Risk-sharing - the saviour of workplace pensions or an idea that has had its day? Gill Wadsworth asks what the future holds for risk-sharing now the Government has rejected the latest batch of proposals
For the last four years the government has been attempting to untangle the private pension web with promises of a fairer system and simpler legislative framework.
Faced with the inexorable decline of defined benefit schemes, in 2006 the Department for Work and Pensions (DWP) commissioned a deregulatory review to analyse the current environment and suggest ways to remove complexity and encourage employers to offer adequate retirement provision.
Throughout the deregulatory process, the Government has encountered criticism from the industry for failing to grasp the nettle and take the opportunity to radically shake up the UK’s private pensions system. Most recently the DWP has come under fire for rejecting various risk-sharing proposals; solutions that are widely seen as central to alleviating the pressure on private pension schemes.
Because under DB arrangements the employer carries the burden of risk almost in its entirety, as longevity has increased while funding positions deteriorated, companies have been less willing to take the strain. Meanwhile, DB’s opposite number, defined contribution, transfers all the risk to the employee who, faced with the unappetising prospect of bearing the brunt of unfavourable economic climates, may be disinclined to join the scheme.
Since 2008, risk-sharing proposals, which aim to redress the imbalance and encourage employers to keep DB schemes open or make DC schemes more attractive for members, have been the subject of DWP focus. A risk-sharing consultation looked at proposals including hybrid, cash balance, conditional indexation and collective DC schemes (CDC), and considered whether legislation was needed.
At the time the DWP concluded the current regulatory framework offers “significant opportunities for employers to share risks or indeed to control costs if they are so minded”. However, the government’s belief that the regulatory framework allows risk sharing to take place is hotly contested by the industry, and commentators argue without legislation, realistic risk-sharing remains difficult for employers to achieve.
James Walsh, policy adviser for workplace pensions at the National Association of Pensions Funds (NAPF), says: “Risk sharing is a direction in which we would like to see the industry go, but we certainly need much more support from Government and more involvement from the industry in developing a variety of schemes of this kind.”
Indeed, the Association of Consulting Actuaries (ACA) annual pensions survey 2009 found that more than three-quarters (77 per cent) of employers thought legislation hampered risk sharing or middle way schemes, and more than half (51 per cent) would consider these schemes if legislation made it easier to do so.
Walsh says: “We think there is some appetite among employers, and certainly among employees, to introduce an element of risk sharing where the outcomes for members would be more certain than they are at present.”
The Government’s scepticism about risk sharing is partly grounded in research undertaken as part of the 2008 consultation into employer attitudes. A qualitative study conducted by Andrew Thomas and Anthony Allen of BMRB Social Research on behalf of the DWP, entitled ’Employer attitudes to risk sharing in pension schemes’ concluded: “Employers with DC schemes considered that they would generally be very unlikely to adopt a risk-sharing approach to pension scheme provision, for three specific reasons increased risk/liability; complex/administrative burden; and difficult to promote to employees.”
Consequently, the Government has rejected two possible risk-sharing schemes. First, in 2008 it dismissed conditional indexation – which would limit employers’ obligations to increase particular pensions in line with inflation – for being too complicated, requiring significant changes in legislation and for lacking employer demand. And in December 2009, following a second consultation period, collective DC schemes (CDC) were discounted on similar grounds. The rejection of CDC comes as a bitter blow to many commentators who are loath to see another risk-sharing scheme bite the dust.
Hamish Wilson, founder of consultants HamishWilson who has long championed CDC schemes, says: “CDC is far more efficient in terms of the outcome for members; for each £1 in you should get a 35-45 per cent advantage [over normal DC] which is huge. CDC is also about choice for UK Plc as well as for UK citizens and we are being denied that choice.”
CDC schemes are no different in terms of risk to the employer than any other DC scheme, other than that they permit members to benefit from dispersing the risk among themselves allowing greater economies of scale when investing, and the ability to smooth financial risks over time.
Wilson questions whether the CDC consultation focused too heavily on the negative aspects of the proposal as opposed to seeking out ways in which it could be made to work, adding: “There is too much emphasis on the risk and not on the benefits of CDC. The Government is being overly cautious.”
However, respondents to a DWP report into employer attitudes to CDC were doubtful the approach would offer any greater security than a regular DC scheme because pensions would not be guaranteed. Further, they argued there would be the additional costs of a trustee board and professional advisers.
The report also found employers were concerned about introducing complexity to the scheme, particularly in terms of communicating and engaging with their workforces.
Beverley Alford, head of pensions consulting at Bluefin, says where companies are putting in a new scheme it tends to be a group personal pension (GPP) arrangement which contains no element of risk sharing and is widely regarded a simple option for both employer and employee.
“Companies are being advised into GPPs which are quite straightforward and it’s easy to explain what happens in the long run,” she says.
Similarly, Duncan Howorth, managing director at JLT Benefit Solutions, says employers’ failure to take up existing risk-sharing opportunities, such as cash balance, suggests they are not actually looking to share risk.
