Defined Ambition pensions – consultation response
Response
to DWP Consultation ‘Reshaping workplace pensions for future
generations’ – Defined Ambition pensions.
Submitted
by Dr. Ros Altmann
Independent
Pensions Policy Expert
(All material on this page is subject to copyright and must not be reproduced without the author’s permission.)
The
DWPs consultation on Defined Ambition (DA) pensions aims to try to
find a way to encourage employers to take on more of the risks of
pension provision. DA is a chance to start again and design employer
pensions that are more flexible and allow more leeway for change over
time, as required to accommodate changes in demographic and financial
variables.
Currently,
the policy of auto-enrolment is spreading pension coverage across
millions more workers in the UK, but the overwhelming majority of new
pension provision is in Defined Contribution (DC) schemes. These
schemes place almost all the risks of pension provision on the
individual worker. This is in stark contrast to the ‘traditional’
British company final salary pension scheme, which used to offer
Defined Benefit (DB) pensions. In DB schemes, the value of the
future pension income is underwritten by employers, so the worker is
only responsible for making the requested contributions, while the
employer has to make up any shortfall in the funding of the promised
future pension income in retirement.
Past
mistakes and well-meaning legislation have resulted in the
traditional DB schemes becoming unaffordable for most private sector
employers. The increasingly draconian regulations and requirements
placed on employers, without the flexibility to adjust to changing
market, economic and demographic realities, has resulted in employers
rushing to remove pension risk from their balance sheets. In the
past, the law gradually tightened employer promises into immutable
guarantees and added extra costs on top of the original pension
promises, including inflation linking, spouse/partner pensions and
revaluation of leavers’ benefits. These have added huge extra
costs (around 50%) to the pensions promise and rising life expectancy
without the ability to change pension start dates for past accruals
has added further costs and risks. Every year that life expectancy
rises while pension ages stay fixed, employer costs will increase.
Even if the same level of pension is paid, the value of that pensions
rises all the time, but workers do not understand that ‘no change’
actually means a change for the worse for the employer. There is so
much misunderstanding of pensions and workers do not appreciate the
additional costs that traditional DB schemes are imposing on
employers as both demographics and market returns have been so
different from previous forecasts. This has led employers desperate
to get rid of the risks they face and to move to DC pensions, which
leave the risks on employees instead. Firms merely promise to pay
the specified contribution levels each month, but this merely builds
up a pension fund for the worker, it does not provide a particular
level of income.
In
DB schemes, the employer must cover all the following risks:
- Salary inflation
- Price inflation
- Interest rate risk
- Longevity
risk - Partners’
pension risk - Revaluation
of deferred benefits - Financial
market risks - Annuity
risk - Regulatory
change risk
In
DC schemes, however, the employee carries those risks and the
employers’ liability is finite.
This
consultation tries to find a third way, with DA trying to push some
of the risks back onto employers. Indeed, it is arguable that DA, as
described in this consultation document, is really what the original
DB schemes were intended to be. They were set up by paternalistic
employers who wanted to help their loyal lifelong workforce enjoy a
few years of retirement after they finished working for the company.
The pension age of 65, set many decades ago, would have meant around
10 years of retirement on average, with many surviving far less long.
Over the years, employers were encouraged to reduce normal pension
ages (even as life expectancy increased) and then the Government
continually tightened up the legal requirements so that pension
promises from the past could never be reduced – only future
accruals could be changed.
Having
thought that these schemes were in surplus and could rely on future
stock market returns to meet their liabilities, employers were
saddled with additional obligations that turned out to be
unaffordable, when it became clear that market movements could not be
relied upon (even in the long-run) and that the surpluses were not
really surpluses at all. They were buffers against bad markets and
future demographic change, that would have ensured extra funds were
available if required. Nevertheless, the DB system relies on
employers always being able to make up any shortfalls and being
willing to underwrite open-ended liabilities for many decades into
the future. The way UK DB schemes have been prevented from making
changes to reflect new circumstances has led to unrealistic
expectations on the part of workers who do not realise how expensive
pensions have become. Workers have almost been given the impression
that pensions grow on ‘magic money trees’ and that the future
pension income can be guaranteed with a fixed past contribution, even
if the income has to be paid for far more years than originally
budgeted for. Pensions cannot keep lasting ever longer at the same
level but many workers do not realise this.
