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• Many DB pension schemes are closing, mostly because they are in deficit.

• Employers that run DB schemes feel these help recruitment and retention, and are the best plan to offer.

• DB pensions can be made cheaper by freezing accruals, converting to average career earnings, or changing
indexation from the retail price index to the consumer price index.

• Plans can be de-risked by changing where pension pots are invested or through buyouts or buy-ins.

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Defined benefit pensions may be a dying breed, but there are ways to make them more affordable, says Peter Crush

According to Aon Hewitt’s 2011 Global Pension Risk Survey last month, 90% of companies had closed, or were closing, their defined benefit (DB) scheme to new entrants. But even when bosses take steps to protect their DB plan, they risk the ire of employees.

For example, when the AA, which operates a career average revalued earnings (Care) scheme, asked staff to pay 1.5% more of their salary into their pension last year, it nearly caused a bank holiday strike. The same happened at the BBC last autumn over plans to put a 1% cap on future pension rises.

Both organisations were trying to do all they could to make their DB scheme more viable because they believe it is right for talent retention and recruitment.

But the Pension Protection Fund’s PPF 7800 Index, published in February, found 56% of DB schemes were in deficit. Even AA president Edmund King admitted he was fighting to retain the organisation’s DB plan.

But having decided to retain a DB scheme, it can be made more affordable through derisking. Clive Grimley, partner at Barnett Waddingham, says: “Reducing accrual rates is one option; altering assets held is another.”

Ten years ago, Boots became the first major employer to switch its pension fund assets entirely into bonds rather than riskier equities. According to Aon Hewitt, 30% of UK DB schemes expect to reduce their overall equity exposure this year, with half looking to cut their UK equity exposure by increasing assets allocated to liability-driven investment strategies (30%) and alternative assets (35%).

Plans to cut investment risk

This tallies with last November’s Towers Watson – Forbes Insight 2010 Pension Risk Survey, which found 75% of final salary plan sponsors planned to cut investment risk over the next five years. Over 60% already use currency forwards, 51% use interest-rate swaps and 38% plan to buy annuities to offset risks posed by future payment obligations.

Other options include buy-ins, where trustees transfer risk to a separate insurance provider to produce the pension’s income stream; and converting payments to alreadyretired staff from the retail price index (RPI) to the consumer price index (CPI). James Walsh, adviser at the National Association of Pension Funds, says: “There is a cost saving to be made here as it offers flexibility.”

Enhanced transfer values are another option. Rather than retaining the risk of an unknown pension liability, employers can offer members an incentive to transfer their benefits away from the scheme. Staff receivea transfer value that is higher than their standard cash equivalent entitlement, but at a cost that is below the equivalent ongoing funding reserve level.

Chris Sheppard, head of Mercer’s Scheme Design Group, says cutting employer contributions has been the most notable change.

Mercer’s September 2010 Scheme Design Survey found the most popular changes to DB schemes in the past two years were closing to future accrual (52%) and increasing staff contributions (25%).

The survey also found respondents have reduced pension increases or evaluations (9%), switched to a Care scheme (8%), and reduced accrual rate (8%). In schemes still open for future accrual, employer future service contributions were 17%, with employee contributions 6.3%. Where changes had been made to benefit provision, employer contributions fell to 11.3%, and staff contributions rose marginally to 6.4%.

Emma Watkins, head of relationship management at MetLife Assurance, says: “Where employers will succeed is by keeping DB, but also asking employees to contribute a little bit more.”

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