The DWP’s DA proposals are wide and varied. So, finds John Lappin, are attitudes to them
The DWP consultation paper on defined ambition cannot be accused of itself lacking ambition. Its optimistic title, “Reshaping workplace pensions for future generations” follows on from a previous paper that promised to ‘reinvigorate’ pensions. But while the minister’s drive for a third way between DB and DC in their current forms has been greeted with as much scepticism as interest, acceptance is growing that the huge amounts of cash that will be built up into workplace pension schemes will need to be run in a better way than they are at the moment.
The welcome for the proposals cannot be described as over- whelming. The CBI has said that the demand for defined ambition is nowhere near as high as the minister thinks. The TUC has criticised the proposals to reduce DB benefits, possibly with one eye on protecting rights in public sector schemes.
The reaction from corporate advisers has been anywhere from deep cynicism about employers’ appetite for anything over above the auto-enrolment requirements to a qualified welcome. Some advisers see some appeal, albeit limited, in the DB proposals, to the extent that it may slow the decline of what remains. Others suggest that some clients may be interested in other aspects of DC-plus, though finance directors and shareholders may present formidable opposition to anything that involves a balance sheet liability. But advisers are not ruling out any options.
JLT employee benefits director Mark Pemberthy says: “We did some research at the back end of last year, and asked employers about their appetite for risk. Philosophically, there are organisations that are interested. We were involved with Morrisons, who did take investment risk on behalf of their members – but it is quite rare.
“We have seen a few private sector employers who have gone down the cash balance route. It is more likely to be organisations which are coming down the risk ladder, rather than on the way up. But we need a healthy debate and a better framework, whether it is shared risk, more employer risk or just delivering risk more efficiently. All of those are good things to get to”.
Aviva head of policy, pensions and investments, John Lawson says that the DB lite suggestion sounds the most plausible partly because it is not a million miles away from defined benefit now. “We would need to get the message across that this is not the DB you know about or that you might have experienced from a big employer or the civil service. This is something with no inflation protection guarantee within it. There is no spouses’ benefit. You may, for example, want to insure your spouse separately”.
He says indexing costs about 60 per cent more than a level pension so it could cut costs by 40 per cent.
“Employers have shied away from anything that looks like a long term commitment. The cost would be much less but you would have that uncertainty. You would still be at the mercy of longevity if you put a longevity option in, and you would still be at the mercy of investment markets and how well the fund does. Employers would still have to fund for it. I still have my doubts about whether employers would still go for it.”
On the DB proposals, LCP principal Andrew Cheseldine says that he can’t see much stopping the demise of defined benefit.
“There is a real mishmash of anecdotal evidence about what individual employers intend to do. Steve Webb says he has talked to individual employers who say “yes we would willingly share some risk with employees”. Would that survive a board room discussion? A whole load of finance directors have been brought up to see anything like DB as a disaster”.
He says that the suggestion that DB accruals could be converted to DC when an employee leaves could lead to issues with employment law as well.
“How easy will it be to get rid of people? Employees will fight tooth and nail to be allowed to retire if they are over 55. If an actuary has to certify that a DC pot is the equivalent in broad terms of a DB pot, when someone is made redundant, you are going to get a lot more complaints about the actuary.”
But Buck Consultants principal and head of pensions policy Kevin LeGrand says that those employers who still have DC have got it for a reason. “They have held out against all the pressures of their peers who have given in. There may be an element of paternalism but a good DB scheme can help in terms of staff management and business effectiveness”.
He says there will pressure from shareholders, for example, where a firm is the only one offering DB in a sector, but he thinks the rate of attrition of schemes may slow because we are down to a solid core who offer DB now and the new proposals may appeal.
When it comes to a consideration of DC-lite, the range of opinion is broadly similar – many employers will be uninterested or wary of liabilities, but that it could appeal to some if framed the right way.
Premier Benefit Solutions director Ian Gutteridge says that some options could work where firm has to manage sensitive industrial relations. Otherwise the proposals will not get much traction. “Why would an employer who has recently freed themselves from the shackles of DB, why would they go back to the world to the world of defined anything? Why do something so daft?
“There may be a place for it for large defined benefit schemes – the report says 140 with over 5,000 members, perhaps where there is a fairly heavy union influence. Otherwise, why would an employer want to go into a world with any form of uncertainty? Why not save the cost and put it into additional employee contributions?”
Cheseldine says he would find it difficult to imagine any of his clients going for DA. Yet he also suggests that an employer with employees absorbed from the public sector might be a different case. “You may not want to provide a final salary scheme, but believe you should provide something else. You don’t want to lose these people who have decades of knowledge and bring you profit”.
He says firms with high staff retention rates might also look at DA and he points out that retailers such as Morrisons and Tescos have gone further than just DC.
“You have to be of a certain size or have a certain objective. He says that even some very paternalistic smaller employers would do DB, but can’t afford the risk that a 15 per cent contribution could go to 30 per cent. With the right kind of DA, you keep it at 15,” he says.
