Crucial choices ahead of pension reforms

Employers have a lot to consider as they prepare to meet the requirements of next year’s pension reforms

If you read nothing else, read this …

• Employers will have to decide whether they offer new pension scheme joiners the existing level of contributions or the minimum required by the 2012 pension reforms.
• The reforms have increased the interest in cash balance schemes.
• Nest is likely to be most suitable for lower-paid employees.

Case study: Qinetiq targets savings

Qinetiq, a defence contractor with more than 6,000 staff in 30 locations across the UK, introduced a group personal pension (GPP) to replace its trust-based DC scheme in April. Run as a bundled arrangement with Zurich Life, the GPP has 2,500 members who are already auto-enrolled.

Qinetiq intends the GPP to be the qualifying scheme for auto-enrolment. It will be working with its adviser, Punter Southall, on the contribution structure and definition of pensionable earnings, so it can certify the scheme before its staging date in March 2013.

Andrew Gibson, group pensions manager, says the company will save about £80,000 in the first year of the GPP’s operation and £150,000-£250,000 in each subsequent year, largely from cost savings related to administration, governance costs and professional fees.

Members are currently defaulted into a balanced lifestyle investment fund and must go online if they want to select another fund, but the company might need to introduce a waiting period, with new joiners defaulted into a cash fund.

Employers have a lot to consider as they prepare to meet the requirements of next year’s pension reforms, says Ceri Jones

For most employers, complying with the 2012 pension reforms has been pushed down the priority list after the financial crisis and subsequent cutbacks. But the UK’s largest employers have only one or two years before their staging dates to comply with the new regime, or face penalties of up to £10,000 a day.

Constantly changing legislation and delays have not helped the planning process. The committee stages of the Pensions Bill suggest that instead of testing the base scheme on pensionable pay, it will now be based on basic pay, presumably to prevent employers arbitrarily setting pensionable pay at a lower level. The Department for Work and Pensions (DWP) has also launched a consultation on the way employers can certify their schemes (see box) but, as things stand, it is difficult to design a structure that complies with the draft regulations.

Advisers are recommending that employers undertake financial modelling to understand the budgetary implications. Providing benefits for employees who are joining a pension scheme for the first time could be a significant cost to the business.

Duncan Howorth, chief executive of Jardine Lloyd Thompson Group, says: “Often clients’ contribution structures are in excess of the minimum required by the reforms, so a key sensitivity is whether to join new staff at a minimum level or at the existing level. Most of our employers expect 25-35% of their employees to opt out, but YouGov research indicates it could be 10-15%. The phasing of contribution levels may also result in fewer opt-outs than employers anticipate.”

While many employers will use their existing pension as a qualifying scheme, some are considering partitioning their workforce so the poorest paid and itinerant staff have access to a lower-grade scheme. Chris Smith, senior investment consultant at Towers Watson, predicts segmentation will be one model adopted by many employers in retail, call centres, branch-based banking and other service industries, such as leisure.

“A couple of retailers are considering the national employment savings trust (Nest) for their transient, low-paid and historically unengaged staff,” he says. “But most employers that already offer an option to all staff will be just happy to tweak it.”

Using Nest

One advantage of using Nest for this segment of workers is that including the lower paid and most mobile staff would affect the provider’s pricing of existing schemes. Brian Henderson, head of defined contribution (DC) advice at Mercer, says: “Pension schemes with thousands of itinerant staff and lots of small cashflows do not appeal to providers. The employer might therefore consider Nest for that segment.”

The retail distribution review will also make pension provision more expensive for short-term employees, because fees for financial advice will have to be taken out of contributions immediately, pound for pound, rather than be factored in over several years.

Steve Herbert, head of benefits strategy at Jelf Employee Benefits, says: “All employers should consider Nest because it is a low charging option. Most group personal pensions have annual management charges of 0.4-1%, while Nest’s annual charge will be 0.3%. Its 1.8% initial charge may be slightly higher, but will make relatively little impact because it is a one-off on new contributions.”

Henderson adds: “Nest will appeal to small employers which cannot achieve economies of scale. The investment choices are sound and the fee structure should be attractive.”

The Nest Corporation is striving to make it as flexible as possible. Paul Todd, head of investment policy for Nest, says: “Nest can be used in a variety of ways. It is a misconception that it is only for smaller employers; larger employers also see it as helpful.”

But sole use of Nest is likely to be the preserve of smaller employers, because the contribution cap of £4,200 a year is restrictive for higher earners. This is expected to be abolished in 2017, making Nest more suitable for a wider cross-section of the workforce.

New guidance

Employers could be forgiven for feeling frustrated as further new regulatory detail comes through. The DWP released guidance on 24 May 2011 about default options for auto-enrolment, clarifying its expectations on several aspects, particularly an onerous new requirement for full reviews every three years and whenever certain events occur, such as developments in the economy.

“This has put the cat among the pigeons,” says Neil Latham, principal at Punter Southall DC Consulting. “It looks innocuous, but is potentially tricky. The monitoring is effectively putting defined benefit (DB) governance into DC.”

The need to revisit pension arrangements in light of the pension reforms has perked up interest in cash balance schemes, which define benefits in terms of an amount of cash for every year of service. Master trusts are another option, but a key attraction the return of short service refunds to the employer is likely to be curtailed.

“Implementation issues, such as how to manage the opting-out process, are being genuinely underestimated,” says Howorth.

Some employers are also looking at defaulting their new starters into cash plans for the first three months, should they subsequently decide to leave the scheme.

Employers have a lot to consider when identifying the correct pension scheme. Planning is not helped by the fact that the final details of the reforms are not yet finalised.

Qualifying regulations

Auto-enrolment will apply to all staff earning at least £7,475 and aged 22 or over with three months’ service.

The DWP launched a consultation in July on the way employers can certify their schemes, including the test (see below) to use where the employer’s scheme does not explicitly provide a contribution equivalent to at least 8% of qualifying earnings, of which 3% comes from the employer.

• A scheme will qualify if it meets one of the following conditions:

• A total contribution of 9% of pensionable earnings, including 4% from the employer.

• A total contribution of 8% of basic pay (including 3% from the employer), provided pensionable pay is at least 85% of the total pay bill.

• A total contribution of 7%, including 3% from the employer, as long as 100% of pay is pensionable.

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• However, the consultation made it clear that pensionable earnings will be whichever is highest out of the employer’s definition of pensionable earnings or basic pay.

Read more on 2012 pension reforms