Is there a 'soft landing' for final salary?
But where does it take us? That’s what I find I’m constantly thinking about these days (that and how the hell am I going to scrape enough money together to get my daughters through university, not to mention funding the future profitability of Top-Shop while I’m at it, obviously). I’m not sure I agree with the commonly-held view that the only alternative to final-salary, or defined-benefit schemes is for employers to switch to groupings of personal pensions or stakeholder pensions instead. Some are, yes, but that’s a step-change for many larger employers that could be difficult for them to sell to their employees. That’s not to say, by the way, that I go along with that other great media favourite, the ‘demonising’ of DC. It’s just that I think that the larger DB schemes that we have were set up for a purpose in the first place and the reasons for employers retaining at least some of the risks associated with pension provision for their staff are probably still valid and shouldn’t be ignored.
What happens with traditional defined-benefit schemes is that all the certainties are with the employees, and all the uncertainties lie with the employer. As an employee you know exactly what your pension will be related to your earnings at or near retirement and your length of service. The employer, on the other hand, has no idea what this benefit promise will eventually cost. The two main risks being run are those of the investment return and of the future cost of annuities. The argument goes something like “these two risks are getting too difficult for employers to underwrite, so they should both be passed on to employees instead.” Well, that’s one way of looking at it, but there is another.
Many people are now saying that there may be a ‘soft landing’ somewhere between the traditional defined-benefit approach and the grouping of individual defined-contribution products, and that for many larger employers other options may suit their businesses better. Essentially, these options all move some of the risk or cost of the pension scheme to employees, but leave the employer still bearing some of the risk too.
A good example of this, and one that has become quite popular in America as it too has moved away from its traditional approach to defined-benefit provision, is where the employer passes the risks associated with annuity purchase on to employees, but retains the investment risk. These schemes are sometimes referred to as ‘Cash Benefit Schemes’, or similar, and are essentially defined-benefit arrangements where the defined benefit is a certain amount of cash provided at retirement for the purpose of annuity purchase. For example, an employer could set up a defined-benefit scheme to provide a fixed sum of, say, ten times salary at the time of retirement, which the employee could then use to purchase an annuity. This approach provides the employee with a good level of security as far as knowing the exact amount of funds that can be counted on in the future, but does not commit the employer to also underwriting future annuity rates. Such schemes are already popping up over here in the UK and I think they’ll become more common over time.
But there are other ways of sharing the risks more evenly too. One idea is, that of running a ‘tiered’ defined-benefit scheme, which is also coming more to the fore over here. A tiered scheme offers employees the option of ‘buying in’ to the final-salary scheme at different levels, all with different levels of commitment from the employer. For example, a scheme could offer eightieths of final salary, say, for employees willing to pay 3% of salary towards the costs, but seventieths or sixtieths for those prepared to pay higher contributions of 5% or 9% for instance.
And why stop there? A typical traditional final-salary scheme providing a sixtieth of final salary for each year of service will, as a rule of thumb, cost around 20% of payroll year on year to provide. Most schemes only ask for 5% or maybe 6% contribution from the employee towards the overall costs, and in some cases the schemes are even non-contributory. It seems to me that there is a good case for employers looking to the employees to contribute more towards the costs of provision if maintaining the generous final-salary benefit levels is what suits both the employer and the employees. That’s not to say that they should both bear half the cost, but there is a case for increased employee commitment being the price for keeping schemes going where an employer is still prepared to underwrite both the investment and annuity risks. Again we are seeing many companies taking this route. Of course, this gives rise to some of the sillier stories in the press about employers going back on their promises and such, but, hey, were getting used to those by now, aren’t we? What it really is, is that employers and employees are starting to look at the pension realities together and coming up with bespoke solutions that work in their particular circumstances. Our pensions environment is changing, yes, but it’s not as simple as DB or DC. In my view, our future’s not that polarised, even if it does make for more dramatic newspaper stories.
The information provided is based on Scottish Life’s current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice.