In depth: Learning to share could help us all
When employees are members of a final salary 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 don't have to worry about the investment returns on the pension fund or the fact that people these days are getting better and better news on their potential lifespans.
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 investment and mortality risk.
Many employers have closed or are in the process of closing final salary schemes and replacing them with money purchase 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 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 when they 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 schemes the twin risks of investment and mortality are transferred to the employees.
And that's the way it is in UK pensions at the end of the first decade of the 21st century: employers shoulder all the risks 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 around the world where employers and their employees share 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. 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.
That's just one example of risk sharing; there are plenty of others.
Apparently though, 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 as bafflingly complex as the one we've got already? Second, 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.
First published in Pensions Week, 22 September 2008