The journey from final salary to money purchase pension schemes is fraught with pitfalls. Gill Wadsworth finds out where things can go wrong
Defined benefit pension schemes have been on the endangered list for some time but their demise has been accelerated in recent years as companies battle with a hostile economic environment.
For most private sector workers the opportunity to join a DB scheme has long been a thing of the past, but even existing final salary scheme members cannot afford to take their benefit arrangements for granted. According to research published by consultant Watson Wyatt earlier this year, half of the UK’s DB plans will be closed to all future accrual by 2012.
But in spite of the rapidity at which DB schemes are closing, the process is not straightforward and companies that are looking to move to a defined contribution alternative need to beware a number of pitfalls. The role of the adviser is critical in ensuring an employer stays not only on the right side of the law, but also on the right side of their employees.
Peter Routledge, head of UK pensions and employee benefits at Towers Perrin, says: “Advisers must ensure the client carries out careful due diligence in advance of any pensions change to avoid any elephant traps. This might involve familiarising themselves with the terms of individual employment contracts and reviewing the trust deed and rules to ensure the desired changes can be made.”
He adds: “It is also important that advisers ensure clients carry out any pensions change in the context of their overall rewards strategy; pensions in isolation can be a tough nut to crack and you can get lost in the technical weeds, but by considering the wider package, some trade-offs may be found to ease the change.”
Employers need to have a clear strategy for the move from DB to DC; what are they trying to achieve, why are they doing it, and how are they proposing to get there? Formulating a coherent framework for the transition greatly enhances the chance of avoiding the elephant traps Routledge refers to, an area in which advisers can play a key part.
Routledge says: “Some clients will want to jump straight to their goal of perhaps a simple, low cost DC plan – thereby getting all the pain over with in one go. However, finding an incremental approach may be more appropriate given their employee relations constraints and the desire to retain employee engagement. Having decided on their endpoint, a crucial next step is for clients to plan their journey appropriately according to their circumstances and needs.”
There are several important areas that need to be tackled on that journey from DB to DC, and the adviser will need to engage in a certain amount of hand-holding as they help the employer negotiate their way through the maze of legal, actuarial, investment and communications challenges.
Employees’ contracts of employment must be examined to ensure they have no rights that affect the proposal. Life assurance arrangements need to be checked to see if they can remain in the DB trust or need to be moved to a new scheme. A sensible method of providing the DB benefits which have already accrued must be put in place, and advisers need to ensure there is a suitable investment strategy which will fund the DB benefits as they fall due. The risk of employers having to make additional contributions to make up funding shortfalls was highlighted in the Office for National Statistics (ONS) Survey, which reported contributions to closed schemes increased from 16.1 per cent in 2007 to 18.1 per cent in 2008.
Although there are numerous legal hoops to jump through and technical details to manage, employers cannot afford to lose sight of the real challenge: successful dialogue with the scheme trustees. Without the trustees’ buy-in it may be impossible, or certainly difficult, to proceed with change, and their influence on employees should not be underestimated.
Clive Grimley, partner at Barnett Waddingham, notes that employers must be open to negotiation with trustees if they want to secure their agreement. He says: “If trustees’ consent is needed, they will need to be sure what is happening is in their members’ best interest, so they will probably want something in return for having to amend the trust deeds and rules.”
Ample time should be set aside for these negotiations; given the sensitivity of DB closure the chances of prolonged wrangles and protracted discussions over contractual small print are high.
Nick Couldrey, partner at Sackers, says: “The employer shouldn’t just expect the trustees to roll over and do what is asked. Even if the employer has a good reason for making the change, the trustees will need to test it and consider the implications for members.”
Compliance with the legislative requirements is important as a minimum standard, but we expect to see adoption of good practice as the norm
Businesses also need to engage with their workforces, not only during the obligatory consultation phase, but throughout the entire process. A failure to adequately communicate with employees over changes to pension provision can prompt a costly and damaging backlash, as was highlighted recently by the threat of industrial action at Fujitsu following the firm’s decision to move to DC. A messy row between unions and the company’s management has dogged the DB closure and made the entire process considerably more costly and difficult to manage.
Param Basi, technical director at AWD Chase de Vere Consulting, says: “The greatest challenge in any such pension change is the communication with the membership. A switch from DB to DC is invariably being carried out as part of a cost-control measure and as such staff are understandably concerned. Additionally, it is most likely to be the longest serving, loyal and possibly most senior staff that are significantly affected. Providing information and advice to scheme members in relation to such changes is extremely important in the successful implementation of such a change.”
Basi suggests providing bespoke literature, group presentations and, where appropriate, one-to-one advice sessions to allow a more in-depth independent and confidential discussion. Although employers may be inclined to baulk at the cost of delivering comprehensive DC education and communication programmes, guidelines published by the Pensions Regulator in October sent out a clear message on companies’ obligations, particularly in the area of pre-retirement information.
