Defined benefit pension schemes Green Paper
20 February 2017
- DWP seems rather complacent about sustainability of UK Defined Benefit pension schemes
- Nearly 90% of schemes are closed and Government needs proper planning for members in future years
- Burdens of Defined Benefit schemes will increasingly put younger workers’ pensions and jobs at risk
- Using annuity costs as a yardstick is unreasonable, unaffordable and unsustainable for most schemes
Complacency based on short-term view: The DWP has today produced its long awaited Green Paper on the affordability of Defined Benefit pension schemes. The document is a wide-ranging roundup of the issues impacting employers and pension scheme trustees in light of large deficits in most UK DB schemes. The overall tone of the paper is based on an assumption that there is no real crisis in pension affordability and that employers can generally afford the liabilities they are sponsoring. This complacency reflects short-term thinking, whereas this Green Paper should be an opportunity to plan for the longer term outcomes for members of such schemes.
Government should be planning for medium-term risks now as schemes in run-off: From a medium-term perspective, it is clear that the Government needs to put plans in place to manage the run-off of Defined Benefit pension schemes. Nearly 90% of all schemes are now closed to new members, more are closing all the time and once the scheme has closed to new members, it is effectively in run-off. It is only a matter of time before it closes to new accruals too. If we wind forward a few years, it is clear that fewer and fewer workers will actually be in these pension schemes and employers will be sitting on a legacy liability that has nothing to do with their business at all. It relates to people who will no longer be working for them and they will have little or no business interest in supporting the scheme. This will entail greater risks to the PPF. Any period of economic weakness is bound to lead to greater sponsor insolvency and we should be planning for such problems now, as it will take some time before arrangements can be agreed and established. Ongoing support for DB schemes will increasingly damage younger workers’ pensions and job prospects.
Younger workers’ pensions and job prospects damaged: The ongoing Defined Benefit pension schemes will also increasingly make workforce rewards inequitable, with the older, longer-serving workers who may still be in the DB scheme having far better pension benefits than the younger, newer employees who will have DC pensions with lower contributions. The Green Paper suggests the cost of pension accrual for a typical UK DB scheme has risen from around 24% of salary in 2009, to around 50% of salary in 2016. Average contributions to DC schemes are nowhere near these levels. The greater the cost of supporting the legacy DB scheme, the lower the resource potentially available to pay into younger, newer workers’ DC schemes. This is bound to lead to tension, with employers looking for ways of removing responsibility for these legacy liabilities. It is highly likely that employers will simply not be willing to support such schemes in the longer term, so a plan is required for managing the pension payments in the longer term.
Consolidation is one solution that makes sense: Establishing a Central Discontinuance Fund or ‘SuperFund’ that can pool many schemes together, reduce running costs and take advantage of more diversified asset allocation would cut costs and enhance potential benefits. Local Authority schemes are already being required to merge their investment allocations – such models could be used for private sector schemes in future too.
Broader asset allocation is still needed – Myners Review called for this in 2000!: The Green Paper is right to call for broader asset allocation strategies and greater exposure to alternative asset classes. It is rather ironic to see this discussed today, in light of the fact that I first wrote about this when helping set up the Myners Review for the Treasury in 2000. Pension changes seem to take an inordinately long time.
Relaxation of annuity requirements would help: The Green Paper does not sufficiently explore the need to relax the requirement for schemes to buy out benefit in the annuity market. Annuity purchase is punitively expensive for most schemes, the current interest rate environment had increased the costs significantly and there is simply not enough volume in the annuity market for all schemes to buyout anyway. It is time to set up an alternative self-sufficiency regime, that does not require annuity purchase.
Overall, the Green Paper will generate useful debate, but the need for action is greater than suggested by this paper. Many employers are struggling with DB scheme costs and as we leave the EU, British businesses will have many other issues to deal with. A system that helps them manage legacy liabilities is needed for the coming years.