With many defined benefit schemes closing their doors, there are several options employers can take in order to retain their final salary pension for staff in some shape or form, says Ceri Jones
Defined benefit (DB) pension schemes in the private sector could virtually disappear within four years, according to research carried out in June by IFA firm Hargreaves Lansdown. As people live longer, DB schemes have become horrendously expensive to run, and their reflection on company balance sheets can hamper investor relations and corporate restructuring activity. There are ways of containing the cost, however, that fall short of the two big moves – namely to close the scheme to new entrants, or to any future accrual.
One solution that has hit the news is career average schemes, or career average revalued earnings (Care) schemes which build up entitlement to a pension based on a member’s salary in every year of employment, not just their final one. While a final salary scheme will be easier to calculate, a Care scheme can be presented as the fairer option because it will not favour staff who obtain pay progression through promotion at the expense of the lower paid who remain in similar pay bands for the whole of their career. This means the resulting pensions more closely resemble the actual contributions paid during a member’s employment.
The disadvantage of switching to a Care scheme is that it won’t make a significant difference straightaway, because it will take some years to work through the system. Consequently, employers are still saddled with two big risks – the investment risk associated with investing funds successfully until members retire, and the longevity risk if members live to a far riper age than predicted.
Paul Clark, regional managing director at Jardine Lloyd Thompson, says: “A lot depends on how risk averse the organisation is. Care schemes do a good job of making the situation less volatile. They allow for closer matching of liabilities because those relating to any service accrued to date are known.”
Another alternative is the cash-based option, where members are given a defined cash lump sum at retirement for each year worked. While employers carry the initial investment risk, employees assume all the risk from retirement onwards so employers do not have to deal with longevity risks. Employers can also limit investment risk by buying gilts, or using one of the new breed of diversified funds which offer some protection by consisting of a mix of inversely-correlated assets that tend to rise and fall at different points in the investment cycle.
However, most employers will need to make a raft of changes to alleviate the costs and risks of maintaining a DB scheme. Depending on the age profile of staff, delaying the normal retirement age will make a huge impact, which is usually an indispensable plank of the solution for employers looking to make sweeping changes. Again, the difference won’t be felt in hard cash terms for a few years as the change will have to be staggered in for members nearing retirement. Hiking staff contribution rates also tends to take a long time to implement because of negotiations with staff and/or trade unions. Many schemes are now based on staff contributions of 8%-9%, and double digits contributions are still rare. Whether such a move is accepted will depend on whether the workforce perceives it as necessary for the survival of the employer or solely as a means to cost cuts.
Reductions made to annual increases to pensions in payment will also result in savings. Reducing the limited price indexation (LPI) on the scheme has a significant effect because it must be pre-funded, says Simon Jagger, director and actuary at investment consultancy Jagger & Associates. “LPI [for pensions earned after 6 April 2005] has been reduced to the lesser of 2.5% or the [retail price index], but some schemes still offer a more generous discretionary revaluation and this could be trimmed in line with the statutory minimum, making a huge difference to reserves.”
An easy option is to reduce the accrual rate, say, moving from from 60ths to 80ths, but employers must take care not to breach the reference scheme test on contracted-out schemes.
Companies may also choose to change the definitions of what is pensionable, by excluding bonuses or overtime, for instance, depending on the working pattern profile, or making an across-the-board decision not to include the full amount of a new wage settlement in pension calculations. “A lot depends on the amount of empowerment an organisation wants to give its staff. A final salary scheme may not be much of an attraction when recruiting young, vibrant employees. The issue is to look widely at the overall benefits programme,” adds Clark.
If you read nothing else read this…
- To deliver sufficient impact on the bottom line costs of a final salary scheme most employers will need to make a raft of changes, such as moving to a career-average basis, changing the accrual rate, raising the retirement age, hiking staff contribution rates and changing the definition of what remuneration is pensionable.
- Reducing the annual increases to pensions in payment can be greatly effective.
- Pension reviews should cover the objectives of the whole perks package, and ensure staff feel they have an influence.