LeGrand says that one of the solutions may be managed DC which the paper notes is available already. He says: “The whole concept of managed DC where you are doing a holistic overview of the whole process, up to and including the pension payout at the end of the day and enabling them to set a target has a lot of potential. You have to provide a fair amount of hand holding”.
Turning to the other DA proposals, Lawson says that Aviva has done some internal modelling on many of the proposals and suggests they are more complicated than the DB proposals.
He says with the guaranteed proposals, the capital values and the capital and investment value could prove hugely expensive under UK solvency rules noting that retail market for fixed term annuity guarantees came in at charging levels of around 2.5 and 3.5 per cent.
“That kind of charge looks really out of line with other thinking on charges. Even putting an investment guarantee to guarantee the fund won’t go down, you pay too much”. Cheseldine also questions why strategies that attempt to bring certainty of outcome may carry a charge cap, while those cross into providing a guarantee are likely not to.
Lawson says you could hold capital which is expensive, and in many ways, mimics with-profits or you could buy futures and options. “If you put these instruments around an equity, you turn it into a gilt in terms of performance. It also comes with counterparty risk”.
He says the pension income builder, where you build up an entitlement each year, also requires investment risk and longevity risk to be borne by other members. “The costs again would be enormous. You wouldn’t get much of a deferred annuity. The changes in medical science could see young people living to 120 years”.
He also questions the possibility raised by the paper of this happening under a weaker insolvency regime and queries why insurers who might have the required skill set would face a harsher regime.
He says that collective DC similarly acts like a big with-profits fund and also requires inter-generational subsidies. He says a fund might face difficult decisions between cutting accruals and cutting pensions in payment. Cuts to supposedly DB schemes have proved very unpopular in the Netherlands where some pensions have been cut around 25 per cent, around 15 per cent from the loss of inflation linking and 10 per cent in actual reductions.
However, the Pensions Management Institute’s technical consultant Tim Middleton is a big advocate of collective defined contribution.
His argument is that it has a better record than pure defined contribution in terms of retirement outcomes and that this could be explained to the public. The pension industry also has the expertise having managed DB.
He says: “We like the idea of self-annuitisation within the scheme, which removes some of the lottery element involved with annuities”. Given that pensions in payment have been reduced in the Netherlands, he says it is essential people are aware of how CDC works but that it is still a tried and tested system.
“If people are aware this can happen, but that year on year they are going to get a better deal than pure DC, in the round it is superior. We see it working for employers who don’t want DB, but don’t want to offer the option of DC. It is a realistic option.
Cheseldine, however, is cynical about whether it could really apply in the UK.
He says: “Collective DC can mean anything. What happens in Holland is a step too far for the UK. It requires cross-subsidies. The Dutch psyche is they will share risk.”
He says that it is actually DB not CDC that have actually cut benefits, but if it can happen in the former it can definitely happen in the latter.
“The cross-subsidy worries me. You are reliant on the actuary. You just have to say Equitable Life and defined benefit’s problems here. There is always an employer who will ask – why are you being so conservative in your assumptions. You may be making a promise on the never. Fully funding it becomes very expensive. The biggest cross subsidy is for people who are pensioners from people who are younger”.
Advisers mostly believe that any changes are several years away even if the DWP did secure Parliamentary time in the home straight before an election.
PTL managing director Richard Butcher says: “The timing of this is a little bit odd, in the sense that it will have to go into another pensions bill. There is going to be a scrap for Parliamentary time and a bill for defined ambition is not going to help any party win an election.”
However Butcher thinks that things will turn again towards more risk sharing. “Looking at some way of sharing risk, inevitably at some point it has got to happen. DC doesn’t work at all well. But a generation of CFOs were badly burned. It may be two generations away.” n
The defined ambition paper published on 7 November, for a six week consultation, sets out a detailed list of proposals for easing the requirements of defined benefit and for building some elements of risk sharing into DC or in a separate proposal encouraging Dutch-style collective DC.
It sets out a laudable list of features that defined ambition should display, including a need to be consumer focused, sustainable, inter-generationally fair, offering genuine risk sharing and to have proportionate regulation and high governance and transparency standards.
The DB-lite options include conditional indexation where future indexation is not guaranteed, but depends on the funding of the scheme. When the scheme is fully funded, the benefits would be increased in line with the scheme’s target but withheld when there is a deficit.
Optional indexation would remove the statutory requirement for indexation. Schemes may be able to remove spouses’ benefits. They could be allowed to convert benefits when the member leaves employment to a DC amount of equivalent value.
They might offer fluctuating pensions – a simplified DB scheme where payment depends on the financial position of the scheme. Finally schemes may be able to link the retirement age to changes to state pension age for future accruals.
The DC-plus options include a money back guarantee, a capital and investment guarantee, retirement income insurance and a retirement income builder where the scheme buys a deferred nominal annuity each year.
The paper also examined collective defined contribution along the lines of the Dutch model where the scheme pays the pension and there is inter-generational risk sharing.