Changing DC Pension Structures

Defined contribution (DC) pension provision has gained a bad name in the UK, in part fuelled by the media’s portrayal of companies slashing costs in the move from defined benefit (DB) provision. But just because companies have shifted away from DB as a response to the financial risks and burdens it places on the sponsor, does this mean that the most common alternative and replacement, the DC pension scheme, is automatically the poor relation?

For many employees, the answer is probably ‘yes’. This is primarily a result of the gradually escalating cost of DB provision, rather than some sudden collective miserliness on the part of employers. Increased life expectancy and the additional guarantees and burdens imposed on DB schemes in recent years have pushed up the cost of DB provision.

Indeed, the cost to an employer of running a good-quality DC scheme today is not so very different from that of many DB schemes when they were originally set up.

The perception of DC as the poor relation has not been helped by the fact that many employers switched to DC for negative reasons rather than going into DC with a positive attitude and clearly defined objectives and success criteria. As a result, many DC schemes have received little or no attention from employers since being set up. Neither has there been very much commitment and understanding from sponsors concerning the need to communicate, educate and support DC scheme members.

However, many employers are now waking up to the reality that their DC schemes are not the panacea which they were originally hoped and assumed they would be. They are generally not delivering what employers and employees want or need, and have introduced a number of new issues and risks for sponsoring employers. As a result we are now beginning to see the emergence of ‘quality’ DC pension schemes. This improvement in quality is in terms of not only the contributions employers are making, but also the investment of time and resources that many are now putting into governance and member communications.

Many company pension DC schemes were set up five, ten or even 15 years ago for new employees at the same time as existing DB schemes were being closed to new entrants. Initially, these DC schemes had few, if any, members and next to no assets but today, for many companies, the majority of their workforce are now in the DC pension scheme and so management priorities are shifting.

INCREASE IN DC

For the past four years, Watson Wyatt has undertaken a survey of DC pension provision among FTSE 100 companies to monitor how these trends are developing. We found that average combined (employee and employer) contribution rates to all DC pension schemes of the UK’s largest companies have risen by a full percentage point in the past year to 14.7% of salary.

For those arrangements with flat rate or matching structures the maximum average rate is over 15%. This is made up of 5.1% from the employee and 10% from the employer. However, these contributions do not necessarily come to all scheme members by default.

Combined contribution rates assume the employee takes full advantage of the matching contributions on offer from their employer.

We discovered a strong trend towards new and reviewed DC schemes having increased contributions. Companies are keenest to reward those who most appreciate the value of their pension and who are willing to make additional contributions themselves.

The survey found that core contributions – what employees have to pay as a minimum to join the scheme plus the minimum on offer from the company – are on average 8.4%; this is 2.2% from employees and 6.2% from employers.

Those employees unwilling to pay an extra 3% or so to their pension are missing out on an additional 3% to 4% contribution from their employer. For some this may be the right decision but for many it may be lack of understanding or confidence that is leading them to miss out on these additional employer contributions. Our experience is that many employers are increasingly focusing on communication and education in order to address the low take up and appreciation of their DC pension schemes.

Similarly, take up levels remain a worry, with many DC plans generally poorer than those typically experienced by DB schemes. We saw very clearly that auto-enrolment solves the problem of low take up rates, with almost all schemes that auto-enrol having DC take up rates of more than 80%.

MANAGING THE RISKS

Companies are realising that while DC does not carry the obvious financial risks of DB, what might be termed the ‘HR risks’ of DC pensions are real and significant. These risks largely concern employee engagement and expectations and, in particular, a company's ability to manage employees who are unable or unwilling to retire because they do not have enough money to do so. With the investment risk sitting with the employee, external events, such as stockmarket collapse, could cause significant workforce management problems.

Managing a workforce under such circumstances could prove difficult. While experience is kept within the company, there may not be suitable jobs available for younger employees. An alternative option is to enhance the pensions of these employees to a level where they can afford to retire. But as well as setting dangerous precedents, the cash may not be available in any case. Either way, not managing this situation proactively could lead to expense volatility, which brings us back to the reason why many employers have replaced DB with DC schemes in the first place.

This is one of the key reasons why many companies are now looking to make DC better; and, at its heart, they are doing so by up rating the management and governance of their DC schemes.