DB
does not fit with 21st
century capitalism. Corporate life has changed and employment
patterns have changed, so that a DC model fits far better with new
realities. Most companies will only exist in present form for 10-20
years nowadays and most workers change jobs on average 11 times in
their working life. Therefore, the concept of a pension being paid
to loyal lifelong workers in 30, 40 or 50 years’ time does not make
sense any longer. The employer cannot be relied on to be around in
the longer term and the worker is unlikely to stay employed until
they retire.
By
moving to pure DC, workers are in a much worse position than before.
This is a problem for the Government, however, as the state pension
is being cut and, whereas past state pension reductions could be
somewhat offset (at least in theory) by relying on increased private
or employer pension income, as Government shifted more burdens onto
final salary schemes, the new-style pensions do not offer such
generous benefits and cannot be relied on to provide good extra
pension income.
DB
schemes were a form of social welfare, underwritten by employers.
This is not the natural role of an employer, it is usually a state
role. The closure of most private sector DB schemes therefore poses
a problem for pensions policy. The state pension cuts leave many
people at risk of inadequate later life income and, if more and more
pensioners are poor, the long-term economic outlook is damaged as
they will not have money to spend and may increasingly require
taxpayer support. Thus, the DA agenda is to try to persuade
employers to take back responsibility for more of the pension risk
that pure DC, albeit recognising that DB – as currently configured
in the UK – is too draconian for employers to voluntarily accept.
The
consultation suggests that the aim of DA is to find ways to offer
more guarantees than are available in DC. There are two models –
‘DB minus’ (where the employer offers some extra guarantee or
even discretionary increases) or ‘DC plus’ where either an
employer or a pension fund offers a guarantee or discretionary
additional benefit on some aspect of future pension.
I
would question the wisdom of trying to offer too much in the way of
guarantees on future pensions. As workers draw nearer to retirement,
a guarantee could be provided but if the guarantee is meaningful it
may be expensive and if the guarantee is low cost it may not be
meaningful. A government underpin would be more attractive than a
guarantee from a private firm or employer.
DA
proposes various models of ‘risk-sharing’ between employer and
employee. This is worth a try, although it is not going to be easy
to persuade employers to take back significant amounts of risk. That
is why it is sensible to propose ‘safety valves’ which will allow
for discretionary increases in benefits year by year, if funding
allows, and changes along the way as other factors change. This
should always have been part of the DB landscape. Indeed, I would
argue that DA should not aim for hard guarantees at all. It should
help workers understand that pensions simply cannot be guaranteed by
private sector firms many decades hence. The concept of guarantees
should be replaced by a ‘best efforts’ promise, which cannot be
relied on absolutely and which needs to be monitored and checked over
time.
The
model which proposes mandatory transfers of members out of DA schemes
into DC schemes on leaving seems to me to be the wrong way round.
Valuing DA benefits correctly will be a nightmare and I
consider there will be significant difficulties with such a scheme
design. I would suggest that this would work much better the other
way round. After a certain number of years in a pension scheme, the
benefits could be converted from DC to DA (or DB), so that employers
will be rewarding loyal service, and adding guarantees (albeit less
draconian than currently) to their long-serving workers’ pensions.
Past accruals could be converted into an equivalent number of years
worth of DA pension accrual. For example, after ten years’ service
a worker could be offered a chance to convert their DC pension fund
into a participation in a DA or DB scheme with ten years’ service
at the salary they earned each year.
Problems
with trying to move to DA
-
Will
employers be willing to once again shoulder pensions risks that they
can pass onto workers in DC? If shareholders do not wish to be
saddled with future risks, DA will not be adopted by many firms. -
Many
employers may be fearful that the ‘ambition’ will not stay as
just an ambition, and will be sceptical that DA will be converted
into a legal guarantee in future, as happened with traditional final
salary schemes. -
Guarantees
may not be deliverable on a reliable basis – schemes must have
flexibility to work more on the basis of adjusting to developments
in people’s lives and financial markets -
There
is bound to be a trade off between guarantees and potential returns.
