In May, Steve Webb, pensions minister said the industry only has 12 months to save the defined benefit model during an industry event at which he outlined a vision for a “slimmed down” version of salary-related pensions, which are under threat as employers drastically scale back their offering due to high costs and spiralling liabilities.
According to figures published by the Department for Works and Pensions alongside the paper, defined benefit schemes have declined rapidly in recent years: the percentage of open schemes has more than halved since 2007 to 14 per cent, equating to just 841 schemes in total.
But what would a new ‘defined ambition’ framework look like?
In the press release accompanying the paper the DWP talks about “greater risk sharing between parties” and offering a “high level of certainty, but with much greater flexibility over the nature of benefits provided”.
In practice, an industry working group put together by the government has proposed three new ‘designs’ for more flexible defined benefit pensions, alongside four models that could be introduced to offer ‘guarantees’ to workers in money purchase, or defined contribution, pensions.
The three designs for flexible salary-related pensions are:
1. Removing indexation on future accruals
Under this design, for future accruals only the statutory requirements for the indexation of pensions in payment would be removed. This effectively means that while the employer would continue to bear the longevity risks of offering a defined benefit, savers would bear the risk that inflation would erode the value of any guarantee.
The paper states employers could choose to provide greater flexbility in benefits - for example providing specific additional benefits when the funding position allowed or adding indexation on a fluctuating basis - but would not be legislatively required to offer a particular inflation link.
It said this approach would require changing the legislation on requirements such as “preservation, revaluation, scheme funding, employer debt and the Pension Protection Fund levy” so that they would only apply to benefits required to be paid and not to those offered on a discretionary basis.
2. Automatic conversion to DC when member leaves employment
This second option would see the employer offering a traditional defined benefit model to members during their period of employment, but if they were to leave their company before retirement their accrued savings would be crystallised and the cash value transferred to a nominated defined contribution scheme.
The paper states that while the employment continues the employer bears the investment risk associated with providing a defined benefit, but that they will be able to reduce liabilities related to workers that are no longer employed with them.
It adds that there is likely to be a need for regulatory protection to “address risks of avoidance activity”, for example by setting out a timeframe for employers to calculate and transfer benefits when a member leaves employment.
3. Ability to change scheme pension age
The third and final proposed design directly tackles longevity by extending existing ‘life expectancy adjustment factor’ provisions to allow employers to adjust a scheme’s normal pension age to limit the risk of increased costs related to longer life expectancy.
The paper states there will need to be requirements on schemes which choose to change their pension age “to limit the extent to which they can increase the NPA in one step”, in order to avoid schemes implementing rapid rises to “catch up” with demographic changes that would severely impact savers.
The fours models to provide defined contribution scheme guarantees are:
1. Money-back guarantee
This would ensure that the amount of accumulated savings at retirement or at the point of transferring out does not fall below the nominal value of contributions made.
The paper argues that while the probability of such a “low-level guarantee” being required to be exercised is small - “less than 10 per cent and close to zero for long periods of saving” - it could have real value for an individual.
It adds that this guarantee could be provided either as a “market-based” solution, or by the establishment of a ‘defined contribution protection fund’ akin to the Pension Protection Fund, for which models suggest premiums “could be very low”.
2. Capital and investment return guarantee
This option is intended to offer guarantees at the mid-point of the pension life cycle and would offer protection over not just the capital contributed but also over investment returns that have been accumulated.
The guarantee would be purchased by a fiduciary on behalf of the member to secure a guarantee against part of the capital and an investment return for a fixed period, the DWP explains.
The paper states that the biggest barriers to feasibility of such a model be “access to illiquid investments, governance and fiduciary element, and the interface between insurers or trustees and investment opportunities”.
3. Retirement income insurance
This model would address the “single event conversion risk” associated with buying an annuity and maximise the investment returns on a member’s fund through the purchase of an income insurance product on an annual basis from a set age, for example 50 years.
The paper states that this would be effectively a half-way house between an income drawdown product and an annuity. The income guarantee insurance would kick in if a saver’s fund is reduced to zero, meaning there is no risk of the individual exhausting their fund and falling back on the state.
It warns, however, that specific barriers exist in the UK to such a model being adopted, including HMRC decumulation rules covering drawdown products and the fact that “prudential regulation of insurance companies is more exacting in the UK”, which mean it is unlikely to be possible in the short to medium term.
4. Pension income builder / collective defined contribution
The final ‘pension income builder’ model is similar in structure to the Dutch General Practitioners’ pension fund (SPH) and the mandatory ATP scheme in Denmark. Member contributions would be used to both purchase deferred annuities each year, with the remainder invested into a collective pool of risk-seeking assets.
This is similar, it says, to ‘collective defined benefits’ schemes, to which it devotes a whole chapter later in the paper. Under this model, contributions are not retained in an individual fund for each member but are pooled - when a member retires the income is paid from the asset pool rather than through the selection of an individual retirement income product.