Howorth says: “The reality is, unless you are a very large scheme, when moving away from DB there is a strong focus on simple models which are less costly and easier for members to understand even if they don’t quite do the job that some of the technocrats would like them to do.”
He adds: “Even some of the more simple risk-sharing ideas or models haven’t been taken up so if people aren’t biting at the more straightforward end, why are we lobbying away at the more complicated end?”
However, Alford and Wilson agree that risk-sharing schemes need not be any more complex than a DB scheme.
Alford says: “I don’t see why a CDC would be any more complicated than having had a DB scheme in the past. There are concepts that are difficult to understand but I don’t think they are insurmountable.”
Wilson adds: “Risk sharing requires intelligence to manage but it’s not difficult. CDC obviously requires management and it requires trustees to continually think, but these are positive elements.”
Complexity may be one barrier to widespread adoption of risk-sharing schemes, but a lack of awareness is undoubtedly hampering take-up. The ACA survey found an alarming lack of awareness among UK employers about the types of middle way schemes available. Nearly half were unaware of conditional indexation and CDC (49 and 42 per cent respectively), while just over a quarter (26 per cent) were unaware of cash balance schemes.
Walsh says: “There is a communication challenge on risk sharing which is something for the industry and Government to address.”
In its response to the initial 2008 risk-sharing consultation, the government pledged to work with The Pensions Regulator to consider “what could be done to share information on current risk-sharing practices more widely still”. Yet in the 18 months or so since this objective was set, it is clear many employers are still in the dark about risk sharing. Part of the problem may lie in a misunderstanding on the part of the DWP about how the regulator views its position in the risk-sharing debate. While the government sees the watchdog as pivotal in disseminating information on possible scheme design and potential middle way solutions, the regulator has a different perspective.
The Pensions Regulator states: “Risk sharing is an issue for DWP and whilst we remain involved in the ongoing review, our role is to ensure that member benefits are secure and safe within all types of pension provision. We do not judge the relative value of one type of provision over another, or have any preference for the type of provision offered to members.”
Given the Government’s belief that the current legislative framework provides ample opportunity to share risk, it is perhaps unsurprising that it is reluctant to tinker with regulations to allow new kinds of risk sharing to emerge. Part of the DWP’s argument against CDC was the potential to introduce legislative complexity and the need to rewrite certain IORP Directives.
But Wilson asks why, if CDC schemes can be proven to offer more secure benefits, European law can’t be changed or amended to allow risk sharing to take place.
“One of the Government objections [to CDC] was it wouldn’t work with European legislation; well what is wrong with changing European legislation if we think it is an obstacle?” Wilson says.
Although the government’s position on CDC schemes is final and the proposal has been consigned to the bin alongside conditional indexation, advocates have vowed to fight on. With a general election looming and the possibility of Labour losing power, risk-sharing proponents will seek to lobby any incoming Government to reconsider the proposals.
“We need a different political outlook and I am hoping that a change of government will allow CDC schemes to happen,” Wilson says.
In the meantime, the DWP says it is still committed to exploring risk-sharing opportunities and claims it is keen to hear further views from the pensions industry.
A DWP spokesperson says: “We continue to be interested in finding flexibilities that could be added whilst balancing this with the aim of maintaining good quality pension provision and protection for members. One priority has to be that such new ideas must work for both employers and members.”
In order for risk-sharing schemes to achieve any traction with Government, the obstacle to overcome is lack of employer demand. In the absence of any real evidence to suggest that these schemes are of genuine interest to UK companies, the chance of progressive public policy in this area seems unlikely.
Howorth says: “I don’t think there is any appetite among employers for it. Risk sharing tends to reintroduce an element of DB so a client might be interested initially but when they realise they still account for the scheme in the same way they lose interest. Employers have moved on.”
Employer enthusiasm for risk sharing is further dampened by a lack of certainty over where Government policy is headed. Alford says that in the absence of any government-backed solutions, companies will delay risk sharing discussions to concentrate or more immediate issues.
She says: “At the moment there is nothing concrete out there and discussion is on what you may or may not be able to do, not what you definitively can do. So people’s biggest concern is how to get rid of their DB scheme or how to put in their GPP.”
Risk sharing has huge potential for both employers and employees to enjoy a more equitable pension arrangement, yet it seems the industry is a long way from finding a solution that can really capture widespread interest. The government appears to have been open to discussion and debate on the issue but relatively few solutions are making it over the legislative hurdles.
The challenge for risk-sharing supporters is engaging with employers and drumming up demand for these types of arrangement. Companies who have felt the pain of providing a DB scheme need to be convinced they will not be exposed to the same kinds of risk and costs either now or in the future. At the same time, employees need a scheme they can understand but which allows them to distribute at least some of the risk elsewhere.
At its core, risk sharing is a common sense solution to key challenges for today’s workplace pension schemes but more needs to be done to iron out complexities and open the concept up to a wider audience.