Defined ambition schemes

Defined ambition (DA) pension schemes are intended to provide a third way between defined benefit (DB) and defined contribution (DC) pension schemes. DA opens up a range of exciting new ways for businesses to offer pensions to their staff. These should be cheaper for employers than DB schemes, while offering employees more certainty over their retirement incomes than DC schemes. The Department for Work & Pensions (DWP) set out its proposals for DA schemes on November 7. Businesses should start considering now whether a DA scheme might suit them better than their current pension scheme.

What is defined ambition?

Under a DB scheme employers promise members a certain level of benefit, but under a DC scheme the employer only promises to pay a certain level of contributions. Employers bear the risk of investment movements and of increases in longevity in a DB scheme, while employees bear all that risk in a DC scheme. Under a DA scheme that risk would be shared between members and employers.

Why defined ambition?

Businesses have been turning away from DB provision since the mid-1990s. The cost of guaranteeing a specific level of benefit under those schemes has proven too costly. However, members of DC schemes have no certainty over the level of benefit they may eventually receive and that uncertainty can put many off saving for a pension at all. Defined ambition schemes could prove attractive to companies and members alike.

Flexing DB schemes

One version of DA is a stripped-down DB scheme. Businesses would be able to offer members defined benefits on a cheaper, more flexible basis than before. This new basis would be available in respect of future service under existing DB schemes, as well as to employers who establish new schemes.

A DA scheme operated on this cheaper basis:

• would not be required by law to provide any increases to pensions in payment, although increases could be paid on a discretionary basis

• could convert a member’s entitlement to a DC pension pot if they leave employment before normal retirement date; this would pass on investment and longevity risk to the member at that stage

• could increase the scheme’s normal retirement date to take account of increases in life expectancy; this would pass on some longevity risk to members.

Businesses with an open DB scheme should give serious thought to the opportunities for saving costs offered by the proposals. They may well choose to flex their DB benefits in one or more of the three proposed ways. These cost savings may allow some businesses to keep their DB scheme up-and-running, rather than closing it down and switching to a DC scheme. That would be a welcome outcome for all concerned.

Providing guarantees under DC schemes

An alternative version of DA is an enhanced DC scheme. These DA schemes take the form of a DC scheme, but offer a guarantee. That may be a guarantee that each employee’s pension pot will not be less than the contributions paid in. Alternatively, the scheme could guarantee a minimum level of investment returns or retirement income.

Defined ambition schemes could prove attractive to companies and members alike

Whatever the form of guarantee, the business remains liable only to pay the level of contributions it has set in advance. The pension provider is liable for ensuring guarantees are met. Those guarantees come at a cost, but they should give members additional confidence to save for their retirement.

Collective DC schemes

A further version of DA is a collective DC scheme where assets are pooled. This gives pension scheme trustees access to a wider range of investment opportunities and returns are smoothed for scheme members. Certain levels of pension are targeted, but actual pensions depend on each member’s share of scheme assets. The business’s liability to pay contributions would be the same as in a traditional DC scheme. Pensions may be reduced if insufficient assets are available. Studies have indicated that members are likely to achieve a retirement income significantly better under a collective DC scheme than under a traditional individual DC scheme.

Collective DC schemes are common in Denmark and the Netherlands. Pinsent Masons has already been working closely with the DWP and the RSA in exploring how collective DC schemes might be implemented in the UK.

Next steps for government

The government is thinking along the right lines. DA gives businesses more flexibility in the type of pension scheme they are able to offer their staff and therefore it is important the government should implement its proposals sooner rather than later. For DA to take off, the proposals will need to be implemented in a simple way that avoids undue additional cost.

Matthew de Ferrars

Partner for Pinsent Masons LLP

020 7667 0189