The ending of contracting out was never going to be straightforward for DB schemes. John Lappin finds schemes adopting a wide range of solutions to this complex problem
If the ending of contracting out for DB proves to be a nail in the coffin of defined benefit, it will not be the only one, given Brexit and its impact on gilt yields.
Janet Brown, partner at pension specialist law firm Sackers, says the issue took a long time to get on to employers’ radar but now a diverse range of approaches exists.
She says: “Normally in pensions you see a herd instinct, where the majority of employers do one thing.
“But I don’t think there was any one thing employers did. We had trustees who agreed to benefit changes; we had employers that used the statutory override to get the amount of NI back by making just that tiny accrual change; and we had employers that decided to do nothing because they had too much on their plate. There was no one-size-fits-all answer. What everyone had to do was communicate the end of contracting out to their employees.”
Some employers have deferred the decision, she adds, but that does not mean they will not change their arrangements in the long run.
There are other related issues. For example, schemes that have made changes have had to look again at the terms of their auto-enrolment to check it still qualifies.
Capita Insurance and Benefits Services head of marketing and research Robin Hames says: “The approach taken by schemes with ongoing accrual varied, typically by size. Larger schemes typically took action to reduce their costs either by closing to accrual or by offering reduced-cost or cost-neutral benefit changes.
“Sponsors of our smaller schemes typically absorbed their additional NI cost and expected members to do the same. And members did.
“So why did some sponsors absorb the higher costs? The practical answer is that active members accruing benefits represent a small part of the pension problem for most schemes – especially in the context of falling bond yields and volatile investment markets. Many small schemes’ trustees and sponsors retain direct or indirect links with the remaining accruing members. For them, softer issues and key employee retention can make the no-change option a cost worth paying.”
PwC pensions practice partner Peter Woods says: “It has affected only a small number of organisations. The biggest response was a few years back when this issue, combined with a number of others, provoked a lot of scheme closures. It was one of a number of triggers, although we have a few left open to accruals. One client is consulting with members to ask them to pay more.
“I think, where a company has employees with DB accrual, it is usually for a minority of employees, so when something difficult happens like this, where the cessation of contracting out has an immediate impact, the company usually says ‘We want you to pay more’.
“A view around the board table may be ‘These guys have still got a really good deal so if they don’t want to pay they can join our other scheme’. The people who are still in DB schemes are generally older employees – the average age of active membership is late 40s or early 50s at best. The cost of a year’s accrual goes up as they get older, so it is still probably a pretty good deal.”
GMP reconciliation
But the biggest administration headache is arguably the GMP reconciliation. Brown says: “That is the necessary evil of the whole situation. Trustees are spending a lot of time on this. Employers are not that interested but they should be. If your records don’t match HMRC’s, often there have been periods of overpayment.
“Employers are also more interested in where they have benefits linked to pension age, which has changed. How does that affect the liabilities to the scheme? How does that affect the scheme? What are the longer-term implications? The link to state pension benefits may increase your liabilities if you say ‘We will pay a bridging pension’.”
PASA GMP Working Party chair Geraldine Brassett says: “As an administrator, I think it is a very active piece of work. It segments into three. With the pensioner population, if you change their GMP it means you are not paying them the correct pension. There is a decision to be taken on what you do in terms of rectification. That is different depending on whether you are over- or underpaying them, the liability position of the scheme, the scheme rules. Some schemes are further on than others.
“The trustees can make some decisions but ultimately it sits with the employer; the employer funds the scheme. Those who have not taken their benefits are easier. You split it between GMP and non-GMP elements, but you are not paying them anything so you haven’t got that issue around rectification. Actives in schemes that were still contracted out will have to be dealt with at valuation. There are all sorts of variables that will influence the reconciliation and rectification.”
She advises schemes not to wait until they have 100 per cent of the reconciliation complete before contacting HMRC and suggests they can know the differences in benefits and the sorts of query if they have got 80 per cent through.
She says it has been a good dialogue to have between trustees and employers. “Yes, there are financial considerations – the impact on liabilities, under- and overpayments – but a good organisation looks at in the round.”
Communication is evidently important. One issue, for example, may be where you give a big slug of money to a member you have underpaid but you need to give them the information to sort that out with the tax office if it puts them into a higher band.
Clearly, in many cases the NI change has driven decisions to close to future accruals long before April.
Aon Hewitt head of pension benefit design Ian Graham says: “It’s fair to say that the cessation of contracting out caused the majority of companies that were still sponsoring contracted out DB pension accrual to consider a change. For around one-third of our clients, it was the trigger to close their final salary pension scheme to future benefit accrual. In almost all these cases, the replacement benefit offered was a defined contribution arrangement. However, in many cases, companies did choose to absorb the additional NI cost.”
