Calls to amend laws to rescue defined benefit pensions

Gordon Brown, the new Prime Minister, could improve pensions for millions of workers with some small changes to the law, says Fidelity International, one of the leading investment management and services groups.

A few changes to pension legislation would enable companies to continue to offer their staff a defined benefit (DB) scheme that leaves the principal investment risk of retirement saving with employers, yet reduces the huge costs faced now and in the future by scheme sponsors.

DB Lite is a model developed by Fidelity that gives schemes linked to pay and service a future but avoids the high costs of current arrangements. Future costs for the employer could be cut by up to a third, while scheme members continue to enjoy a DB pension.

Martin Harris, managing director, defined benefits, at Fidelity International, says: “Gordon Brown should amend pension legislation so that employers can continue to offer workers access to defined benefit schemes by giving the employer greater control over costs.

“A couple of legal tweaks will free scheme sponsors from the crippling burden of providing so many gold-plated benefits. In turn, millions of workers can continue to enjoy the greatest advantage of a DB scheme - that the employer bears the principal investment risk of providing a pension.

“DB Lite schemes are already being put in place at some companies but for sponsors to implement them fully, the law needs to be changed. Were the legislation to be amended, schemes could also pursue more traditional investment strategies, as well as cutting costs. The headlong rush of pension funds into bonds might even come to an end.”

DB Lite - a middle way

Faced with rising costs, many DB schemes have been closed to new entrants. Fidelity International has calculated that provision of a defined pension benefit for a 40-year-old man has risen from an additional 7.4% of the annual salary in 1995 bill to 26.2% in 2005, largely because of improvements in life expectancy and falls in long-term bond yields. Laws that force employers to pay benefits over and above the original remit of DB schemes have also contributed to the increased costs.

Even sponsors of schemes which have returned to surplus in recent months on the back of strong performances from the world’s stock markets and higher bond yields may hesitate to re-open the scheme because of the prohibitive cost of providing DB pensions in the future.

The consequence is that new recruits to a company are typically offered a defined contribution (DC) scheme. While DC schemes do have many attractions if implemented properly and with an appropriate contribution rate, the individual does take on the entire investment risk of saving for retirement.

DB Lite is an approach that gives greater control to employers over a scheme’s costs. Employers no longer have to take the drastic step of closing schemes to new or existing employees. By having the freedom to reduce – or increase – discretionary benefits, the sponsor can shape the scheme in line with the corporate financial outlook.

From the individual member’s perspective, they can still enjoy a company pension where the employer shoulders the principal investment risk of providing an income in retirement.

The cost of sponsoring a DB scheme is affected by five primary factors, which we can think of as a set of levers on a machine:

Retirement age
Accrual rate – what proportion of pay is earned by a year’s service
Ancillary benefits – such as dependants’ pensions
Rate of benefit increase for deferred pensions
Rate of benefit increase for pensions in payment

By pulling on any of these five levers, scheme sponsors can reduce on-going costs and adopt a less prescriptive investment strategy. Sponsors already have discretion over the first three factors – retirement age, accrual rate and ancillary benefits. But changes to legislation are required to give to them the same level of discretion over the rate of benefit increase in deferred pensions and pensions in payment.

The law currently requires annual benefit increases of 2.5% or in line with the Retail Price Index (RPI), whichever is lower, for pensions in payment. It is also mandatory to provide inflation protection up to 5% for deferred pensions in the run-up to retirement

Martin Harris adds: “Since the early 1990s, DB schemes have become ever richer in benefits. But each of these benefits comes at a cost. Employer and employee now need to agree which of these benefits they most want to preserve. Otherwise, employers will continue to jettison the entire scheme – to the detriment of current and future workers.”

How DB Lite works

By lifting the scheme retirement age to 75 – in line with longevity improvements – a sponsor can shave 9.3% off annual pension costs, according to calculations by Fidelity. This does not mean that an employee has to wait until age 75 to retire – that is the age they would be guaranteed a full pension. If the scheme’s investments performed well they might still retire earlier on full benefits.

If this rise in the notional retirement age was combined with a reduction in the accrual rate, the savings would be even larger. A typical scheme rewards an employee with 1/60th of final salary for each year of service. If the accrual rate is altered to 1/75th with a corresponding retirement age of 75, then the sponsor’s costs would fall by nearly 23%. Again, the employee could still retire at 65 on a reduced pension.

It is even possible to cut total costs by nearly 36%. Fidelity calculates that raising the notional retirement age to 67, changing the accrual rate to 1/63rd, removing ancillary benefits and calculating benefits on a career average earnings basis (rather than final salary) would lead to a 23.4% reduction in costs. Discretion over benefit increases for pensions in deferment and in payment, with a corresponding change in investment strategy, would take total savings to 35.7%.