Managing reward: Pensions

Section six of the Personnel Today Management Resources one stop guide on managing reward, covering pensions, including: state pensions; company or 'occupational' schemes; and international perspectives. Other sections .

Use this section to          Understand state pensions          Demystify company pensions          Grasp the issues in the pensions crisis          Argue the case for/against DC/DB          Review or redesign a pension plan

State pensions

Basic State Pension

UK state pension benefits are made up of two components, a basic universal flat-rate benefit (£79.60 per week 2004-05) and an earnings-related element. This approach is in common with many other social security systems internationally, which provide a universal flat-rate benefit together with a 'second-tier' earnings related benefit.

Basic state pension is a defined benefit, and men currently need to pay national insurance contributions for 44 years to secure the full basic rate pension at age 65. Women currently have to pay 39 years' national insurance contributions to secure the same benefit at age 60, though state pension ages will harmonise at age 65 over a 10-year transition period between 2010 and 2020. In effect this means that, by 2020, both men and women will both have to pay 44 years contributions in order to secure the full basic rate benefit at age 65.

Second Tier Pension

The second-tier of state pension provision is called S2P (the Second State Pension). Formerly known as Serps (or Graduated Pension before 1975), the second state pension provides additional benefits for anyone 'contracting-in' (ie, participating in) to the state system with earnings up to £26,600 (2004-05). At earnings above this level, no further incremental benefits arise. A higher rate of benefit accrual occurs for those with earnings up to £11,600 (2004-05), ie, S2P benefits are skewed in favour of lower earnings. Many occupational pension plans are designed to 'contract-out' of S2P, in other words they provide the benefit which would have arisen in the state second tier and in turn both the employer and employee pay a lower rate of national insurance contributions.

Further details of the operation of the UK state pension system, together with an application form for forecasting state benefit entitlement can be obtained from www.thepensionservice.gov.uk.

The effect of this state pension structure is that employees secure retirement benefit from three sources as illustrated below:

Company Pension Plan

S2P

Covers earnings up to £26,600 pa

May be included in company plans

Depends on contracting-out status

Basic State Pension

Company or 'occupational' pension plans

Pension scheme trustees

Company pension schemes are usually set up within a trust, with the operation of that trust governed by a document called the Trust Deed and Rules. This is primarily to protect current and former employees and pensioners assets from being accessed by the company. The trust is managed by trustees who are usually unpaid and either appointed by the company and/or member nomination (member-nominated trustees). The trustees are advised by a scheme lawyer, an actuary (in the case of defined benefit plans) and an investment consultant.

Following the Robert Maxwell scandal, when Mirror Group Newspapers used pension fund assets to support the failing business, the Government introduced legislation (the Pensions Act 1995) and the powers of pension fund trustees were strengthened. The Pensions Act is the most important piece of legislation with which trustees and sponsoring employers have to comply.

The main functions of trustees are:

To supervise the administration of the company pension plan

To appoint fund managers, review their performance and fees

To ensure all statutory obligations are met (accounts, valuations, timely payment of contributions from the company, etc).

Types of occupational pension plan

There are two mainstream designs for occupational pension plans:

Defined Contribution (DC), also known as 'money purchase'. Stakeholder pensions have been designed as a lower cost version of defined contribution, but are essentially the same in design as any other money purchase pension plan. A Group Personal Pension plan (GPP) is another variant of DC. DC plans define in advance the value of the contributions which the employer and/or employee pay into the plan. The value of the pension received depends on the amount of contributions paid into the plan, investment returns during the plan members working life and the cost of an annuity (ie, a retirement income stream, typically purchased from an insurance company) at the time of retirement.

Defined Benefit (DB), also known as 'final salary' or 'superannuation' (a term nowadays largely confined to public sector schemes). DB plans define in advance the retirement pension that will be payable at normal retirement age. The employer bears the risk that investments will not be sufficient to finance the pension 'promise'. The employee will normally contribute to the scheme, but the 'balance of cost' is borne by the employer. The balance of cost associated with meeting the pension promise is substantially determined by future salary growth, inflation pre and post retirement, investment returns, and expected mortality.

