One of the trickiest aspects of benefits provided by any UK pension scheme is gauging how good they are. With different types of benefit, and various ways of describing them, assessing the whole scheme from its individual parts is a daunting task. There’s also the problem of deciding how far a benefit structure that is worse in one respect is balanced by a better provision in another.
To overcome this difficulty we have developed the concept of scheme assessment ratios, which compare benefit packages in terms of what they cost to provide. We estimate what it costs a particular scheme to provide its package of benefits for a standardised group of employees. This is then compared with the cost of providing a benchmark package of benefits for the same group of members. The resulting ratio is expressed as a percentage. If, for example, we estimate a scheme costs half as much to provide as the target scheme, the ratio is 50% or, loosely speaking, the benefit package is only half as good.
The benefits provided by the benchmark target scheme, though not im-portant in themselves, are chosen to represent a good, achievable standard of provision. In particular, they are not meant to suggest that benefits exceeding that level are in any way excessive. The important comparison is the ratio of one scheme with that of another and this can be done by using any consistent yardstick.
The scheme assessment ratios are therefore based on an assessment of what each scheme’s benefits cost to provide for a workforce with a standard distribution in terms of age, length of membership and sex. Assessing the cost of schemes with defined contribution benefits is relatively straightforward. It is simply the total distributions paid age by age plus an allowance for the cost of any risk benefits minus any expenses deducted from members’ accounts. The cost for defined benefit schemes is calculated on an actuarial basis that is effectively the same used for the minimum funding requirement under the Pensions Act 1995.
The comparison is more complicated for schemes that are not contracted-out as the value of the state earnings related pensions scheme (SERPS) benefits that the members also accrue and, where appropriate, the contracting-out rebate is added to the relevant figures for scheme contributions.
It should be stressed that scheme assessment ratios do not show how much a scheme costs an employer. There are circumstances specific to each scheme including the actual age distribution and earnings of the members, that will determine that figure. The existence of surplus or deficiencies will also have a bearing on it. scheme assessment ratios only show how good a scheme is in relation to those employees who are lucky enough to be members. If the scheme is open to a re-stricted class of employees then the question of how good it is will be irrelevant to those excluded. In addition, for those who are members, allow-ance is to be made for any major sources of earnings that are not pensionable.
Another difficulty in assessing the value of a scheme’s benefits is deciding what allowance to make for discretionary benefits, where the size or payment of benefits depends on decisions by the trustees or the employer. This is important in two areas. First, discretion on the part of the employer and/or the trustees can make a significant difference in terms of the reductions imposed on early retirement. Secondly, discretion is important in relation to when members can take ill-health retirement. In calculating the scheme assessment ratio it is necessary to decide how much value should be placed on such benefits and in both cases this is based largely on what is said in the scheme booklets. While such information does not confer any legal entitlement it is reasonable to use it to gauge how employers and trustees will behave in practice.
The main ratio that is produced for each benefit package covers the scheme’s benefits overall, benefits without regard to the level of members’ contributions. However, it is also possible to calculate the ratio net of contributions, with value of members’ contributions deducted from the overall value. One way of looking at this latter figure is that it represents the share of the scheme benefits provided by the employers.
Having developed the system of assessment I apply it in the periodic publication of UPS Pension Scheme Profiles, the latest edition issued in March 2000. This edition has detailed summaries of the benefits offered by more than 250 of the UK’s top pension schemes, on both defined benefit and defined contribution bases, together with the relevant scheme assessment ratios. One thing the report makes plain is the wide variation in the quality of benefits offered by major employers, with some schemes being worth more than three times as much as the poorest. This is illustrated by the attached graph, showing the number of schemes within 5% bands.
Bryn Davies is director and actuary, Union Pension Services in London. Further details of UPS Pension Scheme Profiles 2000 are available by contacting Union Pension Services on +44 207 737 0682