This needs to be understood. A ‘money back’ guarantee on
contributions is not a very ambitious ‘Ambition’ and future
pensions are bound to be uncertain. -
Even
the state pension has turned out to be unaffordable for the state
itself, and it has been cut several times, with further cuts coming.
If taxpayers cannot afford unreformed pensions, then corporate UK
cannot possibly be relied on to deliver future pensions and workers
need to know this. -
Imposing
conditional or discretionary benefits on employers or schemes could
still prove too costly, especially in the face of EU EIPOA
regulations that may come in and extra solvency or reserving
requirements for pension funds. -
Ultimately,
pensions risk cannot be eradicated. Passing risk from one party to
another does not make it disappear and, if markets do not deliver,
or if contributions are too low, pension provision will remain
inadequate.
Specific
Responses to Consultation Questions
1. Do
you agree that a greater focus on providing members with more
certainty about savings or preferably income in retirement may
increase confidence in saving in a pension?
I
agree that providing more certainty can help increase confidence in
theory, but in practice not only will people find it difficult to
trust pensions given past experience, but it may also prove
impossible to actually offer meaningful guarantees anyway.
Guaranteeing a future income many decades into the future is too
risky for private companies to be relied on to deliver. It would be
better to be honest with people and let them know that saving in a
pension fund carries risks so that future pension income cannot be
guaranteed (at least not till close to retirement). However, not
saving is guaranteed to mean lower living standards than if one has
saved.
2. As
an employer, do you have experience of, or can you envisage any
issues with, employees being unable to retire due to DC pension
income levels or certainty about income levels?
Employers
may have some concerns that workers cannot retire if they have
inadequate incomes, but I don’t believe slight improvements to
pension income outcomes are likely to be sufficient to address
retirement affordability in a meaningful manner. Employers can best
help older workers prepare for retirement by facilitating part-time
work in later life, which can help them accrue higher incomes and
continue some saving, in preparation for stopping work altogether at
a later age, while cutting working hours for a period of time
beforehand. Offering financial planning help to workers is likely to
prove a more cost-effective method of dealing with retirement issues
than trying to underwrite pension guarantees.
3. What
are your views on the feasibility of this scheme design?
Flexible
DB schemes are feasible and an improvement on inflexible DB, but
there will still be concerns that employers may not be able to afford
the core benefits themselves. Certainly, permitting discretionary
year by year increases, as funding and economic conditions allow,
would be necessary to attract employers to take on pension risks
again. They would probably still be concerned that the flexibility
in DA schemes could be taken away by future legislation.
5.
Are employers likely to be interested in providing benefits in
addition to a simplified flat-rate
DB pension on a discretionary basis or otherwise?
Private
sector employers may choose to provide additional benefits, such as
life insurance which has disappeared from DC schemes, however
additional pension benefits are likely to be less attractive.
6.
What role do you see for scheme trustees in relation to discretionary
payments? For example:
-
Should
they be involved in deciding whether a discretionary payment is made
at all?
Trustees should be involved in assessing
the affordability of discretionary payments.
-
Should
they be involved in setting out how these payments are apportioned
to members or should this be down to the employer?
Trustees should be involved in
apportionment decisions.
7.
Do you agree that our starting point should be to keep regulatory
requirements around discretionary
benefits to a minimum?
Yes,
definitely!
8.
How do you see funding for the non-discretionary DB element being
sufficiently protected while
allowing for extra discretionary benefits? For example, is there a
risk that paying discretionary
benefits could threaten the funding for non-discretionary DB benefits
for younger
scheme members?
This
all depends on investment returns to a large degree and there is
always the risk that younger members’ benefits could be threatened
by the amounts paid out to older members before the young ones reach
retirement.
Flexible
defined benefit – automatic conversion to DC
9. What
are your views on the feasibility of this scheme design?
I
consider there will be significant difficulties with such a scheme
design. The formula for calculating transfer of benefits is unlikely
to be easily agreed upon and is fraught with risks. I would suggest
that this type of scheme design would work much better the other way
round. After a certain number of years in a pension scheme, the
benefits could be converted from DC to DA (or DB), so that employers
will be rewarding loyal service, and adding guarantees (albeit less
draconian than currently) to their long-serving workers’ pensions.