Then there are hybrid plans. Less than 5 per cent of UK pension plans exhibit features of DB and DC. Some of the early adopters of DC established a DB underpin, ie, the employee is entitled to the DC account value, but a minimum DB promise provided an underpinning safety net. By the mid 1990s the next iteration of DC plans in large companies was a lifestyle approach, whereby DC was made available to younger employees but the DB entry door was left open for employees once they attained, say age 40 or 45. More recently different forms of hybrid plan have emerged, primarily the 'cash balance plan'. Cash balance is a defined contribution plan which has the appearance of defined benefit by guaranteeing an underpinning rate of investment return, eg, that of UK RPI or US 30 year Treasury bonds. Cash balance emerged in the US in the mid 1990s and many UK plcs operate cash balance plans in their US subsidiaries (eg, Reckitt Benckiser). The model has begun to appear in the UK, the highest profile plan being the one available to new entrants to Barclays.

Key features of occupational pension plans

Contributions

A pension plan will usually be 'contributory', in other words the employee will have to contribute to, or match the employer's contribution. Non-contributory plans, where only the employer makes contributions to the plan, are relatively rare in the UK except in certain sectors (eg, financial services).

Tax relief on employee contributions

For contributory plans employee contributions will normally be collected by payroll deduction and tax relief will be delivered via the PAYE (Pay As You Earn) payroll tax system. This means that for a basic rate tax payer every 78p deducted from pay results in a £1 investment to the pension plan. For a higher rate tax payer the net employee contribution is only 60p in return for £1 invested. The employee does not need to claim tax relief from the Inland Revenue because it is automatically delivered via the employer's payroll. Stakeholder Pension Plans are an exception to this principle as the plan administrator recovers the basic rate tax rebate direct from the Inland Revenue leaving the higher rate tax payer to reclaim the 18% differential via their annual tax return (ie, current higher rate tax of 40% c.f. basic rate of 22%).

The employee may make Additional Voluntary Contributions (AVCs) to the pension plan (whether DB or DC) and enjoy the same tax relief, up to a maximum contribution of 15% of pay or a limit of £15,300 (2004-05), whichever is the lower. In April 2006, these limits will be relaxed when tax simplification collapses the existing eight tax regimes into one common pensions tax system.

Employer contributions

For defined contribution plans, employer contributions are usually expressed as a percentage of salary and typically increase with the employee's age, or in a minority of plans, with length of service. The logic of increasing with age is that there are fewer years available to earn investment returns between the time the contributions are made and the pension comes into payment. The employer's contribution will normally be dedicated to providing a retirement pension with other benefits (eg, long-term disability or dependant benefits) being provided via separate insurance contracts financed exclusively by the employer.

For defined benefit plans the employer's contribution is not normally disclosed to the employee. The rate of contribution fluctuates theoretically with triennial actuarial valuations and more likely in practice as a result of annual funding updates. Although most surveys of market practice reveal DB employer contribution rates to be at least twice the average DC contribution, this can be misleading due to the fact the DB contribution rate includes the expense of life cover, long-term disability pensions, spouse and dependant benefits.

Investment strategy

Defined benefit contributions, from both the employer and employee, are invested in funds which are ring-fenced in a trust fund. The trustees will usually delegate the management of investments to an investment sub-committee which will:

determine an appropriate investment strategy

monitor the performance of fund managers

appoint/dismiss and negotiate fees with fund managers.

The asset classes (whether equities, property, fixed income or cash investments) in which the Trustees invest will generally be determined by the nature of the 'liabilities'. In other words if the pension scheme is required to pay benefits to people who are, in the main, already pensioners then their liabilities are largely known, ie, their final salary and length of service have both been established at the time of leaving employment. The only remaining uncertainties are mortality (ie, when on average pensioners will die) and retail price inflation between the date of retirement and the date of death. In effect, the investment 'risk' is relatively low and in turn the Trustees are likely to invest in low risk investment assets such as bonds or other fixed income instruments.

Where a pension fund's members are mostly 'active' (ie, employees who, on average, still have many years of service ahead of them), the trustees are more likely to weight their investment strategy towards equities. Although investments in equities are more volatile the pattern of history has been that equities outperform other asset classes over the long run. By investing in higher risk-higher return assets classes the long-term expense of providing defined benefit pensions should be reduced.

