Pensions in the UK are in crisis. Over the past decade most final salary or defined benefit (DB) pension schemes have closed to new members or future accrual, as companies have sought to lighten scheme deficits. There are now only six DB schemes still open to future accrual among companies in the FTSE 100 and all of these have closed to new members.
Defined contribution (DC) or money purchase schemes, increasingly the norm for private pensions, transfer risk, inflation, interest rate, investment and longevity to members. These schemes are affected by economic conditions, which could leave members at best disappointed in retirement and at worst impoverished.
Regulation killed the British pension scheme, particularly regulation about compulsory pension increases
But for now they are the most viable option. By 2020 there may be more than 16m DC scheme members in the UK compared with 7m today, according to Pensions Policy Institute estimates published in June.
The rise of DC will partly be driven by the introduction of auto-enrolment, the government’s attempt to encourage more people to save for retirement, easing the burden on the state pension. But if DC schemes, including those into which workers are auto-enrolled, fail to provide enough income, the state will need to support those people anyway.
If people working into their 60s think their pension will not provide a decent income they may not want to retire. And anti-age discrimination laws will make it hard for employers to push them out, creating other issues such as rising unemployment among the young.
In the first half of this year pensions minister Steve Webb has spoken and written about the potential of defined ambition (DA) schemes to address these issues. DA would share pension risks more equitably rather than loading them onto the employer (as in DB) or scheme members (as in DC).
One option would be a cash balance scheme in which an employer guarantees a fixed pension pot on retirement with the employee bearing the risk of uncertainty as to what the pot might be worth. Alternatively an employer could guarantee a pension income but allow the date on which it is paid to rise with life expectancy. Or the level of income in retirement could be determined at a late stage, having been narrowed down from a pre-set broader range.
Another model is the collective DC scheme used in the Netherlands. The pension benefit is calculated using a formula similar to that used for DB but the contribution rate is fixed, not the benefit.
In Denmark many pension savers use deferred life annuity schemes. These guarantee future payment is based on a current minimum conversion factor, using a guaranteed minimum interest rate and prudent estimates of longevity. The annuity can be boosted by bonuses if the investment performs better than the guaranteed return or longevity assumptions turn out to be too prudent.
There are already some cash balance pension plans in the UK, as well as a few hybrid schemes in which a small DB element is supplemented with a DC arrangement. But what should government do to encourage employers to take on more risk? Adrian Waddingham, founding partner of actuarial firm Barnett Waddingham, believes deregulation is key. He suggests removing compulsory rises.
"You might say if you took that away members wouldn’t enjoy the same protection. But at the moment people aren’t getting the pension itself, never mind the protection," he says.
There will have to be changes, says Darren Philp, policy director at the National Association of Pension Funds. "Regulation needs to be proportionate to the risk," he says. "If my employer says, ‘You work 10 years and I will guarantee you a pot of £50,000’, regulation should make sure it happens and the employer is clear about the deal. Is the benefit inflation-protected, for example?"
ICAEW welcomes Webb’s initiative, according to its pensions committee chair, Zahir Fazal. But he adds, "No one knows the shape it will take. ICAEW members include financial directors responsible for looking after companies’ balance sheets who will need convincing this is worthwhile and not a commitment over which they will have no control."
Shadow work and pensions minister Gregg McClymont also has doubts. "The government should consider the possibility of permitting pension providers the option of offering collective DC. But this should not take resources away from ensuring auto-enrolment takes off. There’s already a worry that internal government wrangling over reform of the state pension is distracting the minister’s attention from auto-enrolment. Defined ambition risks another loss of focus."
So if auto-enrolment has progressed well by 2015, would DA be a priority for a Labour-led administration if it won a general election that year? McClymont says the party won’t set its priorities until nearer that time but "will undoubtedly include measures designed to reduce costs and improve processes and outcomes for savers. These will include measures that may, or may not, come under the heading of defined ambition depending on what this government is intending to achieve under that heading."
The Department for Work and Pensions (DWP) says it is focusing on auto-enrolment and hasn’t yet been explicit about how it sees DA schemes working. "DWP is exploring with the pensions industry how existing options and new ideas might be developed," says a spokesman. "A defined ambition industry working group chaired by the ACA [Association of Consulting Actuaries] has been set up, as well as sub-groups including providers, actuaries, lawyers, regulators and investment firms. It is intended to publish something about defined ambition later this year. The content will be consultative and exploratory, although we will be clear about the strategic direction." ICAEW will contribute to this process.
Change of focus
Signals from the DWP so far suggest the emphasis will be on creating the conditions to stimulate new schemes rather than on stipulating how such schemes should look. "That would be a good first step, to give employers the freedom to use designs that suit their circumstances," says Kevin LeGrand, head of pensions policy at Buck Consultants.
Waddingham adds: "I’d like the government to deregulate. Regulation, particularly about compulsory pension increases, killed the British pension scheme. This is important as even with government help it will be difficult to get financial directors back in the water."
Waddingham’s colleague Andrew Vaughan, elected ACA chair in June, says ACA will "continue to argue the case for a meaningful rationalisation of pension legislation and regulation so private businesses feel offering a good pension scheme is worthwhile".
Ahead of any such change, introducing auto-enrolment is "the biggest catalyst for change in UK pensions provision", says Ben Stafford, director of UK public affairs at Cicero Consulting. The DA debate is not happening in a vacuum, he says, but in the context of auto-enrolment, debate about the reform of the state pension and planned EU regulatory changes.
Uncertainty continues both over what the current or next government will do about Webb’s ideas and over the ideas themselves. However, DA may form a useful part of a much-needed solution to a big problem for government, employees and staff.
"The most important attributes of a DA pension scheme would include greater certainty for members than a DC pension, and less cost volatility for employers than a DB scheme. Risk-sharing is a key enabler.
We are working with the new Defined Ambition Industry Working Group of pension industry practitioners. Later this month, we plan to publish a Private Pensions Reinvigoration Strategy. This will set out the challenges we want DA schemes to meet, and share ideas from the working group.
Implementation will depend on how far solutions can be delivered within the current legal framework. We hope to set out scheme models and products next summer that don’t require legislative change.
Government will then consider proposals for legislative change, assessing impact on scheme members, employers and the industry."