THE FUTURE | Pension Schemes

Looking at the medium-term future of UK occupational pension provision, a number of key questions arise, as considered in the following sections.

Does the Final Salary Scheme Have a Future?

It remains to be seen whether the final salary occupational scheme has a long-term future. Its obituary has been written many times before. However, this time there is significant evidence of a move away, with more than 50 per cent of such schemes now closed to new entrants.

Where final salary provision is surviving in the private sector, one or more of the following factors may apply:

§  The scheme is still in surplus.

§  Providing a guaranteed, final salary pension is a component of a very caring and paternalistic people strategy.

§  The employer has deep pockets and/or people costs are low compare to turnover.

§  The scheme has been modified to reduce employer cost.

Will the Public Sector Move Towards Defined Contribution Schemes?

Given the huge (and rising) costs of its current schemes, this is a possibility. However, doing so would remove a significant retention lever and would cause major industrial relations problems. Any such change would probably imply a need to increase other elements of pay.

Will Defined Contribution Schemes Provide Adequate Retirement Incomes?

There is a significant risk that many defined contribution schemes will fail to deliver the standard of retirement living expected by their members. A previous generation of defined contribution schemes failed for just this reason.

Tackling this issue implies increasing employer contributions and/or providing education to employees to allow them to increase their own saving. For example, some employers pay for financial advice or offer online pension modelling through the company intranet.

There are also strong arguments for considering some of the hybrid design options outlined above. These generally involve providing at least some pension guarantees to employees, but should avoid the degree of cost fluctuation associated with traditional final salary schemes.

Can Two-tier Pensions be Sustained in one Employer?

Where an employer has scaled back pension for new employees, this creates inequalities with longer-serving staff. Some commentators have suggested a compensating increase to another part of the package. However, unless this is as part of a flexible benefits scheme, such an approach can fall foul of equal pay legislation, where comparisons are made for each element of pay separately.

Another factor to consider here is that staff in the final salary scheme, particularly any who are nearing retirement, will be unlikely to leave. This is especially true if alternative employers have also moved to defined contribution provision.

Can Pensions be Communicated Effectively?

A key and long-standing problem in the pensions field is communications. The difficulties arise because:

§  pensions are intrinsically complicated;

§  retirement feels a long way off to many people;

§  there can be a tension between effective design and ease of communication - for example, providing employees with choice may be desirable, but requires clear communication;

§  some of the language used around pensions is not always helpful to the layperson;

§  pension scandals have reduced employee confidence.

This is a field where HR, marketing and communications professionals can add value. Sadly, many pensions booklets and annual benefits statements are virtually indecipherable for most employees. In addition, communications are often very dependent on the written word.

To ensure employee engagement, pensions communications should:

§  give a clear, easily assimilated overview of the main scheme provisions;

§  allow employees to understand the likely level of pension payable;

§  encourage additional saving, where appropriate;

§  highlight where advice and clarification are available from;

§  in final salary schemes, identify how much the employer is spending on the employee's behalf.

A variety of media should be used, perhaps involving booklets, annual statements, frequently asked question sheets, workshops and interactive pension-modelling tools. Written materials should be tested on non-experts to ensure readability.

Issues and Opportunities Arising from Tax Simplification

The government's tax simplification proposals (see above, 'Executive pensions') and other changes have created some challenges and opportunities for people management looking forward, as follows:

§  Many of the restrictions on scheme design that currently exist will fall away. This should allow some more creative designs to emerge.

§  It will become possible to draw a pension while still working for the same employer. This will allow a phased approach to retirement that may suit some employees and employers.

§  Compulsory retirement on the grounds of age will disappear. This will probably mean more active performance management and a more creative approach to career management for older workers.

§  The minimum retirement age (other than on grounds of ill health) will increase from 50 to 55. Schemes will be given discretion on how to achieve this.

§  Employers may wish to help employees to make the best of the very liberal regulations for making extra voluntary contributions.

Are Final Salary Schemes Well Enough Funded?

The security of final salary pensions in a closed scheme is a complicated question well beyond the scope of this post. However, the latest government proposals are set to:

§  considerably bolster the level of financial obligation on solvent employers in respect of closed schemes;

§  introduce a levy-based scheme to fund a minimum level of benefits from under-funded schemes where the sponsoring employer is insolvent.

EXECUTIVE PENSIONS

The Design of Executive Final Salary Schemes

Historically, most executive pensions in larger companies have been provided on a final salary basis. However, today, around a quarter of FTSE 100 provide their chief executives with defined contribution pensions.

In the private sector, final salary executive pensions have tended to involve accelerated accrual compared to that for other staff. Instead of providing a maximum two-thirds pension after 40 years of service (an accrual rate of 1/60th per year of service), a full pension is normally subject to just 20 or 30 years' service (equivalent to an accrual rate of 1/30th or 1/45th). The two-thirds pension provided is normally inclusive of any pensions from previous employments.

The theory behind accelerated accrual is that executives typically experience rapid salary growth throughout their careers and hence any job change would otherwise constrain their pensions expectations (expressed as a percentage of final salary). This issue is less of a problem in the public sector where the final salary link is often retained when transferring employment.

Recently, commentators have started to question the need to provide executives with a guaranteed pension of two-thirds of final salary because:

§  the final salary may be a short-term peak earned for just a few years;

§  since most executive pension schemes were set up, executive salaries have risen significantly in real terms, income tax rates have fallen and incentive opportunities have multiplied: hence executives now have more opportunities to save in other ways;

§  the cost of this type of provision can be very high indeed.

For these reasons and to limit the tax concessions available, successive governments have limited the amount of pension that may be delivered through tax-approved pension schemes.

Limits on Pension Provision

Traditionally, the pensions available from occupational schemes have been subject to complex limits on the benefits payable, proportional to service and earnings. For personal pensions, stakeholder schemes and some other defined contribution schemes, age-related limits on contributions have applied instead.

In 1989, the earnings cap was introduced. This applied to individuals joining tax-approved pension schemes after 1 June 1989. The cap limited the salary that could be taken into account for pension purposes to £60,000. This figure was indexed to RPI (only) and stands at £102,000 for tax year 2004/05. The earnings cap did not have a profound impact on the level of pension provided to executives, with most large private sector firms providing compensation in the form of one or more of the following ways:

§  funded unapproved pension schemes (FURBS) - a funded pension scheme that lacks most of the tax privileges of an approved scheme;

§  unfunded unapproved pension promises (UURBS) - effectively a promise from the employer to pay a particular level of pension;

§  cash allowances.

From 2006, the government will replace the cap with a 'lifetime limit' on tax-effective pension savings of £1,500,000 (equivalent to a retirement pension of £75,000 per annum). Unlike the earnings cap, this limit applies to everyone, but any existing accrued benefits above this figure will be protected.

There will also be a limit on the pension earned in any year of £215,000. Both the lifetime and annual limits will increase annually.

In future, where pensions exceed the lifetime limit, companies will be able to offer FURBS, UURBS or cash (as above). A further (new) option will be to provide a bigger pension in the tax-approved scheme but to pay a tax 'recovery charge' of 25 per cent on the excess funds: this levy is in addition to income tax, giving a composite rate of 55 per cent.

The Future of Executive Pensions

Executive final salary schemes have been very expensive to provide, particularly on an unapproved basis. Many investors and remuneration committees would now prefer a more modest, fixed-cost approach to be adopted. This might involve a pension allowance of perhaps 20–50 per cent of salary payable in cash or to a pension vehicle selected by the executive. There are signs of this happening, but the executive final salary scheme is unlikely to die completely for some decades.