Oct 23, 2010

The Move Towards Defined Contribution Schemes | PENSION SCHEME DESIGN

Cost fluctuations under final salary schemes are typically the employer's responsibility. The scheme actuary compares the scheme's assets with the estimated fund required to underpin the benefits earned to date. The actuary also calculates the estimated cost of the future benefits being earned (normally expressed as a percentage of payroll).
Add a note hereIn the recent past, schemes often had surplus assets that could be used to fund the cost of the benefits being earned. Many employers could therefore suspend contributions for several years (a 'contribution holiday').
Add a note hereMore recently, many schemes have moved into a funding deficit, whereby the scheme's assets are less than the estimated fund required to underpin the benefits earned to date. These deficits have resulted from stock market falls, increased longevity and changes in the way these assessments are carried out. As a result, employer contribution rates have risen sharply as employers have needed to make up the deficit in addition to paying the cost of the benefits being earned. As well as being painful in its own right this contribution increase has highlighted the potential cost volatility of this type of scheme.
Add a note hereIn itself, a funding deficit might not be enough to provoke an employer to review of pension provision. However, there have been other financial change drivers including:
§  Add a note herea new accounting standard, FRS17, which sharpened the focus on pension scheme funding just as many schemes moved into deficit;
§  Add a note heremoves by the Thatcher and Major governments (and some individual schemes) to guarantee benefits that were previously discretionary (eg pension increases), thereby removing a possible cost-saving safety valve;
§  Add a note herethe abolition by the Chancellor of the Exchequer (Gordon Brown) of advanced corporation tax relief on equity dividends for pension schemes.
Add a note hereAs a result of the cost increases, many leading companies have questioned the financial wisdom of final salary provision. Other factors in this trend have been as follows:
§  Add a note hereFinal salary schemes provide much more value to older and longer- serving employees. However, greater labour mobility has led many employers to question this emphasis, particularly in newer industries with young, high-turnover workforces.
§  Add a note hereThe increasing use of flexible benefits. Because defined contribution schemes involve a personal fund there is no cross-subsidy; they are therefore easier to incorporate into a flexible benefits plan.
§  Add a note hereA 'snowball' effect, with the increasing popularity of defined contribution schemes encouraging other employers to review provision.
§  Add a note hereEmployees have often underestimated the employer's pension costs in final salary schemes.
Add a note hereAll of these factors have led to many private sector employers closing their final salary schemes to new entrants and setting up defined contribution schemes with more predictable costs. This trend has been particularly pronounced in labour-intensive sectors.
Add a note hereThe public sector has so far mostly retained its final salary schemes. This reflects:
§  Add a note herethe need to offer a competitive remuneration package in an environment where many private sector reward tools are practically or politically undeliverable (eg large bonuses, share schemes, private healthcare and generous car policies);
§  Add a note herestrong union support for final salary schemes;
§  Add a note herea lack of political will to tackle a complex and long-term issue - in particular, because many such schemes pay pensions from government revenue rather than from a fund, cost increases are not felt for many years;
§  Add a note herelower turnover in some parts of the public sector.


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