Pensions World

The closure of final salary schemes has not put an end to pension risk explains Barry Mack, Hymans Robertson

Many companies closed their final salary schemes and opened defined contribution (DC) plans to achieve greater certainty of pension contributions. Although the move to DC has gone some way towards reducing the previous volatility of contributions, it has created a raft of other risks which companies need to consider and address where appropriate. Here are some example risks:

Legislative risk

Companies have little or no power to mitigate the impact of changes in legislation. Auto-enrolment illustrates this point well. Some employers introduced DC schemes because they felt they should, rather than wanting to. They may have been relieved when only, perhaps, 25% of the workforce joined the scheme. But with auto-enrolment, many companies will find a significant increase in their absolute levels of contribution, as virtually everyone will need to be auto-enrolled into a qualifying scheme. With very large schemes, these additional contributions could be as high as £10m a year.

Risk of inadequate pension at retirement

Historically, too much emphasis was placed on the amount being paid into a DC scheme with too little attention paid to what pension this may give to a member at retirement.

One of the criteria used for the National Association of Pension Funds’ Quality Mark is a combined contribution rate of 10% (ie employee and employer). So what might that level of contribution bring a member at retirement? Our modelling suggests that a 30 year old, investing for 35 years, in an equity based lifestyle strategy might expect a median replacement ratio of around 39% of their final salary at retirement. However, worryingly, the bottom 5% of outcomes could mean less than 20% of salary; the maximum is over 100%. If members take lower risk by investing in bonds for most of their career, their median expected replacement ratio is only 21% of final salary – arguably too low for most people to live on. This uncertainty for members leads to a further risk for the company.

Without further intervention, one can foresee that, with the abolition of the default retirement age, employees who cannot afford to retire will work longer because they have to, rather than because they want to. Failure to deal with this risk could therefore pose some serious man management issues.

Matching contributions

Many DC schemes offer some form of matching for members above the standard contribution rate. Although in overall terms the impact of matching contributions is likely to be relatively small, it does provide a further risk for companies who will have no control over when a member may decide to increase or reduce their level of contribution. This is unlikely to be a major issue for large schemes, but could have a significant impact on smaller schemes with an abundance of highly paid individuals.

Lack of member engagement

Employee engagement, particularly in contract based schemes, is generally low. However, the communication of issues such as target income and the potential range of outcomes at retirement is vital in helping members (and non-members) gain a better understanding of what combination of contribution rate and investment choice is most likely to allow them to enjoy a comfortable retirement. 

Although the contract is technically between the member and the insurance company, scheme sponsors will need to “up their game” regarding communications to members to avoid the reputational risk of members making poor decisions and holding them responsible, morally, if not legally. Moral responsibility will be particularly relevant where a company has a valuable brand identity to protect.

Poor governance

Finally, the recent guidelines produced by the Pensions Regulator’s Investment Governance Group called for improved governance structures for both trust and contract based DC schemes. Many companies viewed the introduction of contract based schemes as “governance light”; this, however, will no longer be the case. Companies need to recognise the new guidance and the increased costs which will inevitably accompany this.

Closing final salary schemes did not end pension risk. As DC schemes mature and we move into an era where nearly all employees will be in a DC scheme, companies need to reconsider and identify their resulting pension risks. Only then can they prioritise and manage the key risks associated with DC provision.

Barry Mack is head of governance and plan management at Hymans Robertson;
barry.mack@hymans.co.uk