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PLSA welcomes DWP green paper on DB pensions as Hargreaves Lansdown provides commentary

The Pensions and Lifetime Savings Association has welcomed the Department for Work and Pensions Green Paper ‘Security and Sustainability in Defined Benefit Pension Schemes’.

Director of External Affairs at the PLSA Graham Vidler said: “The Green Paper asks the questions necessary to move forward the increasingly pressing debate about the future of defined benefit pensions in the UK. The interim report published by our DB Taskforce last year identified how the challenges facing DB are posing a material risk to members’ benefits, to employers and the wider economy.

“We firmly support the Government’s desire to explore consolidation as a way to secure the defined benefit pensions of millions of savers. The DB Taskforce’s next report, to be published in March, will look at consolidation in more detail.”

Hargreaves Lansdown

Head of retirement policy at Hargreaves Lansdown Tom McPhail said: “The UK’s occupational pension system is one of the best in the world. However it isn’t as good as it used to be and it has struggled in recent years to adapt to a world of rapid economic, social and demographic change. This government consultation is vital if we are to ensure that we have a pension system fit for the 21st Century.”

Cuts to final salary scheme member benefits

The argument is frequently made (mainly by employers and their representatives) that final salary schemes are unsustainably expensive and that changes need to be made to ease the pressure. Most schemes have already closed to new members and to the future accrual of new benefits by existing members (though this does also mean there are no new members coming through to keep paying new contributions).

It is with the existing liabilities accrued in the past, which more meaningful adjustments to the funding position of the scheme can be made.

However, Section 67 of the Pension Schemes Act 1995 means that once a promise of benefits has been made, it cannot be taken away again. So modifying past promises is nigh on impossible. Just about the only option is to tweak the inflation proofing applied to members’ benefits in retirement.

RPI to CPI

Schemes often have complex benefit structures, with different elements of benefits subject to different rules, particularly where contracted out benefits are concerned. The simplest switch is to substitute CPI for RPI. Some schemes have already done this; others can’t because their rules don’t allow it. The table below illustrates the impact this can have on a member’s income over the duration of their retirement.

Inflation Measure Starting Income in 1988 Income as at Jan 2017 Percentage Increase
RPI £1,000 £2,585.67 158.57%
CPI £1,000 £2,105.37 110.53%
Difference N/A £480.30 22.81%

If the government were to introduce legislation allowing trustees to modify their scheme rules, switching members’ inflation proofing to a lower index, it would substantially improve the funding position of some schemes, at the cost of lower member benefits in the long term.

Final salary scheme valuations and investment strategies

There has been a dramatic shift in final salary scheme investment strategies in the past 15 years, with schemes moving away from equity investing, towards bonds and other lower risk investments. This makes sense in terms of reducing volatility and unexpected shifts in scheme funding positions but it also comes at the cost of lower long term investment returns; this in turn means employers have to pour more money into the schemes.

It is worth noting that within schemes’ equity portfolios, the proportion allocated to UK equities has now declined to just 22.4%, meaning the UK’s final salary pension schemes now only have around 6.8% of their assets invested in quoted UK company shares.

One possible solution may be to look at ways to modify the valuation requirements on schemes, to give them greater latitude to invest in higher risk assets which are prone to greater volatility in the short term but which tend to produce higher returns in the long term.

The government is very keen to explore the possibility of increasing pension scheme investment into infrastructure projects as part of this review.

Greater responsibilities for pension scheme trustees

BHS was an eye-opener: pension schemes are supposed to be run in such a way that members’ interests are protected, yet decisions were taken which left the scheme members exposed to the risk of loss.

We expect to see pension scheme trustees coming under scrutiny in the forthcoming paper, with the possibility of greater demands being imposed on them in terms of training, professionalism and responsibilities. This in turn could drive greater consolidation of schemes (see below).

More powers for the pensions regulator

Unlike the regulatory behemoth that is the FCA, the Pensions Regulator is a relatively modest operation. It employs just a few hundred people, yet it is responsible for the oversight of thousands of final salary schemes, millions of scheme members and trillions of pounds of assets. It is also responsible for regulating compliance with the auto-enrolment programme which involves the participation of over one million employers.

With BHS fresh in our minds, questions are being asked as to whether the Regulator should have greater powers to scrutinise and intervene in corporate actions which could affect pension security.

Pension scheme consolidation

The UK has a lot of pension schemes, quite possibly too many.

There are around 40,000 private sector pension schemes in the UK; many of them are arguably sub-scale, with the vast majority of DC schemes having only a few members and over 2,000 DB schemes have fewer than 100 members.

  DB Hybrid: mixed benefit[2] Hybrid: dual-section DC (trust) DC (workplace contract)[3]
Schemes 5,170 180 910 33,650 2,620
Open schemes 820 20 440 26,240 2,400
Total memberships 7,142,000 621,000 5,370,000 8,489,000 N/A
Total active members 1,170,000 55,000 1,203,000 5,151,000 4,880,000

(Sources: The Pensions Regulator’s data based on scheme returns 31 December 2016, Annual survey of hours and earnings (ASHE)[3] 2015 (published March 2016). Please note: the ASHE 2015 reports 4.4 million active members of DC trust-based schemes and 244,000 active members in schemes where the type was unknown.)

The government is interested to explore whether fewer, bigger schemes could lead to the following benefits:

  • Better scheme governance
  • Better value for money from investments
  • Greater scope for infrastructure investing

The government is expected to explore the possibility of introducing an ‘aggregator scheme’ which could take on the assets and liabilities of smaller DB schemes. The design of this aggregator could draw on aspects of both the NEST and the PPF schemes.

Breaking the link between the employer and their staff pension scheme and moving away from the old model of every employer having their own unique scheme, as is already the case with Master Trusts and Group Personal Pensions also opens the door to further possibilities.

For the past couple of years, Hargreaves Lansdown has lobbied successive pension ministers for the government to hand back to individuals control over the choice of their workplace pension. We are optimistic that this choice may emerge through a combination of this Green Paper and the concurrent 2017 Auto-enrolment review.

Scheme Statistics

Tax relief granted by the Treasury to pension schemes every year: £48 Billion. (HM Treasury)

Around 85% of this tax relief goes to final salary pension schemes. (Hargreaves Lansdown)

In 2014, the total amount saved into workplace pensions was £80.3 billion. This was split 53% private sector and 47% public sector.(DWP)

Of the £31 billion paid into funded DB schemes, £11 billion was deficit reduction contributions. (PLSA)

Auto-enrolment is projected to increase the amount saved into workplace pensions by around £15 billion a year. (DWP)

Final salary schemes have total assets of around £1.5 trillion. On a full buy-out basis, they are underfunded to the tune of around £800 billion. (PLSA)

Average final salary scheme income pay-outs are £7,000 a year for private sector schemes and around £8,000  year for public sector. (PLSA)

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