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Make the conversion

It is time for advisers to urge corporate clients to face the facts. An uneconomic defined-benefit scheme can deplete a company&#39s profits, decimate its share price and damage its competitive position. It may even threaten the company&#39s viability.

With the DB liability now based on the full buyout cost of immediate and deferred annuities, most employers should close their schemes to all future accrual, to existing members as well as new entrants. The alternative is to increase employer pension contributions, typically by over 100 per cent, in order to keep on track.

The pressing need to close schemes should come as no surprise. Funding problems have already forced many final-salary schemes – the most common DB arrangements in the UK – to close to new employees. But as the major consultants point out, this step has a minimal impact on the employer&#39s bottom line. Following the change in June 2003 in the way that the DB liability is calculated, for most companies a DB scheme that is left open to existing members represents an unacceptable drain on resources.

Practical advice and support

Employers with problematic DB schemes are desperate for practical advice and support. They are only too well aware that, in the current climate, a poorly coordinated and communicated move to defined contribution could result in harmful negative publicity. Anyone who reads the weekend personal finance pages in the national newspapers will know how easy it is to paint a Dickensian picture of evil companies bent on the mass exploitation of their pension scheme members.

The truth is that the number of employers prepared to sacrifice the trust of their workforce is extremely limited. In our experience, employers are determined to meet their liability for DB benefits accrued to date and are very keen to continue to offer their employees valuable retirement benefits. Above all, they want to be able to continue to offer their employees a job.

Advisers need to be clear about the difference between the controversial underfunded wind-up, where members&#39 benefits are decimated, and the pragmatic scheme closure, where the employer aims to pay the accrued benefits.

Nor should they hesitate to explain clearly to corporate clients the full potential costs of keeping the DB scheme open. As the example below shows, the typical 100 per cent rise needed in the DB pension contribution is necessary to cover the additional buyout cost of the extra guaranteed benefits that members will accrue during just one additional year in the scheme.

Based on actuarial calculations, the example company that currently pays a contribution of 11 per cent will need to pay 23 per cent in the future to meet these liabilities, even if the scheme is already closed to new employees. Moreover, this extra 12 per cent of payroll is not actually giving members anything more than what is already promised under the scheme rules.

Companies that cannot afford to double their pension contribution are in urgent need of expert advice to determine how best to tackle the problem. The challenge for advisers, therefore, is to provide employers with effective liability-driven investment strategies for the closed DB scheme and an affordable and well-communicated DC arrangement that successfully targets members&#39 retirement income requirements.

The holistic DB to DC approach

The role of the adviser is to ensure that the employer has the required actuarial, investment, administration, legal and communications solutions to be able to reassure trustees, trade unions and employees that it is acting in the best interests of all parties concerned. Clearly, the first priority is to examine the existing scheme documentation. Assuming that this permits the DB scheme to close to future accrual, the holistic DB to DC approach consists of three key steps that must be implemented concurrently:

•A robust investment strategy for the closed DB fund.

•The implementation of a modern, flexible DC scheme that targets retirement income through a flexible contribution programme.

•A communications programme that recognises the needs and concerns of each party and will provide individual advice.

Alexander Forbes Financial Services has been advising on DB to DC conversions since 1990 and has completed over 200 cases successfully. Feedback from corporate clients confirms that this holistic approach to conversion is generally received in a very positive manner by employees, who are relieved that the company has taken action to secure its future viability and value the employer&#39s continued contribution to their pension benefits.

Clearly, one of the most difficult issues is the funding position of the closed DB scheme. The adviser managing the DB to DC transition must help the trustees assess whether the continued employer contributions to the DB scheme, together with the scheme&#39s assets, will be sufficient to provide the promised benefits. To ensure these liabilities can be met, trustees will need access to a comprehensive range of funds that provide appropriate asset/liability strategies to deliver a more predictable outcome with reduced volatility.

Communications are key to success

There is no doubt that good communications is the key to success with a DB to DC conversion and this should include advising the trustees and trade unions, where appropriate, as well as scheme members. Group presentations play an important role but the availability of individual advice is vital if the employer wishes to achieve a high level of understanding among members and a high take-up rate.

The Government, the ABI and the Consumers Association, among others, now recognise the importance of financial education and this is particularly true for pensions. Members need to understand how the DC structure works and how they can achieve their target retirement income through a regularly reviewed asset allocation and contribution rate. Employees who can make confident and informed decisions will value their benefits and appreciate the employer&#39s commitment to their financial well-being.

For the employer, this means the pension scheme achieves its primary purpose, namely, to attract and retain good staff. It is a win-win situation.

Robert Macgregor is corporate development director at independent adviser Alexander Forbes Financial Services. The company specialises in the implementation and communication of DC schemes and the provision of investment solutions for closed DB schemes.

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