up by robust education. Employees will commit to a course of action only if they understand the benefit.

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