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Switched on

Recent announcements from Barclays, BP, British Airways and Royal Mail about the future, or possible future, of their pension schemes highlight the dramatic changes sweeping through the UK pension system.

The high-profile schemes attract widespread coverage but members of many other schemes will be seeing similar changes and being offered defined-contribution schemes in one form or another in place of defined-benefit schemes.

This practice now appears to be extending more broadly to existing scheme members as well as new employees.

From the security of a pension based on a proportion of their final year’s earnings, without having to concern themselves too much with the risks presented by asset allocation, fund performance or mortality, individuals suddenly find themselves exposed to all of these issues and much more responsible for their eventual retirement income than they have ever been in the past.

This will throw into stark relief the issues already facing the personal and occupational DC markets – lack of savings, confusion and apathy resulting in under-performance, inappropriate levels of risk, small funds and a failure (or inability) to shop around for the best solution at retirement.

Continued failure to address these issues, particularly lack of engagement, will increase the loss of value experienced by scheme members at retirement. We once estimated that the loss of value resulting simply from failure to shop around was around 500m each year.

As employers switch schemes, there are a few simple rules that members should follow to ensure they get the best from their new pension arrangements and are not subject to severe disappointment at retirement when they can least afford it.

  • Take time to read and understand all of the information offered at the time of the switch, seeking advice if unsure of any aspect.

  • Be clear about what the contributions will be worth on retirement and if this meets with requirements.

  • Regularly review the pension, with an adviser if necessary, to ensure it will continue to meet with requirements on retirement.

  • Understand all the options for generating an income after retiring and shop around for the best deal to meet personal circumstances when the time comes.

    According to ONS, there were 2.7 million active members of private sector DB schemes in 2007, down from three million in 2006. As companies continue to close schemes to new members or even to existing members, the importance of these steps will increase.

    The support of scheme advisers and financial advisers will be invaluable in improving security, peace of mind and, ultimately, a secure retirement.

    Barclays’ current DC scheme is a hybrid, with a cash balance account and an investment account. The cash balance account gives an amount at normal retirement age that is related to earnings for each year and with an allowance for increases in prices over the period to retirement. The investment account is a straightforward money purchase account with an employer contribution, added to an employee contribution, which grows in line with the underlying investment.

    Based on certain assumptions, this arrangement could give an income in retirement that would be close to that expected from a DB scheme. If actual experience varies from assumptions, however, much of the risk is borne by the members and will be felt as a lower pension than they may have expected.

    Compared with many DC arrangements this still seems like a good scheme, although more of the risk of investment volatility and longevity has been passed to the employees.

    Widespread adoption of this type of arrangement when DB schemes close would ultimately result in a significant increase in the average size of maturing individual pension funds.It is quite possible that someone with 15 years of service earning 25,000 could see a fund close to 200,000 at retirement. Many of these funds will now come to the annuity market. A large proportion of other schemes will not offer this level of benefit and the ability to accrue large funds will not be so high. However, the number and size of individual funds emerging at retirement will grow – even if the numbers are spread over 30 years.

    On top of this, there is the matter of potential transfers from closing DB schemes. This will all have a dramatic effect on the at-retirement sector, with an increased demand for existing products and more impetus for development of hybrid income solutions.

    In themselves, DC schemes are not necessarily worse value than DB schemes for an equivalent contribution but the real difference that can upset pension planning is the level of responsibility and risk undertaken by the individual in comparison to a more traditional DB arrangement.

    Given that many people will accrue very large funds – possibly the biggest asset they will have – the value of the right advice and a regular review of the funds cannot be overstated. In some schemes, it will be quite possible for members with 15 years of service to accumulate funds of 200,000 or more, even on modest salaries.

    Most people would not think twice about obtaining advice on how to deal with 200,000 in cash and the argument is no less important for a pension fund.

    The demand for advice and better information at retirement will be at a premium. Organisations with an understanding of the needs of individuals with regard to guidance – and the ability to deliver a range of suitable services – stand to see a substantial increase in business.

    But expecting someone previously oblivious to their pension to suddenly begin to understand the concepts with a wake-up letter four months before retirement is unlikely to yield significant improvement in take-up of the right to shop around overall.

    Our own research showed that 77 per cent of those aged between 55-70 do not understand what an annuity is. We did not test understanding of other retirement options but I would be surprised if the level of understanding was any higher.

    The increased attention on switches, however, presents an opportunity for employee benefits consultants and IFAs to establish awareness and understanding of pensions with those affected and to provide advice throughout an individual’s career, leading to a better outcome on finishing work.

    Many employer schemes have done a great deal of work with their consultants to ensure access to comprehensive and clear information for pension scheme members whatever stage they are at. Continuing education in manageable bits during membership of a scheme could well be the best way to ensure a significantly better informed group at retirement.

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