- The Future of UK Pensions? The DWP Consults on "Defined Ambition"
- November 27, 2013
- Law Firm: Dentons Canada LLP - Toronto Office
The risks associated with the provision of the two basic structures of occupational pension schemes in the UK sit at opposite ends of the employment spectrum.
Defined benefit pension schemes (DB), whether final salary or career average (CARE), place the risks firmly with the employer who is expected to make up any shortfall in funding to provide these guaranteed benefits. Such pension arrangements are very popular with members but much less so with employers as DB costs have increased as successive Governments have added additional requirements to the basic DB offering, such as revaluation and indexation, and member longevity has increased!
In contrast, defined contribution schemes (DC), sometimes called money purchase, place the risks with the employee. In these schemes the member gets no guarantee of what they will receive at the end of their employment but instead relies on the value of the contributions they and their employer make, plus any investment return up to the date of retirement.
This analysis of risk has largely made DC schemes the default option for most UK employers.
The Department for Work and Pensions (DWP) believes that there are alternatives to these two basic structures and has been talking to the pensions industry to see what types of scheme structure could offer members a little more security without putting too great a burden on employers, and thereby shore up pensions savings in the UK.
In its original discussion paper "Reinvigorating Workplace Pensions" the DWP called its proposed third way a "defined ambition" scheme.
So what does the DWP think a 'defined ambition' scheme might look like?
The DWP is consulting on three potential structures for its defined ambition pension scheme:
Flexible DB is proposed as the "DB light" option. Final Salary or CARE-based pensions would be paid but pensions in payment would no longer need to be indexed for inflation. Instead inflation increases or lump sum increases could be paid where the funding of the scheme permitted.
Other proposals include (i) a requirement for members' benefits to convert automatically to a DC basis on leaving employment with an employer and (ii) allowing employers to change a scheme's normal pension age to reflect changes in longevity assumptions.
Taken together these changes would reduce the level of risk assumed by an employer and the DWP is proposing that employers could switch to flexible DB for future accrual in existing DB schemes.
Guaranteed DC has four basic "flavours"
A DC scheme in which the member's pension savings pot at retirement would never fall below the amount paid into it by the member, plus any employer contributions.
An industry standardised capital and investment return guarantee, to be purchased by a fiduciary on behalf of multiple scheme members from insurers or similar providers.
Retirement income insurance bought by a fiduciary on the member's behalf each year from the age of 50 using the member's pension savings fund. At retirement, the member would take a pension directly from their pension savings but where the savings run out the insurance would kick in and start paying a retirement income thereby avoiding the risk of a member running out of money in retirement.
A split pension savings pot, with a proportion used to buy a deferred nominal annuity, payable from the member's pension age. This would give the member a clear and identifiable pension income which would run in parallel with the remainder of their pot which could go into a collective higher risk set of investments to provide future indexation.
The final proposal is a variant of the Dutch collective DC scheme structure. This involves large pooled funds which benefit from the lower costs associated with scale, whilst also allowing members to reduce the risk that when they come to retirement there will be a dip in the investments they hold resulting in a reduced pension income. This structure also allows clear targeted pension incomes given the ongoing contributions from other members that would continue after the individual member has retired.
None of the structures would currently be legal under the existing pensions law framework, but there would be nothing to prevent the DWP introducing legislation to allow them if there were a positive industry response to them.
The level of blue sky thinking exhibited by the DWP in this consultation is to be applauded. There are clear issues with the current DB structures in the UK and arguably the current situation is not sustainable without forcing workers into unpopular DC schemes which are unlikely to provide them with an appropriate pension income at retirement.
The main question, however, is whether this is all too little too late. Most employers that we advise have been moving to contract-based defined contribution schemes for some time, and none of the proposed alternatives are likely to be more popular than basic DC. In so far as the new models put any more risk on employers they will be uncompetitive without some incentive from the Government in the form of tax relief.
The one possible area where the current thinking may achieve traction with employers is in the area of converting existing DB schemes into DB light for future service. This approach may be seen by some as further accelerating the demise of existing DB schemes but equally it may provide an opportunity for DB light to achieve some foothold and distinguish sponsors as the employers of choice, without costing the earth.