UK: The third way
Nearly two decades after Tony Blair espoused a ‘third way' in UK politics, the current government is in favour of a defined ambition approach in occupational pensions that would combine elements of DB and DC. Jonathan Williams asks whether the industry wants it
This autumn will see the long-proposed introduction of auto-enrolment and, with it, launch the biggest single reform the UK pensions landscape has seen since the creation of the Pension Protection Fund. Millions who currently have no retirement savings, as the department for work and pensions (DWP) has been keen to remind us over the past few months, will be compelled to save into a pension fund, either an existing defined benefit (DB) scheme or, more likely, a newly launched defined contribution (DC) arrangement. So far, DB and DC are the only two options available - unless pensions minister Steve Webb is successful.
Addressing the National Association of Pension Funds (NAPF) annual conference in Manchester last year, the minister spoke of his desire to "facilitate" a return to risk-sharing, with an element of guarantee, and has since discussed the possibility of ‘defined ambition' - located, to borrow the minister's phrase, in the region between DB and DC - at almost every public event he has attended.
Exact details on the proposals are not yet forthcoming, with the government planning a consultation on the matter in the near future. The question remains how to practically implement this ‘third way' - and if change should be contemplated on the eve of auto-enrolment.
Risk sharing has had some limited adoption often with a career-average revalued earnings (CARE) or cash balance schemes. The CARE approach has been adopted by some FTSE companies, notably supermarket giant Tesco, who will use their DB fund as their auto-enrolment option, as well as by the BBC, where the CARE option was introduced to address concerns over its deficit. The retailer Morrisons has opted for a cash-balance scheme over its existing DC arrangement before compulsion. However, accounting standards categorise funds as either DB or DC, with no scope for flexibility, such as the collective DC model adopted by the Dutch.
Zoë Lynch of law firm Sackers notes that Webb is not the first to entertain the idea of greater risk-sharing. In 2008, the DWP consulted on the introduction of collective DC and conditional indexation, the latter a key ingredient of the Dutch risk-sharing model. "It was bandied around the industry for quite a while, the thought of doing something about risk-sharing," she says, before it was ultimately deemed to be too difficult to implement.
So defined ambition may not necessarily involve ideas that have not already been considered, even though Webb earlier in the year visited Danish and Dutch pension experts to gather opinions on how he could proceed.
The question remains as to the level, if any, of appetite among employers to take on new risk now that the shift to DC is almost wholly concluded. Paul Macro, principal at Mercer and the consultancy's head of DC in the UK, doubts if the government's aims for defined ambition will be shared outside of Whitehall.
"The real reason why defined ambition, generally, is not going to work is that, as things stand, if the guarantee sits with the company, then there's going to have to be a liability that sits on their balance sheet - which is why most finance directors want to get shot of DB as fast as they can."
The concern that companies will be reluctant to re-enter the DB fray is one acknowledged by the NAPF. Its director of policy, Darren Philp, says the way forward should include not only an emphasis on risk-sharing, but also the ability for companies to select the type of risk they would like to insure members against - with an element of flexibility introduced into what he brands the ‘two-bucket' regulatory system.
Philp suggests that schemes and providers could, by creating greater room for manoeuvre within the regulatory system, innovate and create their own solutions. "It's not about one product or one type of solution, it's about a suite of solutions permissible within a regulatory regime."
Propped up by a number of different underpins, he proposes that schemes could decide which of the many risks they would like to protect against - so a company with healthy pensioners might offer increased protection against longevity or better indexation, while others may opt for guaranteeing contributions or a certain level of return.
Additionally, Philp argues that these guarantees would not necessarily be set in stone, with the level of guaranteed investment negotiated annually as part of the company's overall remuneration package, allowing finance directors to better control and predict their level of risk year-by-year. This approach has shades of the Dutch model whereby company funds can, as required, negotiate funding to offer indexation if this cannot otherwise be met due to the funding ratio. Philp's suggestion is for a re-assessed guarantee each year, rather than for one that is pre-set, but still conditional.
Mercer's Macro remains unconvinced, arguing that it is rare for a ‘third way' approach to work. He says utterances on defined ambition have been "wishy-washy" to date. "It always seems a danger that you take the worst of both ends of the spectrum rather than the best," he says. "The timing is obviously perhaps a little bit late - closing the stable door after the DB horse has already bolted."
He further points to the timing of the discussion, which comes after most large companies will have settled on their auto-enrolment scheme, or at the very least be in advanced discussions on how to proceed. He questions whether any company would simply opt to abandon the planned fund for something "unproven and unfounded".
Macro speculates that a guaranteed investment return fund would either have to be cautious in its investment approach if the risk was shouldered by the company - or, if the guarantee was taken on by the asset manager, it would impact overall returns as a result of higher fees.
"Anything they come up with is going to have to be, as the title says, an ambition," he adds. "What does it mean for the member? It's difficult to see how you'd sell something with such relatively weak backing to it, unless what is being offered is easy to achieve."
If the UK is set to learn about soft guarantees, then surely one of the countries best to emulate would be the Netherlands - leader in the past two Melbourne Mercer Global Pensions indices. Philp seems cautious, noting that it raises questions of inter-generational fairness that could potentially allow for rights cuts across the entire scheme membership, actives, deferred members and pensioners alike.
"One of the barriers to collective DC, although it's not an insurmountable barrier, is that if people decide to opt out because investment returns are falling, then the scheme will potentially lose critical scale - and you need to have that pipeline of people coming through."
He says that while this would not rule the model out completely, there are still a number of issues in need of resolution before any potential launch. Macro is more openly sceptical, noting that the Netherlands is increasingly adopting individual DC as it is understood in the UK - although the Dutch social partners remain committed to the DB system despite major changes proposed by the Pension Agreement and limited interest in the premiepensioeninstelling (PPI).
Another option would be to emulate Australia in introducing a more prescriptive default fund option. Macro is even more sceptical: "I would be very strongly against some form of standard investment, just because everyone is different."
He points to the work undertaken by the National Employment Savings Trust (NEST) in developing fund options to fit the needs of its clientele as an approach that should be pursued - noting that scheme guidelines issued by the Pensions Regulator put more emphasis on fund governance rather than prescriptive regulation.
Not all consultants, however, are opposed to the idea, with Malcom McLean of Barnett Waddingham noting that it would allow for greater comparability among funds in future. He nonetheless strikes a note of caution: "I don't favour throwing everything into the air at this point in time just as auto-enrolment is starting."
An already existing pension option could offer the solution to Webb's promise - with cash-balance schemes established within in the UK regulatory framework falling the middle of Philp's risk-sharing spectrum, according to the director of policy.
This would involve a boost to ‘with profits' schemes - although few would advocate a return to that approach
"The whole model of ‘with profits' generally does not work," comments Macro. "There are still some good examples, but people generally don't like it because they don't understand what's going on under the bonnet."
Of all the existing proposals considered - collective DC, cash-balance and ‘with profits' - communication and clarity is key, raising the question as to whether the government will be able to produce anything like a clear road map.