How popular are pension scheme guarantees?

A pensions landscape where employers bore all the risk associated with funding their employees’ retirement was never going to be sustainable in a country with an ageing population, hence the demise of defined benefit (DB) pensions.

If you read nothing else, read this…

  • The government is seeking a pensions landscape that shares investment and outcome risk between employers and employees.
  • Pension scheme guarantees are one proposed remedy.
  • Critics are wary about reintroducing guarantees.

But now the pensions industry consensus is that the pendulum has swung too far, and that employees have been loaded with all the risk associated with defined contribution [DC] schemes, which were hailed as the saviour of the pensions market. That is why pensions minister Steve Webb is seeking a happy medium whereby employers and employees share the risk.

His proposed solution is defined ambition (DA). Webb has yet to explain his vision in detail, but it is expected to feature pension guarantees, offering employees some form of guarantee, whether in relation to pension fund income or growth or, in the best case scenario, both.

According to a report by the National Association of Pension Funds (NAPF), Defining ambition: Views from the industry on achieving risk sharing, published in October 2012, DA guarantees could include mechanisms that share longevity risk through a ‘life expectancy adjustment factor’, whereby employers are responsible for the investment risk.

Alternatively, capped DB hybrid pension schemes or individualised DC schemes with guaranteed minimum rates of return could be introduced.

But how much employer appetite is there for the reintroduction of guarantees, which could be considered a contributing factor in the downfall of DB schemes?

Jeremy Dell, a partner at financial, actuarial and business consultancy LCP, says: “I think employers are fighting shy of providing any guarantees to their staff in the future. Having seen the impact of providing guarantees to staff and the costs and risks associated with doing that, I don’t think employers are that keen.”

Action required to tackle DC

But Dell says action is required to tackle the DC risk crisis. “The thing about DC is that the benefit [employees] get is a function of the money that gets paid in [to their DC pension scheme], and the level of contributions being paid in is nowhere near enough to give them the type of retirement income they would hope for and expect.”

Steve Herbert, head of benefits strategy at Jelf Group, adds: “I am convinced that, in the next three to four years, employees who have been auto-enrolled at the minimum level and foolishly, although understandably, believed that that is what they are required to put in to get a pension, will in a very short space of time retire and very quickly find out that these levels going in produce two-tenths of bugger all.”

And the current landscape could not be worse. “Life expectancy is rampant and that alone makes DC a real challenge because we’re planning against a moving target, and a target that’s moving further away from us at all points,” says Herbert.

That is why he believes Webb’s push to create some sort of risk-sharing scheme is a step in the right direction.

But Clare Abrahams, a senior actuarial consultant at Lorica Consulting, does not think guarantees are the answer. “Guarantees are not worth the paper they’re written on,” she says. “What use are they if they can’t guarantee an adequate annuity at retirement? The [Labour] government came away from DB [schemes] for a good reason. Webb is coming from a background of Tory-based schemes, and I don’t think he’s up to speed with the good side of DC schemes.”

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Webb pledged to consult with the pensions industry over the summer about his DA vision and how it might work, so all employers can do now is continue with their auto-enrolment programmes and educate their employees about the ramifications of the reforms on the current pension landscape, at least in its latest incarnation.