Partnership: Keep your pension options open - Nigel Barlow, United Kingdom
The problems affecting defined benefit (DB) pensions, or those with a defined benefit aspect, are well documented. In 1980, the actuarial assumption was that life expectancy would increase by 0.25% a year. In fact, since then, male life expectancy has increased by between 2.5 and three years per decade. This means that employees taking retirement this year can expect to live 50% longer than was previously thought.
Increased longevity, combined with legislative changes and financial volatility, has made maintaining pension funding a major preoccupation for many organisations.
An estimate of the number of pension schemes in deficit peaked in March 2009 at around 5,600 (85%), according to the Pension Protection Fund (PPF). Consequently, increasing numbers are looking to close off their schemes to new members.
As of March 2010, there were 12 million members of DB schemes or schemes with a DB component. Only 18% of these schemes were open to new members and new accruals, with 58% closed to new members and 21% closed to future accruals. Winding down a DB scheme, however, is far from simple.
"While the fund is no longer a going concern, even if people aren't accruing future benefits you are still exposed to liabilities that are increasing almost overnight," explains Nigel Barlow, director of technical product development and marketing communications at pensions specialist Partnership. "The ultimate solution would be to buy out the pensions and secure them with another organisation that guarantees to pay the benefits. Ideally, you'd do that for less money than you have in the fund, but in many cases it will end up being more because that's the nature of the cost guarantee. A process of de-risking needs to be carried out first."
De-risking is vital to serve members' interests while protecting the sponsoring company and its shareholders. Though many larger companies might be able to absorb the shock of a buyout, it is often far too risky for their smaller counterparts charged with meeting the full cost. Alternatively, a company could launch a buy-in by purchasing a bulk standard annuity policy as an asset of the scheme. Through this, the sponsor retains responsibility for paying benefits but now has an asset to provide a matching income stream. A third option is for an annuity policy to be purchased when a deferred member reaches retirement.
All of these options, while advantageous in their own way, have pitfalls. Solvency II, an EU bill that will likely require insurance companies to hold higher reserves, comes into force in October, and it will most likely cause the cost of such de-risking strategies to increase. In addition, anything in the defined contribution space requires a higher degree of knowledge and foresight on the part of the pensioner.
"Under a defined benefit scheme, your pension moved along whether you knew it or not," explains Barlow. "Anything you did, as long as you were in the scheme, had no effect on the pension. In a defined contribution scheme almost everything you do affects the pension you end up with. It is quite possible to waste contributions if people do not know how much they should be paying, what kind of pension they will need when they retire, or how much that will cost. People don't think about these questions and, to be honest, who would?"
Such a situation is unsatisfactory for both parties. Contrary to what some believe, Barlow thinks that most employers genuinely want to help their employees after they've left the company. At the same time, contributing to a fund, leaving it to the mercy of the markets and then receiving disappointing returns is wasteful for the employer as well as the pensioner. In recent years, a new option has emerged that could prove beneficial - enhanced annuities.
In 2010, the value of enhanced annuity sales in the UK rose to over £2.4 billion, a 38% increase on the previous year, according to research by Towers Watson. This vehicle can reduce the cost of a buyout or buy-in by taking into account serious medical conditions or negative lifestyle factors such as smoking and obesity.
For some companies, such as those in manufacturing, construction or any other industry with a high degree of manual labour, this member-specific approach can offer considerable benefits.
"Buy-ins and buyouts are based on an average rate for everyone in the scheme," Barlow explains. "We underwrite individually. You fill in a short medical questionnaire and can receive an enhanced rate based on those answers. Compared with their funding assumptions, an enhanced annuity would reduce the cost of a buy-in or buyout and take those people out of the scheme."
This type of policy guarantees existing pension benefits but can be bought at a potentially significantly lower cost because a more accurate forecast is made of longevity risk across a scheme's membership. Traditionally, assessing risk would require filling in a 14-page common quote form containing detailed medical questions, a process that many find intrusive. In response, Partnership put together a more concise alternative, upon which a quote is formulated within 48 hours of completion.
"We have a shortened questionnaire," Barlow explains. "It is one page with ten questions and you just tick 'yes' or 'no'. For some with high liability or those who've answered 'yes' for every condition, individual liability could make a huge difference - upwards of 40%.
"Depending on who you believe, between 40% and 60% could qualify for an enhanced annuity. In the case of some employers, almost everyone in the company could be entitled to an enhancement."
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Such enhanced transfer initiatives, where working pension holders are offered incentives to transfer out of a defined benefit scheme, have come under heavy scrutiny in the past. Claims were made that, due to a lack of information, employees were moving out of their schemes into alternatives that were much less beneficial in the long run. In Barlow's view, clear communication is the key to a fair, risk-free winding down.
"You commit yourself to a communication programme," he explains. "Some companies do it very well, some don't and some don't even try. That is one of the key issues if you have a defined contribution scheme. How do you get people to engage with the scheme and understand what their choices are? People tend to discount how long they are going to live after retirement. Many think ten to 15 years.
"If you tell them 22 years, they probably wouldn't believe you anyway. The principles are quite straight forward. You just need someone with the right experience to make sure you aren't leaping out the frying pan into the fire."
Enhanced annuities are much more representative of the actual longevity risk of a pension scheme. Hence it is little surprise that their popularity is on the rise.