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The true scale of the DB dilemma

The stresses on the defined-benefit sector have already been well documented but the scale of the problems still has the capacity to impress.

For IFAs specialising in group personal pensions, this offers many reasons to be cheerful but it is not all going to be plain sailing.

A recent Lane Clark Peacock survey of DB schemes shows 96 of the FTSE 100 index companies in deficit to the tune of £42bn under FRS17 accounting measures. This is a big number but it is dwarfed by the £125bn which LCP reckons it would cost to buy out their liabilities fully.

There is a good reason to take more note of the latter figure. As reported in a paper presented to the Institute of Actuaries, the actuarial assumptions used by DB schemes have led to a significant under-representation of the scale of the problems. The paper is a damning indictment of DB schemes and gives stark warnings about the future.

By comparison, annuity insurers are more acutely tuned to the risks and costs of funding guaranteed benefits and are more tightly regulated. The annuity market is also highly competitive. As a consequence, the annuities offered by insurers are a more reliable guide to the cost of these DB scheme liabilities than the official cost of £42bn.

For some schemes, the deficit exceeds the market capitalisation of the sponsoring company.

The DB schemes are sitting on unfunded liabilities of about £125bn, which is getting on for a average of £10,000 per member. This is money which the employer owes the scheme but which the trustees would str-uggle to get if the employer suddenly went bust. As the actuarial paper puts it, for the member, this is just the same as giving the employer an unsecured loan equal to his personal share of the deficit.

The Pension Protection Fund is supposed to fix this but it probably will not. It is questionable whether the fund will ever get off the ground and if it does, then it may simply make things worse.

Another likely scenario is that trustees find themselves in the invidious position of having to persuade members to accept benefit reductions as the only alternative to making a call on the employer’s debt to the scheme and in the process force the employer into liquidation.

Perversely, the Government is contemplating making the PPF retrospective and is still dragging its feet over moving away from the flatrate levy – two issues which are guaranteed to undermine employer support.

All in all, DB schemes are in a hole which it is very hard to see them climbing out of.

Defined-contribution sch-emes, on the other hand, are not quite there yet. The big issues here are trustee responsibility, cost and commercial advantage. After A-Day, there will be no difference between a DC scheme and a GPP in terms of contribution and benefit limits.

The main difference will lie in the governance structure. With DC schemes, employers will still have to appoint trus-tees – 50 per cent of whom will be member-nominated – and they will still have to give time for the increasing demands of trustee training. The schemes will still have to pay levies and employees (acting as trustees) and the company will still be potentially liable to financial sanctions or legal action if something goes wrong.

Not surprisingly, in many cases, GPPs are already chea-per to run than the equivalent DC scheme. As an employer, it is highly questionable whe-ther it is commercially prudent to take on such unnecessary costs and business risks. To do so hands an advantage to any competitor who is unencumbered by such considerations.

GPPs, in spite of their slightly louche past, now offer the most sensible solution for many employers. From the employer’s point of view, a GPP does very much what it says on the tin – you pay money in and eventually your employees retire. For the members, there are three risks – not putting enough in, investing inappropriately and the conversion risk at retirement. All three of these risks can be addressed through effective employee communication car- ried out by the GPP’s IFA.

For the IFAs, there is an interesting follow-on question on commission. The handful of insurers still active in the GPP market are still paying some up-front commission but the amounts are dwindling all the time. On present trends, commission will be predominantly level or fund-based within a couple of years. This will mean an elongated payback period for the IFA. At the same time, the increased cost of servicing the scheme will need to be offset by a reduction in the up-front cost of writing the business in the first place.

This trend will be exacerbated if business volumes do increase as a result of fallout in the occupational sector. If there is plenty of business to go round, the few providers in the market will be allowed the luxury of picking and choosing clients. To a limited extent, this is already happening as some insurers are declining to pay commission on small schemes.

They will also be more inc-lined to reward sticky business so they are likely to offer more attractive terms to IFAs who can not only win new clients but look after the ones they have. In conclusion, there is lots of fun to be had but the cost of entry may put off many IFAs.


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