Switching from defined benefit to defined contribution pension can be a positive step

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  • Changes in life expectancy, the economic downturn and mobility in the labour market have contributed to the shift from defined benefit (DB) to defined contribution (DC) schemes.
  • Many staff perceive DB plans to be of greater value than DC, but this is not necessarily so. Low DB accrual rates may produce a lower return than good contribution levels to a DC plan.
  • Employers should clearly explain the good points of moving to a DC plan, such as the employer contributions.

Moving from a DB to a DC pension scheme may end up being to employees’ liking, says Jennifer Paterson

Pensions are an emotive issue, and rarely more so than when an employer finds it necessary to close a defined benefit (DB) scheme, particularly to future accrual. In the past year, a number of high-profile DB closures have hit the headlines, and the trend is set to continue. According to the Employee Benefits/Johnson Fleming Pensions Research 2010, published in August, 60% of respondents that offer a DB scheme plan to close it over the next year.

Changes in life expectancy, the economic downturn and labour market mobility have all contributed to the shift from DB to defined contribution (DC) schemes. Professor David Blake, director of the Pensions Institute at
Cass Business School, says: ‚ÄúThe nature of employment is changing and pensions are changing with it. In the early days, if staff did not stay long with a company, they would have lost all the premiums paid. The days when staff worked for the same employer from age 16 to 65 have long gone.‚ÄĚ

But although many employees automatically view DB schemes as worth more than DC plans, this is not necessarily true. In some cases, staff may actually be better off in a DC scheme. John Lawson, head of pensions policy at Standard Life, says: ‚ÄúDC depends entirely on how much your contributions are and how they grow. All things being equal, if you put the same amount of money into a DC [plan] that you do for a DB [scheme] and forget about investment fluctuations, you should get a similar amount of benefit back.‚ÄĚ

But convincing often-sceptical staff of this fact will require both time and effort on the employer‚Äôs part. To begin with, they should walk through the entire process from beginning to end, starting with the honest truth about the reasons for closing the DB scheme. Steve Herbert, head of benefits strategy at Jelf Employee Benefits, says: ‚ÄúIt is about telling staff the truth, that the employer has tried everything it can, and still cannot sustain it. If an employer explains to staff in very cold, simple facts why a DB scheme is not sustainable, they will accept it.‚ÄĚ

Tell employees good news about DC

To temper the bad news, employees should also be told of any good news accompanying the change. For instance, employer-matched contributions in the DC scheme should be communicated clearly to staff. Nigel Aston, business development director at PensionDCisions, says: ‚ÄúThere seems to be a received wisdom of DB good, DC bad. It is more likely to be a case of large contributions good, small contributions bad. The first thing an employer can do is put in a generous contribution [to a DC plan]. In the current climate, that can be a challenge.‚ÄĚ

Employers should also communicate other incentives available via a DC plan, such as making contributions via salary sacrifice. Martin Palmer, head of corporate pensions marketing at Friends Provident, says: ‚ÄúThings like salary sacrifice are useful in a DC world because it allows the individual to effectively give up salary and get a higherlevel of contribution as a result.‚ÄĚ

Employers should also inform staff that anyone in a DC pension scheme is automatically contracted into the state second pension. Standard Life‚Äôs Lawson says: ‚ÄúIt is not all doom and gloom when switching to DC. Employers should emphasise it is not a straightforward loss of a guaranteed benefit. Staff are getting more guaranteed benefit from the government than they would if they had remained in the DB scheme. A DC scheme can actually work out quite well.‚ÄĚ

Clear communication is vital

The next step is to further explain the options available to staff. For example, unlike DB schemes, DC pensions enable staff to get more involved with their investment options. Lawson adds: ‚ÄúA DC scheme is an employee‚Äôs savings and they should take an interest in it. Emphasise the need to manage investments. It is their fund, and they should make the most of it.‚ÄĚ

But if staff are to reap the full benefits of a DC scheme, they will need clear communication from their employer. Tony Pugh, head of DC at Mercer, says: ‚ÄúWith most staff now in DC plans, employers have to help them get the most out of it. The first step is employee profiling because unless an employer knows their staff, their needs and abilities, they cannot do any targeted communication or education about their pension.‚ÄĚ