For example, after ten years’ service a worker could be offered a
chance to convert their DC pension fund into a participation in a DA
or DB scheme.
10.
If employers are able to use scheme designs 1 and 3, do you think it
is still helpful for legislation
to allow for this scheme design?
I
am not in favour of this scheme design, since mandatory transfers
will be difficult to value. If the design works the other way round,
so that employee benefits are converted from DC after a set number of
years, then those benefits would remain with the employer but would
not be tiny amounts from just short periods of accrual.
11.
Do you think this scheme design could be extended to permit employers
to automatically transfer
members out of the scheme at retirement?
I
think it would be far better to leave it to workers to decide if they
want to transfer out and if their accrual only becomes DA or DB after
a certain period of time, they are less likely to want or need to
transfer. Transferring between industry-wide employers could be
another model to consider.
12.
What would be the most suitable way for benefits to accrue under this
model? And how might
this best be communicated to ensure members understand the value of
their pension
benefits?
Benefits
that could be automatically converted to DC would be difficult to
explain and I do not believe it is sensible to try to do so.
13.
Assuming a CETV would not represent ‘fair value’ for the accrued
rights when the member leaves or retires, how might it best be
calculated? Should the basis for calculation be different when the
transfer is initiated by the employer (for example on redundancy)?
This
question illustrates why I believe the proposed model is flawed. The
value of the CETV would be open to manipulation and the complexity of
different calculations depending on whether the employer or worker
initiated the scheme exit would be costly, complex and unreliable.
14.
For schemes providing a lump sum benefit, what are your views on how
the cash value should
be calculated for members who leave before retirement? Should the net
present value
of the lump sum be calculated on how many years away from pension age
they are?
I
am not in favour of this model
15.
Could the accrual rate and pension value be along similar lines to
existing cash balance arrangements?
Workers
should be allowed to stay in current cash balance arrangements after
they leave employment, not forced out.
16.
What forms of regulatory requirements would be needed to:
• prevent
avoidance activity?
• ensure
the scheme has access to sufficient funds to enable a transfer when a
member
leaves?
Mandatory
transfers could result in unfairness to members not transferring out,
depending on assumptions used for the valuations. Scheme cash flow
would need to be carefully managed but it is not clear that will be
an easy task.
Changing
scheme pension age:
17.
What are your views on the feasibility of this scheme design?
Changing
scheme pension age is sensible but again will be difficult to manage
fairly. Certainly, the ability to say to younger workers that they
cannot be sure of their scheme pension start date until nearer the
time they may start to take benefits is vital. As life expectancy
continues to rise, it will be necessary for employers to have the
leeway to increase pension age in future. If future pensions have to
start at different ages, depending on the original contribution date,
the administrative complexity will be too challenging.
18.
It could lead to more schemes having proportions of accrued pension
payable at different pension
ages. Would this further complexity outweigh the benefits?
Yes!
Future pensions should start from a date to be determined in future,
rather than pre-set many decades in advance.
19.
What role do you see the scheme trustees playing? Should they be
involved in setting a new
NPA, or should this be down to the employer and the employer’s
actuary?
Trustees
need to be involved in order to protect members’ interests, but
there should be negotiation between all the parties, with employer
and actuary having to justify the increase.
20.
What are your thoughts on how future pension ages are set?
• For
GAD to publish a standard index based on longevity assumptions?
• Or
do you prefer schemes linking their NPA with the State Pension age,
so that when the latter
changes, the scheme’s pension age automatically changes in line
with this?
It
is not up to Government to determine scheme design. Future pension
age could be determined by industry, as some industries have lower
life expectancy than others, or it could be tied to state pension age
or another measure of longevity. This would all need to be justified
in negotiation and would be complex in practice.
21.
How might the decision to change the NPA work in multi-employer
schemes?
I
believe in trying to standardise benefits across employers –
assuming multi-employer schemes are all in the same industry. If
different employers have different life expectancy for their members,
then it could prove difficult to adjust pension age a different
scheme design may be needed.
22.
As an alternative to opening a new scheme, do you agree it should be
possible for an employer
to modify the rules of an existing scheme so that it can be
re-designed as a Flexible
DB scheme in relation to new accruals, for example, it is possible to
change the NPA and/or introduce automatic conversion to DC when a
member leaves?
