Strike a balance on pension provision

A SERIES of high profile companies have recently announced the closure of their final salary or defined benefit pension schemes. Instead, they propose to provide defined contribution schemes, or money purchase arrangements, effectively transferring risk from the employer to the employee. But it is worth exploring whether a more reasonable balance could ensure sustainable pension provision over the long term.

Regardless of how it is paid for, pensions involve inter– generational transfers. For example, in the unfunded state scheme, pensioners rely on the working generation to provide their state pensions.

In contrast, most occupational schemes are funded. The assets underlying pensions are invested in the real economy and schemes rely on the continuing success of company and government business plans to generate the returns needed to finance pension payments.

In the UK, occupational defined benefit (DB) pension schemes have strong regulatory protection, particularly in respect of pensions in payment. Any contributions paid will first be used to ensure existing pensioner benefits can continue to be paid in full. If employers cannot afford additional contributions, the scheme's resources will continue to be used to pay pensions, reducing the security of the future pensions of those not yet retired.

In the three months to February 2009, more than 120,000 people lost their jobs. Not all of these worked for companies with final salary pension schemes, but it might be hard for those who did to reconcile their circumstances with the relative financial security available to the previous generation of employees in their firm. Indeed, companies may be pushed into insolvency because they cannot afford to finance the pension scheme.

Legislation since 2002 has imposed a higher pension liability on employers and a stronger regulatory regime. Many pensions in payment cannot be reduced, even if inflation is negative, whilst employees have to forgo pay rises or accept pay cuts by reducing working hours. Effectively, pensions in payment could be increasing in real terms, imposing further costs on employers, while employees' pay falls in value.

However, DB pensioners are not necessarily over protected. Some are financially vulnerable, with no further opportunity to accumulate savings. Pensions can also fall in value during periods of high inflation and do not share in periods of high economic growth, when pay often increases faster than prices, and the inflation measure that pensions are linked to does not necessarily reflect an average basket of goods. In the 12 months to December 2008, the retail prices index increased by only 0.9 per cent, whereas the pensioners' price index increased by 6.5 per cent.

Defined contribution (DC) schemes also require inter– generational transfers but, provided individuals purchase annuities with a provider that remains solvent, the effects will be muted. If annuity purchase is deferred, or if the annuity is paid by an occupational DC arrangement, then members remain exposed to investment risk and so rely on the economy remaining sufficiently productive to support their choices, just as DB members do.

In fact, the economic risks DB members carry throughout their retirement is concentrated, for DC members, at the point they annuitise. If they are compelled to purchase an annuity when investments have fallen or annuities become more expensive relative to their savings, they will retire on lower incomes.

If we relied solely, or largely, on DC arrangements, pensioners' incomes would be partly determined by the point in an economic cycle when they reached retirement, with some better off because they reached retirement at a time of economic confidence. This can be minimised by investing in assets that 'match' those underlying annuity pricing, but over time these assets generally under-perform more 'risk seeking' strategies, so individuals would retire with lower pensions.

The Pensions Commission, which recommended the policy for auto enrolment into 'personal accounts' currently being implemented, believed these effects would not be material because people retiring during market falls, or increased annuity prices, would choose to remain in employment until market conditions recover. As we see currently, employment opportunities will not always be available to provide this self-correcting mechanism.

There is no consensus as to the appropriate level or best means of provision to the retired population. Maintaining high levels of overly secure benefits may impose unfair burdens on workers; low, unsecured benefits may impose unfair risks on pensioners.

The current market turmoil does not undermine the logic of funded defined benefit provision, but it does focus the mind on how to achieve a reasonable balance between the interests of the groups involved in their financing to enable long-term, sustainable pension provision.

Deborah Cooper is principal at consultancy firm Mercer

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