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With-profits spectre haunts DB proposals

Standard Life is warning that there are significant risks to Government plans designed to help employers keep open the dwindling number of defined-benefit pension schemes.

Head of pension policy John Lawson sounded the alarm last week over two alternative risk-sharing proposals outlined in a Department for Work and Pensions paper which has just closed to consultation.

Lawson argues that the proposals for conditional indexation or collective defined-contribution schemes hand a get-of-jail-free card to poorly funded schemes.

Conditional indexation would allow schemes to hold back increases to pensions in payment and revalue pensions in deferment if the fund was weak. Indexation would be restored when the fund recovered. Collective DC schemes would allow the employer to pay a fixed amount into a fund, with the risk shared between members.

For Lawson, the spectre of with-profits endowments looms large. He predicts that just as these investments failed to pay off many mortgages, so the plans put forward in the consultation promise more than they can deliver, potentially leaving consumers’ expectations disappointed.

Lawson’s comments mirror the concerns of pension minister Mike O’Brien, who seemed to have formed a very strong opinion about the proposed schemes before the DWP consultation period had come to a close.

O’Brien told the Financial Times earlier in August that he would not be tabling amendments to the Pensions Bill this autumn to make way for the proposals although he did not rule out legislative changes at a later stage if the consultation backed this approach.

O’Brien said he was worried about the complexity of the schemes and was not yet clear whether they would help to keep existing DB schemes open or further accelerate their decline.

The Association of Consulting Actuaries has put its weight firmly behind the conditional indexation proposal which it says has been successful in the Netherlands and would be easy to get off the ground in the UK.

Meanwhile, human resources company Hewitt Associates is backing the collective DC scheme which it believes offers a “logical compromise” between employers’ need for the financial certainty of DC and employees’ desire to safeguard their future income with DB.

Yet O’Brien and Lawson are not the only ones unconvinced by advocates’ claims that the schemes can deliver the best of both worlds – DB gains for employees without financial pain for their employers.

Aegon Scottish Equitable head of pension development Rachel Vahey does not buy the argument. She is worried about complexity, cost and the potential for member confusion. She says: “At least where members have taken on the whole of the risk, they have the certainty of knowing that. With this halfway house, they have nothing to prepare for and nothing to work with.”

Lawson proposes an alternative which involves adding pre- and post- retirement guarantees to DC funds using hedging. Standard Life is looking to bring out products with post-retirement guarantees by the end of this year but it is still investigating how pre-retirement guarantees would work in practice.

Under Lawson’s suggestions, DC benefits would effectively be turned into a guaranteed cash sum, with the retirement fund increasing when investments perform well.

He believes it would be possible to transfer the guaranteed cash sum into a defined benefit using deferred annuities or guaranteed income drawdown.

But Hewitt Associates UK lead of global risk services Kevin Wesbroom believes life offices are missing a trick by not backing collective DC as he believes they have the skills and experience to run such schemes.

He says: “There is a failure of imagination on their part. These arrangements rely on somebody operating smoothing mechanisms which feels a little like with-profits. They have the experience of this but they have been scarred by it because the way with-profits was run in the past was obscure and they believe the public will not give them a second chance. If insurers learn from the mistakes of the past, they should be well-placed to be a part of this market.”

He sympathises with the alternative option that Standard Life is putting forward but says long-term hedging on this scale would be extremely costly and require a huge amount of capital provision.

Hargreaves Lansdown head of pensions research Tom McPhail argues that Lawson’s idea has the same problem of complexity as the risk-sharing proposals in the DWP paper, meaning there is danger of consumers not understanding the guarantees that are in place.

Lawson defends his suggestions, claiming that the message to consumers should not be over-complicated and that they only need to understand what level of guarantee they will get for a given cost rather than the mechanisms behind the guarantee.

Consultancy Watson Wyatt’s response to the consultation urged the Government to leave the door open to new scheme designs by ensuring that legislation is not too restrictive. It also cautioned the Government against backing a winner by sanctioning either conditional indexation or collective DC.

Specialist pension law firm Sacker & Partner is sceptical about employers’ appetite for innovation in a difficult economic climate.

Partner Helen Ball says: “Employers that have already implemented significant legislative changes to their company pension schemes may be reluctant to spend additional time and money to make further alterations.”

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