Yes.
23.
Do you agree that employers should not have the power to transfer or
modify accruals built up
under previous arrangements into a new arrangement, beyond what is
allowed under current
legislation?
No.
24.
Should there be a requirement to provide independent financial advice
in all cases where an
employer offers to transfer a member’s accrued rights from a
traditional DB scheme to a new
arrangement?
Yes
25.
Do you think having more certainty than traditional DC would be
welcomed by members, and
help generate consumer confidence and persistency in saving?
See
answer to Question 1. Members would probably welcome more certainty
but need much more education about the value and cost of pensions.
26.
As an employer, if these products mean there is no funding
liability, only the requirement to
contribute as for a traditional DC scheme, would you be interested in
offering these products
to employees?
If
there is no funding liability, it is hard to see what kind of
meaningful guarantee could actually be on offer. The costs of
guarantees will vary, but a guarantee that is worthwhile in terms of
delivering future certainty is likely to be very expensive and a
guarantee that costs very little is likely to be worth very little.
27.
In relation to medium- and long-term guarantees outlined in model 2
(capital and investment
return guarantee), and model 3 (retirement income insurance), would
removal of
the legislative barriers be sufficient to stimulate the development
of market-based solutions?
It
is already possible to obtain capital and investment return
guarantees, as well as current and deferred income guarantees. For
example, MetLife offers such guarantees but they come at a cost.
They are available on existing DC scheme arrangements or savings
plans and do not require new DA legislation. The problem is that
there are not enough providers of sufficient size and strength to
underwrite mass-market guarantees. This is a niche area, only
available to wealthier savers. Introducing a ‘fiduciary’ to
negotiate cheaper guarantees seems a really nebulous concept and it
is not clear that this is a practical option.
As
regards retirement income insurance (option 3) this looks like buying
deferred annuities, which are even more expensive than ordinary
annuities, with an equity fund to provide a bonus on top of the
deferred guaranteed income. This is likely to be a very expensive
way to provide future pensions. Deferred annuities are exceptionally
poor value due to the risk and profit margins built in. They may
offer a guaranteed income, but it will be very low. It is far better
to try to buy a guarantee much closer to retirement and leave members
to keep on accruing additional savings during their working life.
28.
As insufficient scale has been identified as a barrier to providing
affordable guarantees, is there a role for the Government in
facilitating different types of pension vehicles that would create
greater scale for this purpose?
I
do not believe the Government itself should design new pension
vehicles, that should be up to the pensions industry. However, I
think there could be a role for Government in providing longevity
gilts, which could help offset some of the longevity risks of
pensions and the Government itself could consider underwriting
annuities, which would allow much better rates. The profit and risk
margins on current annuities are clearly very high and there is room
to pass significant cost savings onto consumers if the provision of
annuities were taken over by the Government. By threatening to
compete in the annuity market, the Government would probably then
force annuity companies to improve the value they offer.
30.
Do existing protection arrangements for DC products provide
sufficient protection for members
in the event of provider insolvency?
It
is not clear that savers with more than the statutory minimum
compensation limits in personal or group pensions with financial
services firms are sufficiently covered by insurance protection in
event of provider insolvency. It is not clear whether the PPF itself
would be involved in this DA area and how it would value the promised
benefits.
32.
Are these models likely to be an attractive option for employers and
members?
Such
options could be made to sound attractive, however the long-term
risks of these provisions and the probability of disappointment for
current or future retirees makes them less attractive in the medium
term.
33.
On model 4 – pensions income builder – what are your views on
this model in which members
are in effect deploying their own capital to guarantee their own
entitlements?
It
is likely to prove difficult to explain this concept to members in a
manner that they can understand and the likelihood of
misrepresentation or misunderstanding is high. This model will not
provide guaranteed pensions and, although employer contributions will
be capped, this means workers’ pensions may not pay as much as they
expect and they may have a false sense of security.
34.
Do you agree that CDC schemes have the potential to provide more
stable outcomes on average
than traditional DC schemes?
I
agree that CDC schemes have the ‘potential’ to provide more
stable outcomes on average. That does not, however, mean they will
definitely do so. CDC does mitigate risks, especially in the nearer
term, rather than being fully exposed immediately to mark-to-market
risks.
