The trm Report - November 2004

Comment
History Lesson
Michelle Cracknell

It is an annual ritual to speculate what may be in the Budget. 1989 was no different. There was a very strong rumour that it would become compulsory to provide inflation-proofed pensions on all defined benefit schemes. (Of course, it was not until April 1997 that this particular legislation was introduced).

Back in the late 80’s, the cost of an inflation-proofed pension was approximately twice the cost of a non-escalating pension. The introduction of compulsory increases to pensions would therefore double the cost of the future pension benefit two times its current level.

At the time, one of our clients had a typical defined benefit (final salary) pension scheme. It was contracted-out of SERPS and provided 1/60th of final salary for each year of service. In common with many schemes of this size, there was no in-built escalation of the pensions in payment. The doubling of the cost of the scheme was considered to be untenable and we were employed to look at the various options available to the client.

Company’s Objectives

The client’s objectives were:

• To contain the cost of retirement benefits for its employees
• To provide broadly similar retirement benefits for its employees
• To continue to offer a scheme that was easily identifiable as part of the company’s benefit package
• To reduce the administrative costs of the scheme.

The Solution

It was proposed to replace the company’s defined benefit scheme with a contracted-in money purchase arrangement. This met the company’s objectives as:

• Future pension costs would be known
• The contribution rates could be targetted to broadly provide the same benefits
• As an occupational pension scheme, it would be clearly identified as a company benefit
• Contracting in to SERPS would remove a layer of administration thereby reducing costs.

It was decided to opt for individual contribution rates that, based on reasonable assumptions, would provide broadly the same pension benefits. However, this was not a straightforward matter.

Firstly, the former scheme was contracted-out and hence the member’s contribution was being subsidised by the lower rate of National Insurance. The level of subsidy obviously varied depending on the level of earnings. The member’s contribution rate was reduced from 5% of salary to 3.5% of salary for each member using the average level of subsidy and rounding the result to a sensible amount.

The second issue was that the future pension benefits would be provided by the company pension scheme AND the state additional pension (which at the time was SERPS). It was the combination of these two benefits that needed to match the defined benefit of one-sixtieth of salary for each year of service.

The assumptions (or relationship between assumptions) that have the most major impact when calculating the contribution required to provide a target level of benefits are:

• The difference between the pre retirement investment assumption and the rate of salary escalation
• For a non-escalating pension, the investment assumption used post retirement. Realistic assumptions were chosen to calculate individual contribution rates for each member; accurate to two decimal points.

During the review, a third issue was raised. The defined benefit scheme had a very long history and members of the scheme who joined prior to 1987 had very beneficial commutation factors for part of their pension. It was necessary to ensure that the new scheme did not disadvantage these members. The only way to retain the same favourable levels of tax-free cash sum was to continue with an occupational pension scheme structure.

The new scheme was launched with effect from 1st April 1990. A full breakdown of the new contribution rates and the estimated benefits (as a percentage of final salary) split into each of the components was communicated to the members.

What History Has Taught Us

Hindsight is a wonderful thing! Many lessons have been learned over the last fourteen years.

Over the last fourteen years, we have seen a major change in economic conditions. We have had a sustained period of low inflation which has led to very different financed dynamics for a pension scheme. The major impact of this low inflationary environment has been the reduction in annuity rates.

It has also been a period during which we had many changes in pensions legislation including the compulsory inflation increases to pensions in payment originally rumoured in the late 80’s.

Finally, there has been a rollercoaster of returns from investment markets testing the skills of even the most professional fund managers.

Impact on Members

Ask any member of this scheme and he/she will say the new defined contribution scheme is inferior to the former defined benefit scheme. But, is it? Has the scheme underperformed and were the target contribution rates wrong?

There are many issues that have impacted on the members’ benefits:

• Until 2000, the size of the fund was on target to provide the same pension which, when added to the SERPS, would provide the same pension as the defined benefit scheme IF annuity rates had not reduced so dramatically
• A contributing factor to the lower pension is the fact that part of the pension must increase in payment
• The perception of the membership of a lower pension benefit is sometimes because the SERPS pension is not immediately taken into consideration
• Finally, few members take the opportunity to tailor the pension to suit their circumstances but instead mirror the format of the old scheme pension. Thereby missing out on one of the advantages of the Defined Contribution scheme.

The Defined Contribution Scheme is not inferior to the former scheme although it carries the investment and annuity rate risk which in the period so far has worked against the members.

What Lessons Have We Learnt

If the exercise was repeated what would we have done differently?

The communication exercise at the time the scheme changed focussed on the company’s aim to “match” the benefit that would have been provided by the former scheme. In practice, this has not been achieved mainly for reasons outside the control of the Employer, namely:

• Changes in economic conditions (lower interest rates)
• Changes in pensions legislation (increasing pensions cost more).

If the exercise was carried out today, we would recommend that the communication focussed more on the difference between the schemes and the fact that the pension could be less than the targeted level.

The changes from a contracted-out scheme to a contracted-in scheme means that the use of Combined Pension Statements (including SERPS/S2P) would be beneficial. Equally, this applies to schemes where the average salary is low and State pension benefits are a very significant pension of post retirement income.

The target contribution rates (to two decimal points!) were technically correct BUT indicated spurious accuracy. In hindsight, introducing bands of contribution rates for different ages would perhaps have sent a better message that the new scheme was not guaranteed to provide the same benefits.

All aspects of life carry risk. The communication that we have done in similar exercise more recently has focussed on the different aspect of risk. Ongoing communication should examine the key risk factors that will impact on the level of final pension i.e.

• The investment risk
• The risk of converting a fund to a pension
• The risk of future changes in legislation on both private and state benefits.

As we now face up to “Pensions Simplification” and a new Pensions Act, employers will be reviewing their pensions strategy. Undoubtedly, more defined benefit schemes will close to future accrual. Trustees will be considering how best to implement administrative change. Communication with members will need to be better than ever before.

Michelle Cracknell
Director
Origen
020 7061 5836

michellecracknell@origenfs.co.uk