Defined contribution plans follow similar investment principles except that the employee's pension fund is theirs alone. An employee is not a participant in a collective investment vehicle. The employee rather than the company carries the risk that pension investments will not be sufficient to provide an adequate income in retirement and the responsibility for managing investments falls to the employee also.

The trustees, or in the case of a stakeholder pension the organisation, has a responsibility to educate employees, so that they have sufficient understanding to make well informed investment decisions. The employer is often reluctant to do so, for fear of being seen to be providing financial advice.

In practice, an employee who is a member of a defined contribution plan needs to think in similar terms to the trustees of a defined contribution plan. They need to be prepared to take a high level of risk when they are younger and move progressively towards more secure investments in the 10 years before their planned retirement.

The evidence from numerous studies in the UK and the US indicates that employees tend to invest too conservatively when investment decisions are left to the individual. Trustees or employing organisations often attempt to manage out this risk by setting up a 'default' investment option. Default funds are often passive index tracking investments which migrate into bonds/fixed income as retirement approaches. An illustration of a typical lifestyle investment strategy appears above.

Retirement benefits

In the UK benefits from a company pension plan are paid in the form of a tax-free lump sum and the remainder in the form of retirement income. Theoretically an employee can take all of their benefits as income, but this is extremely rare due to the fact that income is taxable and the lump sum is tax-free, as follows:

Lump sum benefits

Stakeholder pensions 25% of the fund value can be paid out tax-free

Trust-based schemes (DB and DC)3/80ths of final salary per year of service, subject to a maximum of 1.5 times salary may be received tax-free. For those who joined their company pension scheme after 1987 the tax-free lump sum of further restricted to a maximum of £150,000 even if the above formula would deliver a higher value for highly paid executives.

In April 2006, the tax laws will be simplified and all pension funds will be able to deliver up to 25 per cent of the members fund value tax-free.

Retirement income

With a defined benefit pension scheme a pension will typically be paid direct from the fund, whereas a defined contribution plan will advise the employee the value of their pension fund at retirement and invite the individual (often with the assistance of an independent financial adviser) to purchase an annuity from an insurance company. The insurance company will quote prices for a single life or joint and survivor depending on the member's status, ie, a married employee is more likely to purchase an annuity which provides for a spouse's benefit following the member's death. As life expectancy has increased, so the cost of annuities has increased also. This is a key reason why companies have moved away from defined benefit pension promises.

International perspectives

State benefits

State pension is usually based on social security contribution history, though some countries have introduced compulsory retirement savings via other means. Singapore's Central Provident Fund and Hong Kong's Mandatory Provident Fund are examples.

Some Governments 'privatise' second tier social security and require citizens to save with an insurance company. Chile was the first country to adopt this model and others (Poland, Argentina and Mexico) have since followed suit.

In Europe second tier 'complementary' benefits are often provided via a sectoral collective agreement, ie, all employees within a particular industrial sector participate in the same scheme.

Company pensions

Company pension plans, other than for executives, are relatively rare in mainland Europe due to the existence of social security systems which are much more generous (and much more expensive therefore) than the UK.

In the US, the best-known form of retirement plan is the 401K Savings Plan. This is a defined contribution model in which the employer matches employees contributions (based on a formula of the employer's choosing).

Occupational defined benefit plans are in decline worldwide. Even Japan (where DC was previously illegal) introduced legislation in 2001 to encourage the setting up of DC accounts.

An employer's perspective on DC

Advantages

The employer's costs are known in advance

The regulatory burden is much less than DB

DC is easier to explain and understand

Disadvantages

DC plans are attracting negative publicity

Employee relations risk if benefits fall short of expectations

Member education is an employer responsibility.

An employer's perspective on DB

Advantages

Represents a competitive advantage in labour market

Cost to company significantly exceeds perceived value

Can reduce the cost of redundancies

Disadvantages

Accounting standards (FRS17) create profit volatility

Improved mortality is increasing DB expense

Investment returns have been poor in recent years.

An employer's perspective on cash balance

Advantages

The employer's costs are known in advance

Less risk of employee relations issues

Readily presentable as a shared responsibility

Disadvantages

Cash balance is an unproven concept

Lack of familiarity, creates 'suspicion of the new'