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Shared expectations

The DWP consultation paper on shared-risk pension schemes explores ways of meeting the desires of both employers and employees. Are these proposed schemes good for potential members?

Employers have quit defined-benefit schemes in their droves as they prefer defined contribution where future costs are more certain.

The paper offers two main options – conditional indexation and collective DC.

Conditional indexation allows the scheme to with-hold increases to pensions in payment, and revaluation of pensions in deferment, if the fund is weak. Indexation would be restored when the fund recovers. There are also plans to allow increases to retirement age for benefits already earned if mortality improves.

These safety valves would ensure employers would be able to set stable long-term contribution rates, similar to DC, without having to make good on deficits in times of economic woe.

I have a couple of major issues with such an approach. First, DB schemes are funded according to scheme-specific assumptions. In some cases, the assumptions made are somewhat optimistic which can make a weakly funded DB scheme appear fully funded or even in surplus.

In the short term, taking such an approach might suit an employer but eventually, the scheme will have to pay the benefits. There is no way round this other than where the employer becomes insolvent and, even then, the Pension Protection Fund offers a decent level of protection for most members.

But allowing weakly funded schemes a get out of jail free card seems to be a recipe for disaster.

My second concern is that members of these schemes would have a hard task understanding the benefits. They might rightly feel aggrieved if they saw no increases in their pension just as inflation was going through the roof.

The other alternative of collective DC is not really that different from conditional indexation except that the funding rate is fixed and benefits can be cut if the contributions prove insuffic-ient to pay the target pension.

Is there a way to give employees greater benefit certainty? One way might be to add both pre- and post- retirement guarantees to DC funds using hedging, in effect, turning a DC benefit into a cash balance benefit, with increases to the retirement fund where investments perform well. The guaranteed cash sum can then be turned into a defined benefit using deferred annuities or guaranteed income drawdown.

This approach might also allow those in the savings phase to stay invested in higher-risk, higher-return assets rather than the current preferred DC risk mitigation strategy of lifestyling.

This looks like a much better option to me. By setting expectations on the low side, pleasant rather than nasty surprises are a more likely result.

John Lawson is head of pension policy at Standard life

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