Defining pension schemes on the road to retirement

Tough challenges face the UK pensions industry as investment funds shrink and contributions are squeezed. Nick Martindale looks at the range of pension plans on offer

The first organised UK pension scheme can be traced back to the 1670s, when the Royal Navy put in place provisions for its officers. But it was in the 1950s and 1960s that corporate pensions became a prominent part of working life.

As both society’s attitude to jobs and the country’s economic fortunes have ebbed and flowed, so too have companies’ pension offerings, from generous final salary schemes to defined contribution plans and the introduction of auto-enrolment and the National Employment Savings Trust (NEST) later this year.

Yet, while defined contribution (DC) schemes are now the most generous arrangements most new entrants can hope for, many organisations have considerable liabilities for existing defined benefit (DB) schemes, and must take on responsibility for investing and managing assets, usually through the help of a dedicated provider.

The strategy an organisation adopts will depend on the age profile of its members, the liabilities the scheme will face in the future and the company’s long-term attitude to de-risking.

“Many pension funds haven’t yet recovered from the credit crunch and have seen their deficits grow year on year,” says Richard Dowell, head of clients at investment management firm Cardano UK.

“The approach which focuses principally on just generating high-asset returns is long gone. Instead, a safety-first approach is required, which focuses on improving the funding ratio without experiencing nasty shocks, and asset decisions taken relative to the pension scheme liabilities,” he says.

Irshaad Ahmad, head of UK and Nordics at AXA Investment Managers, uses the analogy of a football team as a means of building a balanced investment portfolio, with distinct defensive, midfield and attacking components.

Many pension funds haven’t yet recovered from the credit crunch and have seen their deficits grow year on year

“The attacking line-up focuses on growth assets that have the potential to generate strong performance and real returns, such as global equities and emerging markets,” says Mr Ahmad. “The defensive component focuses on less-risky, matching domestic fixed-income products.

“In midfield, schemes should consider asset classes that combine an element of liability matching with the opportunity to gain additional returns,” he says. These might include short-duration, high-yield bonds; global inflation-linked bonds; global convertibles; or infrastructure investment, he adds. 

Defined benefit (DB)

A DB pension scheme commits an employer to having to pay out a certain amount of money for employees in retirement for as long as they live.

Career average schemes were popular in the 1960s and 1970s, says Kevin Wesbroom, senior consultant at Aon Hewitt, but these failed to factor in inflation. By the late-1970s, schemes offering a percentage of an employee’s final salary were common and these flourished throughout the 1980s.

A combination of government legislation around company obligations, poor stock market performance in the 1990s and early-2000s, and the introduction of Financial Reporting Standards (FRS) accounting rules in 2001 saw a gradual decline until the final FTSE 100 company to offer a DB scheme to new members announced plans to move to defined contribution earlier this year.

Defined contribution (DC)

The rise to prominence of DC schemes – where employers only commit to a set amount going into a scheme rather than coming out of it – in the 2000s reduced companies’ exposure to underperformance and increasing longevity, and transferred risk to employees.

The big challenge for employers here is to persuade staff to take sufficient interest in their pensions so they can afford to retire. “It’s incredibly important that people are guided through the decisions that they need to make,” says Darren Philp, director of policy at the National Association of Pension Funds.

From October, larger companies will have to auto-enrol employees in workplace schemes, unless individuals specifically opt out. All organisations must do this by 2016.

Stakeholder

Introduced in 2001, stakeholder pensions were a means of encouraging people to save in low-cost, private schemes, when companies offered no provision.

“There was obligation for employers to set up a pension plan, but not to put any money into it,” says Mr Wesbroom. “It was a good idea, but it didn’t really work. NEST and the competitors to NEST will effectively replace this.”

It did, however, encourage the pensions industry to introduce capped annual management charges, paving the way for the eventual introduction of NEST, says Mr Philp.

National Employment Savings Trust (NEST)

The concept of NEST was developed by Lord Turner in his 2005 report, which found there were insufficient incentives for people to save for retirement.

Under the scheme, employees working for organisations, which don’t have any form of workplace pension provision, will be entered into the government’s default plan. Employers will eventually be required to provide contributions of 3 per cent of salary, with employees putting in 4 per cent and the government 1 per cent.

Employers currently offering more than this in existing schemes are unlikely to switch to NEST, however, says Paul Macro, UK head of defined contribution at Mercer. “At some point they have decided that offering pensions is a good thing and they want to do it properly,” he says.

Defined ambition

Pensions minister Steve Webb recently mooted the idea of a “defined ambition” scheme, along the lines of that operated in the Netherlands, as a halfway house between DB and DC.

“Although the employer’s financial commitment to the scheme is a specific monetary contribution, the pooling of scheme assets and a system of internal annuitisation would allow the scheme to provide pre-determined, although variable, levels of benefits,” says Tim Middleton, technical consultant at the Pensions Management Institute. “It would share investment risk more evenly between the scheme sponsor and members.”

Mr Macro, though, says it is unlikely there will much appetite for this among employers. “It will take quite a lot to persuade finance directors that they want to take more risk on,” he says.

Public sector

The largest remaining vestige of DB schemes, public sector pensions have been the subject of much debate over their sustainability.

The main difference with private sector schemes is that – with the exception of the local government pension scheme – they have historically been unfunded, meaning they are financed out of current employee and employer contributions. Those working in the Armed Forces, Civil Service, NHS and teaching all have schemes of this nature.

Lord Hutton’s report into public sector pensions in 2010 advocated schemes moving from a final salary to career average basis, increasing the age at which people retire and rising contributions from members.