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Talking Point: The future of DB schemes

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  • Talking Point: The future of DB schemes

TALKING POINT - Research from the National Association of Pension Funds (NAPF) - suggesting 52%, or 1,000, open defined benefit (DB) schemes could close as a result of the impact of the economic crisis - has raised a debate on whether DB schemes can be saved.

The NAPF has launched an action plan for the government that sets out a number of steps to be taken by the government, including becoming the guarantor of the Pension Protection Fund (PPF) as it claimed this would provide member security and occupational schemes would know there is a limit to the PPF levy. (See earlier IPE article: 1,000 open DB plans could switch to DC)

Although the NAPF research focused on the economic impact on pensions, and suggested this is the main driver for the predicted closure of DB schemes, Towers Perrin highlighted another option suggesting equality among the workforce is another motivating factor.

Whatever the reasoning behind it, 52% of UK DB schemes open to new members and 27% of closed DB schemes expect to switch to a defined contribution (DC) or hybrid/career average scheme.

We would like to know whether you think there is a place for DB schemes in the UK pensions industry? Is DC the future or can DB be saved? But what needs to be done if final salary pensions are to stay in the private sector?

We’d like to hear your views on the matter, especially from pension fund officials, so if you have any comments you would like to this week’s Talking Point email julie.henderson@ipe.com and we will post your comments to continue the discussion.

Have Your Say: Grayson Clarke, resident fund management expert on the EUCSS Project for China, says:

“I am the fund management expert on the EU-China Social Security Reform Project, resident here in Beijing for the past t years and I have been following the debate on DB very closely through the pages of IPE.

“I am a passionate supporter of DB with the conditional indexation approach - what might be called the Dutch model. I have supported its adoption here in China though it has virtually no advocates. I believe it is by far and away the best pension model for three reasons: it is overwhelmingly administratively cheaper than the individual account model. Through conditional indexation it offers much better risk-sharing between the current retirees and the current contributors and between employees and employers.  And thirdly It offers a dedicated ring-fenced asset base to meet pension liabilities, which is not the case with the notional defined contribution approach or reserve funds where accrual rates or reserve fund contributions may be subject to government priorities (which as we know at the moment are saving the banking system and reflating the economy).

“What has fundamentally undermined DB is first the rigidity of its benefit structure (hence my support for conditional indexation) and second the use of balance sheets based on mark to market accounting as the principal reference point for determining the financial solvency of DB schemes. I do not blame the accountants for this (I am incidentally one of them). Balance sheets are meant to produce a snapshot of a company’s financial position at a given point of time and this snapshot is based on one set of values. Balance sheets cannot have a range of values - only one. We have also learnt to our cost that the more flexibility is given to companies to state assets at different values, the more they will take advantage of this to state everything in the most optimistic investor-attractive way possible.

“So the real issue is the use of balance sheets prepared on IAS principles for solvency assessment. Here I have a suggestion. What is most important in the short-term is the percentage of liabilities being realized in the next five years (i.e. those which we have to pay short-term). Instead of thinking about the total long-term valuation of assets (which are mostly short-term anyway) and total future liabilities focus the cover ratio on the short-term position. In crude terms, it can work like this. Say a pension fund has cover ratio of 90% and needs to be at 120%. If 10% of its estimated liabilities fall due in the next five years, then instead of injecting funds to move the cover ratio back to 120%, require the fund to increase the cover ratio to 93% (i.e. to close the gap slowly). This ratio can be recalculated on an annual or even six-months basis so that it can take advantage of rising stock market trends but at the same time (for an adverse correction) not have to find huge sums to meet liabilities that will not fall due in the short-term. I am sure an actuary may be able to formulate the basic proposal in a more elegant way but this step is essential to prevent the completely unnecessary closure of many basically solvent DB schemes, and hopefully start reversing the trend.”

Have Your Say:Robin Simmons, partner at law firm Sacker and Partners LLP, admitted the current financial climate is causing many employers to consider closing membership of their DB pension schemes to existing members, but warned “while in most cases it will be possible to do so, there are legal hurdles to be jumped”.

“Some pension schemes’ rules prevent closure to existing employees - so employers should check first whether this can be achieved at all. But where it can, employers will need to consult with affected employees for at least 60 days and give proper consideration to employees’ views.

