Reinvigorating Workplace Pensions

Introduction

The Department for Work & Pensions (DWP) has published a long-awaited strategy document on Reinvigorating Workplace Pensions that sets out what the Government believes to be the key elements needed for a private pension system that delivers decent pensions to savers and restores confidence in the system.  For the most part there is little in it that is new: it is more a self-congratulatory recital of what has already been put in place.  Strangely, this includes the pension reforms that have introduced automatic enrolment – a strategy introduced by the previous, Labour government!  To that extent the paper is something of a disappointment given the Conservative Party’s promise to reinvigorate pensions once it came to power.

One area where there is some new material is the section that deals with the possible introduction of “Defined Ambition”(DA) pensions, that provide outcomes that are more predictable than those from Defined Contribution (DC) pensions while not exposing employers to the same burden as Defined Benefit (DB) pensions.

Summary

The two main reasons why reform is needed are that:

• the working population will not be able to support an ever-increasing pensioner population and
• those below retirement age are not saving enough to provide an adequate income in retirement.

The Government’s objectives are to:

• increase the amount people are saving in pensions,
• increase the return people receive on their savings,
• enable the development of new products that encourage risk-sharing between employer and worker,
• increase trust and engagement in pension saving and
• ensure the sustainability and stability of the UK pension system.

The current paper is not a formal consultation, rather an indication of the direction of travel.  Formal consultation on some elements of the strategy may follow.

Responding to an aging society

Between 2012 and 2050 the proportion of people aged 65 and over is projected to increase from 17% to 24%.  Because State pensions are paid out of current taxation, this means that the burden on the working population will increase over that period, even after allowing for the planned increases in the State Pension Age.  Of course, this problem is exacerbated by introduction of the “triple lock”, by which the Basic State Pension is now increased each year by the greatest of price inflation, earnings inflation and 2.5%!

At the same time, people below retirement age are not saving enough to provide an adequate income for themselves in retirement in addition to the Basic State Pension.  Some people are put off pension saving because they risk losing means-tested benefits in retirement if they save.  The Government has developed proposals to create a single-tier State Pension. The single-tier pension will be set at a level above the standard minimum means-tested guarantee, so should help to reduce the extent of means-testing – which in turn will make saving worthwhile.  These reforms are the subject of a subsequent consultation published in January.

Occupational pension schemes

Traditionally, the majority of occupational pension schemes have been Final Salary schemes or Money Purchase (Defined Contribution) schemes.

A Final Salary scheme is an example of a DB scheme and provides a pension that is calculated as a proportion of the individual’s salary at or close to retirement.  Typically the individual contributes a fixed percentage of his salary each year and the employer meets the balance of the cost.  Thus the employer bears the risk of:

• the individual’s salary rising faster than expected (although this is within the employer’s control to an extent!),
• the individual living longer than expected,
• the scheme’s assets earning a lower return than expected.

The individual bears only the risk that the employer becomes insolvent at a time when there are insufficient funds in the scheme to secure his benefits.

Under a DC arrangement, the employer and the individual contribute a fixed percentage of salary each year, which is invested in an account for the individual’s benefit.  At retirement the individual uses the amount of money then in the account to provide a pension for life.  Since the employer is committed only to fixed contribution rates, the individual bears all of the risks.

Thus Final Salary schemes and DC schemes sit at opposite ends of the risk spectrum.  Some intermediate scheme designs are available under current legislation, such as

• career-average schemes, whereby the pension is based on salary averaged over the individual’s working life rather than on final salary, or
• cash balance schemes, whereby a defined cash sum is provided at retirement rather than a pension, so the individual bears the risk of the cost of buying a pension at retirement.

However, any scheme that is not purely DC is subject to all the weight of legislation that applies to Final Salary schemes, including the Statutory Funding Objective, as well as levies to the Pension Protection Fund.

The provision of Final Salary and other DB schemes in the private sector has been declining since reaching its peak in the late 1960s; indeed there are now fewer than 3 million private sector employees who are active members of DB schemes. 

The future is DC?

The reduction in DB provision has coincided with an increase in DC provision.  However, not only has this transferred risk to individuals but contribution rates have also reduced.  The Government recognizes that the minimum contribution rate under the auto-enrolment legislation – 8% of earnings between the lower and upper earnings limits for National Insurance contributions – is likely to be insufficient to provide an adequate income in retirement.  However, it is worried that imposing a higher minimum will just lead to more people opting out of pension schemes.  It wishes to explore, therefore, methods of encouraging individuals to pay higher contributions in future.  One such method is automatic escalation, whereby individuals sign up in advance to increase their contributions automatically when their salary increases.

