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The risk sharing revolution

Risk sharing pension schemes offer the ability for employers to control their pension costs while providing a better deal for members than defined contribution arrangements. But have too many corporate fingers been burnt by the cost and liabilities involved in offering defined benefit plans? Ian Farr asks whether compnaies can be persuaded to share risks

Over the last two years, I have spoken at venues across the UK and abroad on the theme of risk sharing schemes - pension schemes where employers share pension risks, instead of schemes where 100% of risk is taken, by and large, by employers (defined benefit schemes) or 100% by employees (defined contribution schemes).

Given the closure of many UK defined benefit schemes to both new entrants, and increasingly to new accruals, I have generally found strong support for a future where companies can feel confident in offering good pension schemes as long as costs can be effectively controlled. For some, this has meant defined contribution is seen as the only answer. Their argument says that having burnt their fingers, UK companies are no longer prepared to take on the risks associated with offering a pension scheme - shared or otherwise. The pain in correcting defined benefit scheme deficits and the forward risk in offering such arrangements, alongside accounting reporting issues, means the desire to share any pension risks into the future is, rightly, questioned.

But is risk-sharing dead in the water? Are we moving to a long-term situation in the UK where nearly all employees in the private sector will only be offered defined contribution pension schemes, where they must take on 100% of the investment and longevity risks? For a number of reasons, I think that many UK companies - particularly mid-sized to larger businesses - take a quite different long-term view, reflecting their genuine desire to provide their former employees with a stable platform for retirement. Yes, at present, many have taken the decision that they can no longer afford to offer defined benefit arrangements, but there is good evidence that many want to do more than the minimum and - as caring employers - they want to protect their employees from some of the risks associated with pension saving. What makes me say this? Here are just three reasons.

First, the ACA's 2007 Pension Trends Survey, whose 330 participants hold pension assets of £127bn (€160bn) with 2.1 million members, has shown employers still see their perceived duty of care as the principal reason for offering a company pension scheme. Maintaining and developing an image as a caring employer, and being keen to attract the brightest and the best, is more important than ever in a world where retaining talent is ever more important.

Second, a recent survey of financial directors carried out by Fidelity International, found that over half of the companies offering defined contribution plans were concerned that their schemes were not generous enough to provide their staff with an adequate pension in retirement. While the switch to defined contribution has been rapid, the sense is that this occurred because of the absence of an acceptable, workable alternative under UK legislation that significantly reduces employers' risks. Here, the regulation and benefit guarantees conferred by the UK Parliament on any type of non defined contribution arrangement, making them defined benefit schemes, has had the unintended consequence of turning employers away from such schemes. 

And third, returning to the ACA's 2007 Pension Trends Survey, we found that 72% of the companies participating supported the promotion of new risk sharing schemes that better control employers' costs whilst also providing a more stable benefit platform than possible by defined contribution. A recent survey by HSBC and the Pensions Management Institute echoed these results.

Increasingly, I think there is a fourth reason that will be driven by government. In the UK, it simply will not be politically acceptable to retain a position where over 5m public sector employees are in open indexed linked final salary schemes, but over the longer-term with the vast majority of private sector employees dependent on pensions linked directly to the volatility of stock markets for the majority of their pension income. A UK government, perhaps even this one, will recognise the need to act to close the gap, albeit not through greater public spending or excessive regulation.

So, where do we go from here? In the UK, alongside their reforms to introduce low-cost private pensions to more people from 2012, the government has established an ongoing deregulatory review of private pensions in an attempt to address the demise of ‘good' occupational pensions. Early on, this review recognised the potential for more risk sharing schemes, but it failed to grasp the legislative reforms necessary to generate interest in such schemes.

The Association of Consulting Actuaries, meantime, has focused on promoting a simple reform to existing legislation through an amendment to the current Pensions Bill going through Parliament. This would allow employers to offer conditionally indexed risk sharing schemes, similar to those offered in The Netherlands.

The ACA proposal has been supported by the main UK pension bodies, the Confederation of British Industry and has been taken up by Conservatives and Liberal Democrats, as a first-step initiative to free-up the restrictive benefit design enforced by present UK legislation on employers who wish to do more than simple defined contribution.

Under the ACA risk-sharing proposal, mid-sized and larger employers would be free to offer new conditionally indexed schemes designed to share risks with employees. These conditionally indexed schemes would offer to employees a far less volatile pension outcome than defined contribution - the latest 2008 Pension Trends Report published by the UK Office of National Statistics shows 68% of individuals feel that a pension linked to the stock market "was too much of a risk". Pensions would be based on career average earnings and service under such a new model. Apart from on occasions when scheme funding falls into deficit (the "condition"), pension benefits would be indexed in line with a scheme specific index, typically price inflation up to a 2.5% cap per annum. Restoring indexation would be the first priority when a scheme returns to surplus.

Funding would be based, as with existing defined benefit schemes, on the new prudent funding standards set by the Pensions Regulator, with PPF levies securing further protection for members (but with lower levies based on the lower risk profile of such schemes). So, while pension increases might be held back from time to time because of a past service deficit, over the longer term indexed benefits would accrue, supported by the prudent funding standard. And because these would be new schemes with new rules it would be the case that normal retirement age - subject to proper actuarial checks - would be increased to reflect improvements in longevity. For employers, costs would be controlled into the longer term in a way that existing defined benefit schemes have found so difficult.

The ACA amendment does not stand in the way of the promotion of other possible types of risk sharing arrangements, such as cash-balance schemes, collective defined contribution schemes, hybrid schemes and so on, but the reality is that some of these require legislative changes that are not ready for this year's Pensions Bill or have to date engendered little interest due to their complexity, often in communication terms.

To address these points, the UK government has announced a consultation exercise on risk sharing to be conducted over the summer. The recommendations being published in the autumn. This is welcome in that it recognises that new benefit designs are needed to free-up the UK occupational scheme market. However, this timetable means any outcome will miss this year's Pensions Bill, with no guarantee that legislative time will be available next year. In a situation where companies will be reviewing their existing arrangements ahead of the introduction of auto-enrolment and personal accounts in 2012, it is vital that at least one ready variant of risk sharing - conditionally indexed schemes - is available to employers in the near-term. 

For more information about risk sharing schemes and a question and answer paper, please visit www.aca.org.uk (policy statements). 

Ian Farr is outgoing chairman of the UK Association of Consulting Actuaries

This series of articles, published in conjunction with our Netherlands sister title IPN, seeks to create a platform where various authors, academics and practitioners discuss possible solutions to solvency and risk sharing issues that have the common objective of making the DB pension system more robust for the future. 

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