“In addition employers will need to get the support of the scheme trustees to any proposed closure, and they would expect to see a ‘good business case for going down this road’. The trustees would also need to “tread carefully to ensure that they address any conflicting interests they might have between their dual roles.
 
“It’s true that these schemes are taking a battering from all angles, but for most the real financial exposure for employers relates to benefits that have already been earned. Often continuing to provide benefits for current employees is adding to the woes for employers, but not materially. The real focus we are seeing is in negotiations between employers and trustees around funding those past liabilities.”


Have Your Say: Paul Jayson, partner at Barnett Waddingham, suggested the NAPF findings are ”dramatic but not surprising. Employers operating DB pension schemes have been burdened by ever increasing legislation, which has led to the gradual erosion of such pensions in the UK.  The current recession has merely turned this erosion into a landslide.”

He added: “It is worth noting only a minority of workers in the private sector are saving for retirement in DB schemes.  Of those workers who are actually saving anything - through DC schemes - most are not saving anywhere near the levels required for a decent income in retirement.

“The government’s response is the proposed implementation of Personal Accounts from 2012.  This, however, will do little to address the chronic under-pensioning of most people in the UK.  Coupled with a legacy from the bank bailouts and the requirement to meet the unfunded public sector pension bill, tomorrow’s pensioners face a bleak future.”


Have Your Say:Joanne Livingstone, principal at Punter Southall, supported the NAPF’s “call for action, which follows our own five point plan issued earlier this month. Both programmes recognise that reform is necessary and that there are a number of options available to government beyond just yet another bailout.”

Have Your Say:Kevin Wesbroom, UK lead global risk services at Hewitt, admitted “faced with the potential alternatives of reducing headcount or pay cuts, a reduction in pension benefits may be one of the least unpalatable options”.

He claimed there is a range of alternative strategies to help reduce pension pressure, such as the capping of pensionable pay, changes to accrual rates or the amounts that members have to contribute, as well as changing the scheme design, and revealed “many companies are doing all they can to avoid having to take the drastic final step of closure”.

“Employers and trustees need to work through the full range of ways to deal with current deficits - if they jump to inappropriate solutions they may condemn their workforce to being more poorly prepared for retirement. Support from the government to help these alternative approaches may help us to avoid a rapid decline in the coverage of high quality pensions - and also the inevitable social consequences which would follow,” added Wesbroom.


Have Your Say:Keith Barton, chairman of the Association of Consulting Actuaries (ACA), said: “With the opportunity to update legislation missed in 2008, other than at the fringes, it now seems likely that the next opportunity for significant pension reforms may have moved out to 2010 or 2011, very probably until after the next general election. One thing is certain. If we have to wait that long, there will be very few private sector employees who are accruing pensions in DB schemes.

“The role of the government and the Pensions Regulator (TPR) are of vital importance at this time. A firm lead needs to go out from both to sponsors and trustees that makes it clear the best interests of pension scheme members will in most cases be delivered by trustees and sponsors working together to ensure sponsors are able to continue to support ongoing DB schemes.”

Have Your Say:Peter Kraneveld, said:

“Is there a place for DB schemes in the UK pensions industry? Probably not if the present trend continues. Is there a place for DB schemes in the UK? Certainly. DB offers a far better diversification of risk for participants. So who will offer it? 

“The present discussion on pensions in the UK is all about risk and how to avoid is. The interests of participants generally do not count for much in these discussions. In addition, the sector seems to be heavily influenced by US practices and it has developed a visceral dislike of the EU. Meanwhile, there is enough serious scientific evidence that DC doesn’t work: people don’t save enough (this is euphemistically called undersaving in Britain), do not understand investment risk and take the wrong investment decisions. With the first pillar offering only a narrow basis for retirement, there is reason to believe that the sector is content to follow the US on its path to having to work until you drop and poverty among the elderly.

“EU regulation allows foreign competitors to offer DB in Britain. There is and will be growing demand for DB, especially among those who have experienced what DC has to offer. As the population ages and labour grows scarce, companies offering DB wil have an advantage on the UK labour market. It seems that they’ll be foreign companies and foreign pension funds. At the same time, the generation that didn’t save enough will be demonstrating in front of the factory gates, while lawyers will be filing suits against those who offered DC. Tell me again how DC limits risk…”

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