When employees are members of a final salary (aka defined benefit) occupational pension scheme run by their employer it is the employer who is taking all the risks. From the employees’ point of view they get the benefit of knowing exactly what pension they will become entitled to when they retire; it is a fixed percentage of their final salary. That’s great for them because they then don’t have to worry about the investment returns on the pension fund or the fact that people these days are continually getting better and better news on their potential lifespans. Lifespan-wise things are on the up and up right now.
But employers running such schemes do have to worry about the investment returns and the increasing costs of providing pensions as people live ever longer because they’ve promised lifelong pensions at fixed levels to their employees. Employers running final salary schemes are responsible for both the investment risk and the mortality risk.
Many employers have closed or are in the process of closing their final salary pension schemes and replacing them with money purchase (aka defined contribution) schemes instead. A defined contribution scheme is great for employers because the costs can’t run away with them. They promise to pay a set amount of money into their employees’ pension pots every year and that’s that. It is then up to the employees to worry about the investment returns their pension pots accrue and the eventual cost of buying an annuity (a posh name for an annual pension) when they come to retire. The amount of money accrued to buy a pension with and the increases in the going rate for pensions as time goes by thus come to be real issues for employees to focus on and worry about. In money purchase pension schemes the twin risks of investment and mortality are transferred to the employees.
And that’s the way it is in pensions in the UK at the end of the first decade of the 21st Century; employers either shoulder all the risks related to providing pensions for their employees or all the risks are transferred to their employees instead. There’s no middle ground.
But there could be. There are plenty of examples from all around the world where employers bear some of the risks and their employees also bear some of the risks. Believe it or not this phenomenon is referred to in all the best pension circles as ‘risk sharing’ (not too hard to work out why, is it?) One way of designing a risk-sharing approach is for the employer to guarantee a fixed cash sum to employees to be spent under the pension rules to buy an annuity at retirement. A cash sum of ten times final pay, say, could be an attractive defined benefit to offer employees. In this way the investment risk would still lie with the employer as they’d have a fixed sum to provide at a fixed time, but the mortality risk would lie with the employee as they would have no guarantee in advance how much annual pension they could buy with such a sum. I think schemes like that are pretty common in the United States.
That’s just one example of risk sharing; there are plenty of others.
I read yesterday in the Financial Times that ministers have ruled out changes to the current Pensions Bill that were proposed by the Association of Consulting Actuaries that would have made it easier for employers to introduce more risk-sharing pension schemes. I think that’s a shame. Doubly so as part of the reason for rejecting such amendments to the Pensions Bill would appear to be that it would add complexities to our pension system. I mean, excuse me, but two things hit me right between the eyes when I read that. For a start, if not introducing complexities to our pension system is what we’re all about how on earth did we get a pension system that’s as bafflingly complex as the one we’ve got already? And second, I guess, given that we’ve got a highly complex pension system anyway, what difference will a bit more complexity make? And anyway, maybe it would be worth it if it stopped the polarisation of ‘all the risk on employers, or all the risk on employees’ that we seem to be stuck with right now as our private sector company pension schemes are undergoing unprecedented change.
20 August 2008
Source: Financial Times, 19 August 2008
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