35.
Given there is no tradition of risk sharing between pension scheme
members in the UK, are
individuals going to be willing to share the benefits of protection
from downturns in
the market and increased certainty of outcome, with the potential
disadvantages of intergenerational
risk transfer?
The
question of whether members will be willing to share the protection
benefits pre-supposes that they will understand how the scheme works.
There is a notable lack of inter-generational solidarity in Britain
today, with younger generations seeming to believe that older people
have had too much of the share of national wealth in terms of
pensions and housing. The CDC design certainly means younger
generations could lose out relative to older members of the pension
scheme, because future returns may not materialise as predicted and,
therefore, funding may fall. This goes back to the point that we
need to reduce the idea of ‘guarantees’ in pensions and help
people understand that pensions cannot be relied on to be exactly as
predicted many decades ago, due to changes in demographics and
markets. If members are not led to believe that their pension income
can only rise and if they are clearly told that there may be times
when their pension income could have to reduce, then they may accept
the principles, but it is important that they understand. People
accepted with profits concepts at the time, but that was partly
because they did not realise how much returns could fall during bad
times. CDC has the potential to mislead in the same way as
with-profits did, or indeed Equitable Life. It is important that a
distinction is made between past mistakes and future best practice.
CDC is likely to deliver more reliable outcomes for most people than
pure DC, but this is not guaranteed. Pure DC is probably the most
risky form of pension saving for individual workers.
36.
Is a CDC scheme designed to manage funding deficits by cutting
benefits in payment going to be acceptable in the UK where
traditionally maintaining the value of benefits in payment has been
an overriding priority?
We
need to get away from the idea that pension benefits can never be cut
under any circumstances – this is financially unsustainable. Even
taxpayers have been unable to commit to maintaining state pensions,
so private companies are even less able to do so.
37.
What levels of funding do you consider would be appropriate to
ensure that a CDC scheme has sufficient capital to meet the
liabilities and minimise the risk of benefits in payment being cut?
It
is impossible to answer this, there will always be times when
assumptions about appropriate funding levels prove incorrect. A
‘best efforts’ basis is more reasonable.
38.
Given the need for scale and an ongoing in-flow of new members to
ensure the sustainability
of a CDC scheme, will it be possible to set up a scheme without some
form of Government
intervention?
Industry-wide
schemes could provide scale, but it will always be the case that new
members carry more risk than older members. This is the nature of
CDC. That does not mean younger members will necessarily get lower
pensions, but they are more at risk of this.
39.
As a mutual model, it has been suggested that CDC schemes might
prove attractive to the trades unions and other social partners –
might this be an option worth exploring?
Any
ways in which we can increase the scale of pension saving schemes is
worth exploring. Economies of scale are very important.
41.
Do you have any comments on how to characterise the defining
characteristics of DA pensions?
DA
pensions should emphasise the word ‘ambition’ so that members
know this is an aim, not a cast-iron guarantee. Members should be
told that the benefits will be influenced by factors such as
investment returns and changes in life expectancy and that the final
pension received cannot be predicted until later life.
47.
Do you think that setting up a CDC scheme should be subject to formal
approval, for example
licensing by a regulator?
Yes.
48.
Do you think that CDC schemes which do not provide a guarantee or
promise should also be licensed?
Yes.
49.
Do you agree that such CDC schemes should also be subject to DA
requirements on governance
and member communications?
Yes.
50.
Should there also be an option for schemes that currently offer DC to
convert to CDC?
This
should surely be an option, but requirements for clear explanation
and member choice are needed alongside this.
51.
In the absence of both a guaranteed pension entitlement and an
individually defined pool
of assets, how should assets in a CDC scheme be apportioned such that
pension accruals
can be measured for tax purposes against the Annual Allowance and the
Lifetime Allowance?
Restricting
lifetime accruals does not make sense to me and the annual allowance
should be based on the amount of money per member actually being paid
into the scheme.
52.
What specific areas should we address in relation to governance and
member communications
for DA schemes?
Governance
needs to ensure best efforts to deliver the pension ‘ambition’
but communications need to make it clear that these are aspirations,
rather than guarantees that can be relied on indefinitely.
ENDS
Dr. Ros Altmann
December 2013