Speaking last month, June Mulroy, Pensions Regulator executive director of operations, said: “Compliance with the legislative requirements is important as a minimum standard, but we expect to see adoption of good practice as the norm.”
Engagement with the workforce can also help ensure the design of the replacement DC scheme meets members’ needs and offers them a benefit of genuine value. Advisers and providers need to help shake off the prevailing view that “DB is good and DC is bad” by encouraging employers to tailor DC schemes to the specific requirements of their employees.
Stephen Lefley, director of corporate distribution at Zurich Corporate Pensions, says: “Don’t underestimate the challenges of trying to engage a DC membership. Employers and advisers need to recognise the well-documented behavioural traits, and design contribution and investment strategies accordingly. Also, try to make each and every experience a member has with the DC scheme a rewarding one.”
Greater attention should be paid to the default fund, which remains by far and away the most likely destination for the lion’s share of members’ savings. Advisers must help put in place a sufficient level of suitable fund choice and ensure default options are flexible enough to move in line with members’ changing circumstances.
Basi says: “A move towards more actively managed default funds and more than one default fund is inevitable in our opinion.”
Employers shouldn’t just expect the trustees to roll over and do what is asked. Even if the employer has a good reason for making the change, the trustees will need to test it and consider the implications for members
Progress has been made in improving the default option for DC members, with providers continuing to work towards solutions that offer more value to members. Last month Friends Provident launched its lifetime investment programme, which provides employees with greater flexibility within a default lifestyle fund. However, the industry needs to continue developing this area for employees to have a genuinely adequate retirement benefit.
Contribution levels are also critical in countering the inferiority complex that dogs DC. The ONS survey found that the average total contribution rate (member and employer) for open DB schemes in 2008 was 19.7 per cent, compared with an average of 9 per cent for their open DC counterparts.
Lefley says: “Try to keep contributions levels as high as possible and charges low, as these two factors will have the greatest impact on the delivery of successful outcomes.”
The Government’s schedule of pension reform, which includes compulsory employer contributions to company plans, has added a whole new dimension to this debate. The new system will eventually oblige employers to contribute 3 per cent of salary to a pension scheme into which employees are auto-enrolled. Whether this sees employers offer the bare minimum or whether they choose more generous levels of contribution has been the cause of great discussion across the pensions industry. However, many commentators remain optimistic that companies will offer benefits over and above the statutory requirement, and ultimately businesses should be encouraged to make their pension schemes a worthy savings vehicle.
Basi says: “Where a switch from DB is being envisaged, it is more likely to be replaced by a quality DC arrangement rather than personal accounts.”
Employers also need to consider whether they run the DC scheme on a trust or contract basis, an issue which, like contribution levels, has greater resonance because of the forthcoming government proposals for auto-enrolment. Under the existing legislation, trust-based schemes are the sole way in which employees can have their contributions refunded should they choose to exit the scheme within two years of membership, leaving the employer able to recoup their own contributions. Such a situation is not permissible under contract-based arrangements, which makes these less appealing to employers who have a largely transient workforce. Further, although contract-based is often seen as the cheaper option, Watson Wyatt argues that “you get what you pay for”, and employers may end up paying more in the long run to make up for implementing an inadequate contract-based plan.
A spokesman for the consultant says: “The structure of a DC plan itself, whether trust or contract, has nothing intrinsic about it which makes it more or less expensive to run. The difference in cost is driven by the quality of the arrangement and the service that is required. In other words, the approach adopted in areas such as communications, administration and investment choice; you get what you pay for.”
The Government’s precise structure and framework for pension reform is not yet entirely clear, but undoubtedly it is already impacting on the shape of future benefit structures.
For some in the industry, auto-enrolment and personal accounts are seen as accelerators in DB’s decline. Towers Perrin’s Routledge says the fact that pension reform is just two years away makes it easier for companies to move from DB to DC “because it very much establishes that DC is the pension provision of the future”.
He adds: “The fact that auto-enrolment will push up employer costs may also be an incentive for employers to act now to try to control existing costs associated with their pension arrangements.”
Elsewhere in the industry the regulatory change is viewed more positively since it is starting to generate debate among hitherto disengaged individuals.
Lefley notes: “What auto-enrolment and personal accounts will do is provide much needed focus and publicity for DC pensions, and encourage individuals to engage much more readily with the important questions around retirement provision. This environment should result in more of a captive audience for employers but will not help in responding to some of the difficult questions that always accompany a move away from DB.”
The success of DC as a replacement for DB ultimately hinges on how well the transition is managed. If employees recognise that the company is providing a worthwhile benefit which will genuinely offer some financial security in retirement then the demise of the company DB scheme does not need to be viewed as a crisis. The role of the adviser is pivotal in ensuring the new DC scheme is communicated effectively, designed appropriately and, above all, meets the needs of both the business and its employees.