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Pension Schemes - Managing the Risks
Any discussion about pension scheme design can quickly become polarized with the focus on the two extreme ends of the risk spectrum - defined benefit ("DB") and defined contribution ("DC"). In simple terms, the employer bears the risks under a DB arrangement while employees bear the risks in a DC scheme.
"DB vs DC" is a convenient title for magazine articles and seminar topics but in many cases it simply provides a forum for repeating well rehearsed and (generally) well understood arguments for and against these different types of pension arrangement. This doesn't really take the debate forward, and employers should recognise that as in all arguments of this kind there are options in between the two which can have benefits for both employers and employees.
Cash Balance Schemes
For example, employers might consider the introduction of "cash balance" arrangements. These plans target a pot of money at retirement rather than a specific amount of pension. Like a traditional DB scheme this target is usually expressed as a percentage of final (or average) salary and depends on service. For example, the benefit promise might be 15% of final salary for each year of service. Like traditional final salary schemes the employee will pay a fixed amount, with the employer paying the balance of cost and hence taking the investment risks (and perhaps the salary risks) in the period up until retirement. However, the employer's obligation is limited to providing the promised pot of money at retirement - at this point the interest rate and mortality risks pass onto the individual member who will need to purchase a pension with at least part of that pot.
There will be a need for the members to receive financial advice at the point of retirement but the members have much greater control and flexibility over their retirement income. Everybody's individual circumstances will be different and will justify different combinations of cash, pension, income drawdown, survivors' benefits, etc. Changes in employment patterns for older workers (later retirement, and more flexible working arrangements) will also demand a greater degree of flexibility in retirement income. This type of arrangement also fits easily with the new tax regime - as the proposed maximum allowance is also defined in terms of a cash amount at retirement.
Which risks are worth taking?
Employers should know which risks they are taking on - it is becoming increasingly important to understand these risks. We discuss the main financial risks in providing pension benefits below, with some comments on the implications for the employer.
Investment risks
Investment risks are never straightforward, but they become easier to manage if the investor can take advantage of pooled resources, economies of scale and access to high quality professional advice. It also helps if there is sufficient flexibility in the underlying funding arrangements to cope with the short-term ups and downs of investment markets which are an inevitable fact of life for long term investors.
We believe that trustees, in conjunction with the sponsoring employer, are in a much better position to manage these risks than individual employees. Put simply, the majority of employees do not have the necessary understanding or financial awareness nor are they able to afford the kind of professional expertise and advice needed to make these decisions. Whilst "lifestyling" is one way of helping with this problem, individual DC investors are often left either confused, choosing the default investment option, or both.
Salary risks
Traditional final salary pension schemes link the whole pension benefit to the members' final salary. This design has historically been seen as a way to reward long-serving employees - a feature which may not be so relevant today. In DC schemes, contribution levels are based on salary, so there is some remaining salary risk. DB schemes can be "final salary", or "career-average" - the latter being similar to DC schemes in terms of salary risk. The best choice in terms of how much salary risk an employer wants to bear will probably depend on the particular circumstances of that employer.
Cost of pension
Mortality risks and long term interest rate trends are scary! Only a pensions actuary would find cause for concern in the fact that we are all living longer but inevitably this makes pensions more expensive unless retirement ages are increased. Effectively in a defined benefit scheme an employer is taking a bet on how long a recently recruited 21 year old employee is going to live. Most employers are acutely aware of the impact of recent improvements in life expectancy but this trend could continue due to advances in medical science and genetic engineering.
Conclusion
Whichever risks an employer is prepared to bear, there should be a pension scheme design which fits. Many companies will continue to provide traditional final salary benefits for their employees because they can manage the risks involved - this is still the best way to ensure the members get a meaningful income in retirement. However, for those companies looking for alternatives, DC schemes are not the only option. Indeed, increasing disclosure requirements for DC schemes, coupled with greater pensions coverage within the media, could mean that a well thought out pension scheme (such as a cash balance scheme as outlined above) can still be an important and attractive benefit for employees that need not leave the employer taking undue risks.
If you would like to discuss this note please contact any of our offices.
Barnett Waddingham, April 2004.