Charges are also to be scrutinised and the Government (or the Regulator) has the power to prevent a scheme from being used for auto-enrolment if its charges are deemed to be too high.  The DWP intends to explore whether a pensions market with a smaller number of larger-scale, multi-employer pension schemes might be able to provide better value for money for employers and employees than do individual employer-related schemes.

…or is there a “third way”?

Arguably the most interesting chapter of the Reinvigoration paper is that which explores the concept of Defined Ambition pensions – DA, the middle ground between DB and DC, where the risks are shared between the employer and the scheme members.  The paper sets out the following principles for the development of DA pensions:

• they should be consumer-focussed, recognizing both individuals and employers as consumers;
• they should be affordable over the long term;
• they should be fair between different generations of member;
• they should incorporate genuine risk-sharing;
• the regulatory structure should be proportionate;
• they should be transparent, with high standards of governance.

Some DA models are already possible under current legislation but, as noted earlier, they suffer from a disproportionate regulatory burden.  Such models include career-average revalued earnings (CARE) schemes and cash balance schemes.  Schemes are able also to adjust their retirement age to reflect increasing life expectancy; however, they may do so only in relation to future benefit accrual.

New models being explored are described below.

Simplified/core DB schemes – “DB-lite”

• Conditional and optional indexation – pension increases would not be guaranteed but would depend on the scheme’s funding position being sufficient to afford them.  This type of arrangement would alleviate the pressure on employers when schemes are in deficit, while ensuring that members benefit when schemes are in surplus.
• Remove the requirement to provide a spouse’s benefit.  This suggestion does not really reduce risk for employers.  In addition, schemes that are not contracted-out of the State Second Pension do not have to provide a spouse’s benefit anyway, so this is not a new innovation.
• Conversion of benefits – benefits would be DB until such time as a member leaves the scheme, at which point the accrued benefit would be converted into a DC fund of equivalent value.  Under such a model the employer would bear risks only in respect of current employees and pensioners who retired from active service.
• Fluctuating pensions – similar to conditional indexation, the scheme would guarantee a core level of pension and pay a discretionary amount on top.  The discretionary pension would be subject to a lighter funding regime and could fluctuate from year to year depending on the scheme’s funding level.
• Linking scheme retirement age to State Pension Age – this model would allow a scheme’s retirement age to change automatically in line with changes to the State Pension Age, in respect of both future and accrued benefits, allowing employers to pass some longevity risk to scheme members.

Enhanced DC schemes – “DC-plus”

• Guarantees – various forms of guarantee could be provided:
  • an individual guarantee that the member’s fund will never be less than the amount of contributions paid into it.  The paper quotes research by the OECD and the Institute and Faculty of Actuaries into the cost of such a guarantee and concludes that the guarantee should be optional: those who value such a guarantee may be prepared to pay for it;
  • a mutualised guarantee funded by a levy on members’ funds, to guarantee eg the capital level of a member’s fund or benefit payments beyond a certain age.  The latter would involve the member purchasing an annuity to cover pension up to a certain age only, passing some longevity risk to the mutualised fund.  The levy would not be funded by the employer and would not show on the employer’s balance sheet.  However, the form of the mutualised fund is still to be discussed;
  • an insurance arrangement to provide a guaranteed rate of return during accumulation or a guaranteed income in retirement.
• An employer-sponsored smoothing fund, used to manage a target outcome for members.  Such a model is likely to involve more volatility of contributions for employers than does pure DC.

Collective DC

This is a model that is popular in the Netherlands and Denmark.  The rate of employer contribution is fixed and the risks are shared between the members through the pooling of their funds.  An expected benefit is calculated but not promised and benefits can be adjusted according to the scheme’s funding level.  Since the fund is collective, it can remain invested in growth assets for longer, as well as making savings in administration.  While the Government does not consider the wholesale adoption of Dutch-style CDC appropriate for the UK market, it is happy to consider whether some elements could be built into a DA model.

One challenge for DA pension schemes is that they are likely to be more complex than either DB or DC, in a market where levels of understanding are already low.  The DWP is working with a DA Industry Working Group to assess the implications for changes needed to the regulatory and legislative systems to enable DA schemes to flourish.  A further publication is expected in due course.