Defining moment

Defined-contribution schemes are dominating the market as final-salary schemes wither. James Phillipps looks at the involved process of switching schemes or running parallel ones and the decisions that employers need to make

This trend looks set to continue apace with the weaker economic outlook likely to result in further defined- benefit scheme closures as finance directors look to better manage their costs.

One in 10 final-salary schemes closed to new members last year, bringing the total closure of defined-benefit arrangements for new joiners to 67 per cent, according to the NAPF.

What is more, a recent survey by Aon Consulting found that half of employers with final-salary schemes say they expect to close them to further accruals by 2011. The dominance of defined contribution schemes in the private sector goes without saying.

Switching from a final salary to a DC arrangement is an involved process. Employers have to first consider whether they want to introduce the DC arrangement for all employees for future service only, new employees only or just certain categories of employees.

The next decision is whether the DC arrangement is to be run as a separate section within the existing trust-based scheme, in most cases, the DB scheme, or as a separate arrangement, either trust or contract-based.

As part of that step, the employer also has to choose which form of DC scheme it wants. If it opts for a contract-based arrangement, then the decision is typically between a group personal pension plan or stakeholder scheme.

Watson Wyatt says that of the 73 per cent of FTSE 100 companies that offer DC plans, more than three-quarters are trust-based. The majority, 49 per cent, run a trust-based scheme as a section of a DB arrangement and 28 per cent run an occupational DC under a standalone trust.

Of the remainder, 12 per cent offer a group personal pension plan and 11 per cent stakeholder. Although stakeholder can be trust-based, the research found no employers took this option up. But once you get out of the FTSE100, contract-based arrangements become increasingly prevalent.

John Lawson, head of pensions policy at Standard Life, says whether it makes sense for the employer to run DC under trust or opt for a contract-based scheme largely depends on the aims of the company. He notes that the trust-based route is a more expensive option and involves a greater regulatory burden.

“If the long-term game plan is to get rid of the trust, then a GPP is the best option. As the DB scheme winds down, the company can then ultimately buy out the liabilities and close it,” he says. “But if you open the DC scheme as a new section of the same trust or as a stand-alone trust, then you are just perpetuating the cost of running the trust and will always have it.”

The additional burdens of running trust-based DC schemes include the need to find appropriate staff members to act as trustees, train them and insure them against legal liabilities if they do not choose investments wisely or monitor and communicate with members effectively. This route will occupy more management time and there is also a heavier regulatory load with the need to meet Pensions Act requirements and other compliance.

Richard Hobbs, managing director of Beachcroft Regulatory Consulting, says the trust-based approach is often seen as “more paternalistic” and preferred by firms that want to appear committed to providing staff pensions and involve them in decisions, particularly in light of a recent DB scheme closure.

The trustee body acting as an intermediary between individuals and the pensions and investment providers can better negotiate charges and select, monitor and change underperforming funds where necessary, providing a hands-on service for members, he says.

The benefit is more clearly identified with the employer and the overall scheme has more flexibility. The company will also typically have the processes and admin in place to run a trust-based scheme, having previously run a DB scheme.

This paternalism, compared with the more individual-based nature of a contract-based scheme, is the driver behind many companies opting to perpetuate a trust, Hobbs says, but, ultimately, he believes the outcomes are the same.

He says: “In a trust-based scheme someone will take a paternalistic decision on your behalf. In a contract-based scheme, a life company will take that decision and put you in a managed fund. People pretty much end up in the same place though.”

One of the downsides of contract-based schemes is how to fund investment advice for members and the fact the provider will restrict investment options. The arrangement is also less flexible, communication has to be carried out through an authorised person and the scheme is life company-branded and so less likely to be seen as an employer-provided arrangement.

On the plus side, the schemes have a lighter regulatory burden and are more portable for employees.

Tom McPhail, head of pensions research at Hargreaves Lansdown, says this flexibility may be particularly attractive to companies with high turnover of staff.

He says: “You could argue that DB is better suited to the civil service where there is still a job for life mentality. If you are in an industry with high turnover, then a DC scheme makes more sense. It just needs to be well funded.”

But if an employer has closed its DB scheme to new employees, Lawson says it should carefully consider the potential damage of opting for a low contribution DC scheme for new staff.

Besides impinging on staff morale, he believes it could throw up potential litigation risk.

“If you have people of the same age doing the same job and one gets a different pension, then theoretically it could be an issue,” he says.

“The UK government says you can have different pensions for people who joined at different times but I am not convinced that EU legislation makes the same distinction, particularly in the 2001 primary directive.”

He says the Government embellished European legislation to bring in this protection for existing schemes, but was too generous.

Therefore, if an employee took his case to Europe and the new pension was found to be significantly inferior to the old one, then the complainant could potentially win a discrimination case regardless of UK interpretation of the rules. Then the employer could face having to harmonise the benefits back, which would “cost a fortune”, he says.

However, the difficulty of comparing DB and DC benefits would make a case challenging to bring, Lawson notes, unless the DC employer contribution rates are particularly poor.

But one area that could be another cause for concern, he points out, is where employers have opened a DC scheme under trust and subsequently closed that to new members and opened a contract-based DC scheme for new employees due to a belated decision to eventually close the trust.

This would enable easier like for like comparisons although Hobbs believes the risk is still slight.

“The litigation risk is not nil but is not great either,” Hobbs says. “Employers are not even obliged to make a contribution so if they are they are way ahead of the law. I believe it is more of a human resources issue.”

Adam Samuel, a compliance consultant agrees, saying employers cannot be found guilty of discriminating against someone on the grounds of when they join a firm.

He says: “If you are discriminating on the grounds of age, sex, disability or sexual orientation, then you are rightly for the high jump. But if you have taken a rational decision to close a DB scheme to new employees, then that is in the terms and conditions they sign up to.”

European anti-discrimination legislation has yet to be tested in court in a case involving pensions. The age discrimination legislation only came into force last November and Harriet Quiney, a solicitor at Fishburn, believes that besides the technical aspects, there are several other barriers likely to block any attempts.

She says the cost of such a move would be prohibitive to many and the claimant would be likely to feel uncomfortable continuing to work for an employer while taking them to the European courts.

“If you are a lawyer, you would be looking for the right case to come along if you were going to back it,” she says. “But it is not necessarily something the trade unions would be interested in backing because the end result could be that the scheme closes, which is not an outcome anyone would want.”

Adviser view –
Employers value their final-salary pension schemes very highly and a company with different pension schemes has by definition different classes of employees.

Ensuring there is not a culture of the haves and have nots among longer-serving employees in a DB scheme and newer ones in a defined-contribution arrangement can be a delicate process.

As best practice, many employers award DC members higher pay rises than their DB counterparts, whether on the shopfloor or in the boardroom.

John Lawson, head of pension policy at Standard Life says: “Running a sepa- rate DB scheme for executives would be unduly expensive and letting them into a closed scheme would break scheme rules.”

When Standard Life closed its DB scheme to new members, it introduced a DC scheme with 14 per cent employer contribution, which it believes is not that far off its DB rates.

When life and pensions chief executive Trevor Matthews joined in July 2006, Standard did not make an exception and allow him into its DB scheme, which is closed to new members, and instead compensated him through additional salary and benefits.