One way of profiling staff is by age. Jonathan Watts-Lay, director of Wealth at Work, says: ‚ÄúIf an employer has a 25-year-old in its workforce, waxing lyrical about pensions is great, but that 25-year-old is thinking about other things, such as paying off debts, or a deposit on a flat. Staff want savings vehicles that are secure and tax-efficient. One a lot of [employers] use is sharesave plans.‚ÄĚ

Anthony Barker, managing director of Pensions Capital Strategies, adds: ‚ÄúWe are seeing a lot of workplace savings wealth portals, basically an integrated benefits and savings management system where staff can see all their benefits and savings.‚ÄĚ

Higher pension savings

Such schemes can result in higher pension savings in the long term. Watts-Lay explains: ‚ÄúSomeone who saved ¬£800 a year through tax savings on childcare vouchers created a ¬£2,000 pension pot every year. They were taking the money saved on the vouchers, paying it into a share incentive plan and, five years later, putting it into their pension.‚ÄĚ

Friends Provident‚Äôs Palmer adds: ‚ÄúProvide education and try to engage staff in terms of the contributions employers are paying on their behalf.‚ÄĚ

The move from a DB to DC pension scheme also gives employers an opportunity to reinvigorate other parts of their benefits package, using some of the money they are saving, says Jelf’s Herbert.

Inevitably, many employees will view a switch from DB to DC negatively, but Herbert concludes: ‚ÄúEmployers will never get 100% of staff happy about losing the DB scheme, but if they get 50% moderately comfortable with it, the rest will eventually follow.‚ÄĚ

Case study: DC take-up makes news at ITN

ITN closed its defined (DB) benefit scheme to future accrual and introduced a new defined contribution (DC) scheme on 1 April 2010.

When it closed its DB plan, it also introduced salary sacrifice to make the new group personal pension (GPP) more tax-efficient. Staff must put in a minimum of 4% to receive a matching contribution from the organisation. For instance, if they contribute 7%, ITN will pay in 10%.

ITN’s 700 employees were informed of the changes in a targeted communications campaign that began in November 2009. It included postings on the intranet and a number of workshops, some of which were held in conjunction with GPP administrator Standard Life.

Sue Utting, ITN‚Äôs compensation and benefits manager, says: ‚ÄúIt was basically taking everyone who was in the DB [scheme] around every eventuality of what would happen, what their options were, why things were put in place, what the rules were, everything to do with their DB closure.‚ÄĚ

Since the switch, ITN has increased pensions take-up by 20%. ‚ÄúWe also have about 10% of staff who have opted outside of the standard investment management choices and are doing all sorts of whizzy investment management themselves, so that shows a degree of engagement we were quite surprised about,‚ÄĚ adds Utting.

Case studies: How DC pensions can pay off

  • John, 65, is about to retire. He earns ¬£15,000 a year and has been in a final salary plan for 40 years. It is contracted out (so he does not get Serps or state second pension (S2P)), pays a 1/60th benefit but makes a state scheme deduction of half the basic state pension. His final salary pension is 40/60ths times ¬£15,000 less half of 52 x ¬£97.65 (¬£5,078) = ¬£10,000 – ¬£2539 = ¬£7,461. He also gets a state pension of ¬£5,078, giving a total pension of ¬£12,539 a year.
  • Jim, 65, also earns ¬£15,000 and has been in a contracted-in DC plan (qualifying for Serps and S2P) for 40 years, paying contributions of 15% of earnings. His pay has risen by 3% a year over 40 years and his fund‚Äôs rate of return is 6% net of charges, giving him a fund of ¬£155,000. He uses this to buy an RPI-linked pension with 50% spouse‚Äôs benefit, giving a DC pension of ¬£5,388. Jim also gets a basic state pension of ¬£5,078 and Serps/S2P of ¬£3,200, giving him a total pension of ¬£13,666.
  • Although John was in a final salary scheme, Jim has over ¬£1,000 extra income.

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Source: John Lawson, Standard Life

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