Graham adds that Brexit may push more schemes to close to further accruals. “Those that chose to continue with their final salary pension arrangements could be regretting it because post-Brexit economic conditions have driven a sharp increase in the cost of pensions.”
Willis Towers Watson senior consultant John Cockerton says: “We have had about one-third of clients saying ‘No change’, then around a fifth saying ‘That’s it, we are closing to future accrual’. Around 20 per cent are still working out what they are doing. The rest are fiddling with scheme design, whether it is member contributions or pensionable pay cap or career average. These schemes have a complex history. Because of that, they have had enough complexity. So mostly it is either increase member contributions, replace the scheme or do nothing.
“My gut feeling is those organisations that are not changing things have, say, 50 employees in a DB scheme and see it as a drop in the ocean. However, post Brexit we have seen the underlying cost of buying pensions increase by 5 to 10 per cent. If I didn’t bother changing my scheme for a few per cent around contracting out, there is another 5 per cent cost since Brexit. That has been two or three times the magnitude of contracting out. Then you look again and say ‘Can we really continue providing this?’”
Managing liabilities
When it comes to managing liabilities across schemes, Hames says: “Sponsors of DB pension schemes should be aware of the wide range of liability- and risk-reduction options available: from pension increase exchange, where non-statutory pension increases can be simplified, reduced or removed to reshape benefits, reduce liabilities and make it easier and cheaper to eventually pass on the liabilities to an insurer; flexible retirement options, where members approaching the age at which they can take their pension are offered a range of potentially attractive options but which reduce the scheme liability going forward; and small benefit commutation exercises; to capping pensionable salaries and stopping or reducing future accrual for schemes with accruing members.
“Managing liabilities can also involve getting a better grip on what they look like. Exercises such as data capture and verification, benefit audits, postcode-based mortality investigation and getting to grips with historical, legal or equalisation issues can give trustees and sponsors the foundations on which to build their de-risking and liability reduction strategies.”
Defined ambition is not filling the gap
With so much debate about the impact of schemes closing to further accruals, has this led schemes to seek out a middle way? Absolutely not.
Aon Hewitt’s Ian Graham says, with DB pensions now within the remit of the finance department and not HR, there is little appetite for complex risk-sharing arrangements.
“With DC arrangements ever more prevalent, companies appear content to differentiate themselves on the basis of their employer contribution rate. After all, it is very unlikely that they will be competing for talent with a company that would be willing to offer any sort of defined pension benefit to new hires.
“The steady reduction in the number of employees actively building up final salary benefits means these schemes are increasingly seen as an issue for the finance function rather than HR. Most members of final salary pension schemes are no longer employed by the sponsoring employer and so we have seen a gradual shift in ownership of pensions issues towards finance.
“This shift in ownership has driven an increase in demand for solutions to help manage the financial impact of pension schemes. In particular, a lot of clients are offering pension scheme members much greater flexibility around how they take their benefits. For instance, many are choosing to include transfer quotations alongside retirement quotations, to increase awareness of the option to take benefits more flexibly outside the scheme. The increasing complexity of the options available to members has also led to an increased prevalence of companies providing their employees with access to independent advice to help with their decision. When you get the communication strategy right, this sort of exercise can lead to 30–40 per cent of members transferring out of a pension scheme at retirement, which represents a significant reduction in the risks that companies face in sponsoring a pension scheme.”
Capita’s Robin Hames says: “The greatest opportunity for new risk sharing in DB schemes has arisen not from the end of contracting out but from the introduction of pension freedoms in 2015. Now DB trustees and members can rewrite the contract between them with mutual consent. For a price – an appropriately attractive transfer value and the potential for members to select against them – risk can be transferred to the member”.
“While Cash Balance, CARE and similar risk-sharing scheme designs still appeal to a limited section of the market, they are no more attractive now than they were before 6 April 2016. For most, unless forced down these roads by third parties, DC was and is the answer. While this may not seem equitable on an individual basis, it has resulted in risk sharing in an overall sense across the past and present workforce: sponsors retain all the risk in relation to past and future DB benefits, and DC members bear it in relation to their future benefits.”
Willis Towers Watson’s John Cockerton says: “Do I see anyone trying to get into the defined ambition space? No.
“Do I think people should go there? With the corporate memory of DB risk and where they are still carrying a lot of risk, are they going to take any back on when they have got too much? No.
“Until we get a sound framework to work into, it is not going to fly.”