Pensions World

Allison Plager, financial journalist, on the adjustments DC schemes will have to make to cope with the changes ahead for pension provision

Who can doubt that defined contribution pension (DC) schemes are in the ascendant? Defined benefit (DB) schemes continue to close, especially to new members, as sponsoring companies and trustees struggle with funding and regulation, and instead employers are turning to DC schemes which divest them of responsibility for paying the pension and often come with considerably less regulation.

Funding in particular is a massive problem for company pension schemes and is often a major stumbling block in corporate transactions, as potential purchasers baulk at taking on a substantial pension deficit. The recession has inevitably had a severe impact on the state of pension schemes. According to a recent report, The FTSE 100 and Their Pension Disclosures, from Pension Capital Strategies Ltd, the total deficit of FTSE 100 pension schemes amounted to £54bn at 30 September 2009, compared to £18bn a year ago. However, this is an improvement on the figure at 30 June 2009 when it stood at £90bn. As Charles Cowling of PCS says: “It is not surprising that companies are reacting to the current difficult conditions by closing down final salary pension schemes. We believe that within the next two to three years the very large majority of final salary pension schemes in the private sector will be closed to all employees.”

More interest

Given that the closure of DB schemes to all employees is a growing trend and is leading to more companies replacing them with DC schemes or transferring previous DB scheme members into an existing DC scheme, what is the effect on that scheme?

Watson Wyatt’s Paul Macro points out that employees who used to be in a DB scheme “tend to be very interested in their pension scheme” because they will have seen the value of DB and want to replicate it as much as they can. Thus “they may well pay more into the DC scheme”, which will be good news for the provider because the scheme will become more profitable. As a result, Mr Macro recommends that companies in this position “should negotiate their charges downwards, since the business is doing better than expected”. He adds that few providers will do this voluntarily, so the sponsoring company will need to approach the provider.

Companies should review the scheme as a whole to see that it is fit for purpose. The default option, for example, may not be appropriate for former members of a DB scheme. Such individuals will not have had to consider specific investment options before and might be more open to risk, bearing in mind that they will have the fall-back of the DB pension for part of their retirement. The DC scheme therefore, says Mr Macro, could offer two default options: one for new, perhaps more risk averse, members and one for movers from the old DB scheme. However, he points out that it will be important to ensure that the provider can handle this administratively and that members understand the options.

Table 1 GPPs – Plan minima and charges

Table 2 GPPs – Commission, terms and investment

Crucial to the success of this is communication. As Mr Macro says, DC schemes involve a large element of personal choice and so communication of what is available is “critical to the end result”.

Increased popularity

It seems that, despite the economic climate, payments to pension schemes are greater. A recent survey by Mercer confirms that average contributions to DC pension schemes have increased. Looking at the schemes of 345 UK companies, representing some 1.2m members, it shows that, since 2007, employers have on average increased their contributions from 6.8% to 7.25%, and member contributions have increased from 3.6% to 4.65%.

Mercer’s Tony Pugh is encouraged by “this increased level of commitment to DC pension provision” saying “it reflects a maturing attitude to DC as it becomes the most prevalent form of provision in the UK”.

Reflecting Mr Macro’s comments, he says that “as sponsors leave behind DB in favour of DC for new hires and, increasingly for existing employees”, the need for a scheme to be successful is high on most corporate agendas, and “this, in part, could be accomplished by higher contributions”. Few companies felt that the DC scheme was appreciated by members, though, with only 16% of participants believing this to be the case.

In terms of switching from a DB to a DC scheme, careful management is the key, says Mr Pugh. “Educating employees on what DC schemes can offer and how much contribution is required for members to enjoy a comfortable retirement remains an urgent task.” Communication with employees is therefore of paramount importance.

The problem with communication, particularly with regard to DC schemes, is that employers are not allowed to provide financial advice. The National Association of Pension Funds (NAPF) has recently called upon the government to change the law at least to make it easier for employers to talk about pensions. It has suggested that this include consideration of giving them a legal indemnity. A survey, Talking pensions, conducted by the NAPF, reveals that 69% of employers feel that this would help.

Table 3 Defined contribution – features and minima

A simple choice?

Employers have some flexibility if they wish to offer a DC pension. The Tables in this survey cover group personal pensions, stakeholder pensions and DC schemes, providing initial information about charges, investment options etc. Group self invested personal pensions are also becoming more prevalent and they will be discussed in another article in Pensions World in January 2010.

When it comes to making the decision as to which type of scheme to choose, it may come down to how much of a part the employer wants to play in the scheme. Ann Flynn of Scottish Widows says: “Defined contribution is paternalistic while GPP and group stakeholder provide greater member flexibility”. She adds that “DC provides legislative governance through the role of the trustees and the investment choice and management is managed at the level. GPPs provide excellent technology and service and a wider investment choice. A group stakeholder is similar to the GPP, but with a charge cap and thus a reduced fund choice.”

While it is true that stakeholder charges are capped, as Aviva’s David Gwyer says, “the pricing of a GPP and group stakeholder are often very similar”. Ultimately, the choice will depend on the sponsor company’s circumstances.

Auto-enrolment

A major issue for any company, with or without a pension scheme is the introduction of auto-enrolment in 2012. Six months’ consultation followed the first draft regulations (published in March 2009) and concessions have been made. For example, employers already running pension schemes will have a longer timescale in which to enrol new employees in a qualifying scheme.

Table 4 Defined contribution – charges and investment

Table 5 Stakeholder – features and minima

However, PricewaterhouseCoopers’ Marc Hommel points out that while businesses “see the social merit of the automatic enrolment policy”, they are concerned by the additional complexities, costs and impact. He says that the new regime will force “companies to review what they currently provide to ensure that they and their employees are getting value for the money spent and risks taken. Many will question the extent to which current designs are valued or make sense for their business. Alongside the costs and risks of defined benefit provision, employee confusion and administrative complexity, the new requirements will be a key determinant in employers’ future pension strategies.”

Certainly, companies which use existing arrangements are likely to find a lot more people in the scheme as they will be in it by default. Mr Macro agrees that this will increase costs, so says that companies “need to check that they can afford their existing contribution level”. The legal minimum is likely to be less than most companies already contribute, but he points out that those that do stick with the legal minimum could face problems as it will be tied to band earnings, including all elements of pay, rather than be a simple percentage of salary.

So much going on

It is probably not going too far to say that DC schemes represent the future for company pension provision. DB schemes have become too troublesome and onerous for most employers to consider, but most employers continue to see the value in offering a pension scheme, and indeed are already bound to if they have five or more employees.

The pensions landscape is going to change further with auto-enrolment and Personal Accounts, although the detail surrounding the latter is still very much in a state of flux, particularly with a general election due in 2010 and a possible change in government. Skandia’s Richard Facer believes that Personal Accounts, if introduced, “will galvanise many employers to review their own arrangements”, perhaps using them “as a nursery scheme, adopting the Personal Accounts enrolment and investment model” or even replacing existing DC arrangements.

Whatever the outcome, employers will have to look at their current offering to ensure that “they are fit for purpose, provide a good outcome for their members and represent value for money”.

Overcoming the problem of encouraging individuals to save for their retirement is not easy, particularly when the country is in recession and people are concerned about their jobs. It is therefore ever more important that employers with DC schemes take steps to communicate the value of the scheme to their employees and that the provider is offering suitable investment options, good administration, etc.

Auto-enrolment is going to create considerable work. The pension scheme needs to be prepared.

Table 6 Stakeholder – payment and investment

Allison Plager is a financial journalist; allison.plager@lexisnexis.co.uk