Risk Sharing
Comments from ACCA
August 2008
ACCA is pleased to comment on the DWP's consultation paper on the above. ACCA is a professional body representing over 120,000 qualified accountants who work in business, public practice and the public sector both in the UK and overseas. This response incorporates the thoughts of members of ACCA's pensions committee, which comprises senior individuals with long experience of pensions as employers, trustees, accountants/auditors and investment advisers.
Our response to the ideas discussed in the consultation paper is, in summary, that they are worthy of discussion and could play a part in influencing a relatively small number of mainly larger schemes to stay in the DB sector. We would agree that some employers would prefer to retain DB schemes, as opposed to moving to the DC sector wholly or in part, if they could acquire more certainty and control over the costs of funding their pension liabilities. The provision of an option to adopt one or other of the proposed models could therefore be attractive to some, in our view, although it should be acknowledged that adopting any of the models discussed would involve significant initial and on-going costs of their own, and add further complexity to the pensions environment. From the public policy perspective, the adoption of the models discussed would lead to a significant reduction in income for pensioners and their dependants which, given improvements in longevity and current economic conditions, could generate a further decline in public confidence in pension saving. We consider that, should any of the models discussed be incorporated into law, there should be provision for full and meaningful consultation with scheme members before any change occurred.
We would like to make a number of general points in response to the contents of the paper and then address selected consultation questions.
The principle of indexation
In our view, the key issue in this debate is whether members of occupational schemes should have an expectation that the value of their benefits will be upgraded to take account of the effects of inflation or earnings. The Government has stated in the past that it favours the retention of some form of mandatory indexation in order to give ‘a good degree of protection against inflation'. This policy has been reflected in its decision to restore the link between the state pension and average earnings. The problem is that such inflation-proofing is very expensive and becomes more so with every recorded improvement in member longevity.
The reforms brought in in recent years regarding the revaluation of deferred pensions and LPI for pensions in payment were considered, at the time they were introduced and ever since, to be substantial achievements. The former reform addressed the long-standing grievance held by those who changed jobs during their careers that, in the absence of inflation-proofing, the value of their pensions tended to decline substantially by the time they retired and sought to draw them. This came to be seen as a deterrent to changing jobs. The reform, when it came, was seen as a boost to the more flexible jobs market that we now have. The reform on LPI, in turn, was seen as a valuable mechanism to help individual pensioners maintain their quality of life over the course of their (increasingly long) periods of retirement.
The recent reduction in the mandatory level of LPI, from a maximum of 5% to 2.5%, and the future reduction of the revaluation cap to the same level, will have a significant and immediate impact on the value of both deferred benefits and pensions in payment, especially since inflation is already at a level that ensures that the real value of both will decline. The knowledge that inflation will, from now on, erode the value of occupational pensions may yet affect further the level of confidence in pensions as a means of accumulating retirement income.
At the same time, the cost to employers of providing these benefits is now very much greater than it was when they were introduced and that cost continues to rise. It must also be taken into account that the UK seems today to be very much in the minority, internationally, in having any provision for inflation-proofing at all.
Fairness between members
The Government's package of recent pension reforms has been built around a number of key tests, one of which is ‘fairness'. We think it is reasonable to ask whether a reform which would have a disproportionately adverse effect on one group of members – viz retired members, who are most exposed to the effects of inflation – would be consistent with this test. We also suspect that the treatment of retired members, especially under the second of the two proposed conditional indexation models (which only targets LPI rises), would cause problems for scheme trustees, who have a responsibility to treat all members equally and fairly.
Given the material impact that the adoption of the proposed models could have on individual members, we believe that they should all be consulted on any change and there should be a meaningful consultation exercise, with specific procedures set out in law as happens in the case of the selection of member nominated trustees.
Impact on existing schemes
The proposals would not have any substantial effect on the funding position of existing schemes, since the rules on conditional indexation would only apply to new schemes set up to take advantage of them. The process of setting up new schemes would in itself entail substantial costs. Hence the ‘benefit' to schemes, in terms of restricting their future liabilities, would only become apparent over the course of many years.
At the same time the proposals would inject further complexity into a pensions environment which is already very complicated, and this would make it even more difficult for ordinary members to understand. From the perspective of employers, the new complexity would add to the danger, which others have already identified, that many would be tempted to downgrade their schemes to the minimum required by personal accounts.
Disparity between the private and public sectors
We accept that the ideas for reform discussed in the consultation paper are put forward with the praiseworthy objective of encouraging employers to retain DB schemes. Nevertheless, the sacrifices that the reforms would necessarily require on the part of scheme members, and especially retired members, inevitably shed fresh light on the increasing disparity as between the quality of pension provision in the private and public sectors. If the conditional indexation approach were widely adopted by DB schemes, then even in the ‘best' private sector schemes, members would end up adopting a substantial additional element of risk in relation to the value of their benefits. In the absence of any corresponding reform, this would mean that the value of preserved benefits for those in the private sector would see a material decline over time – and this at a time of rising inflation – while public sector benefits would maintain their value.
We feel it is worth noting in this context that the primary case study cited in the paper concerns the Netherlands. It is our understanding that, in that country, the rules regarding saving and benefits are essentially the same in the private and public sectors. Accordingly, when the switch away from final salary-based schemes to conditional indexation schemes took place in recent years, all workers there would have been affected equally. This would not happen in the UK.
The impact of regulation of pension schemes
In deciding what action to take on risk sharing, the Government must not consider this issue in isolation: the cost of providing for longevity risk is not the only reason why employers have been moving towards DC schemes in recent years. A fuller discussion of the reasons why the number of DB schemes is falling would have needed to address a number of very significant contributory factors, including the abolition of ACT relief in 1997, the downturn in the equities market, changes in accounting standards and, by no means least, what appears to be the ever-increasing scope and cost of regulation.
With regard to the latter point, we are aware that the regulatory burden in other countries which have a similar tradition of funded pension schemes, viz the Republic of Ireland and the Netherlands, seems to have been constrained more effectively than has been the case in the UK. In fact, in the case of the Netherlands, we understand that one of the virtues of that country's industry-wide system is that the scheme provider carries out so much of the administration that in the UK is undertaken by individual employers. One possible avenue of investigation, short of adopting drastic new options, would be to explore whether it was feasible to introduce a system in the UK whereby schemes could pool their administrative functions in the way that apparently works successfully in the Netherlands.
Our comments on specific questions posed in the consultation paper are as follows:
Q1 Given that we have protected scheme members and are bringing in measures to combat undersaving, should we undertake a far-reaching deregulation of the way risks are shared in pension schemes?
It is fair that the issue of risk sharing is discussed. But, as the consultation paper itself makes very clear, the great majority of schemes and their members are already discussing this very issue, under current legislation, and have been doing so for a number of years, leading to a substantial increase in risk-sharing. In any case, we do not see what is discussed in the consultation paper as amounting to de-regulation. Rather, it is about introducing new arrangements which would require a raft of new regulation of their own. If the Government was minded to conduct a more far-reaching review of the regulation of pensions, we suggest that this is an opportunity to look at the issue of the increasing disparity between public and private sector pension arrangements.
Q6 Do you believe greater flexibility in the way employers and employees can share pension risks would increase (or slow any decline in) the availability of high-quality workplace pension provision.
We suspect that a relatively small number of larger schemes would see the adoption of one or other of the models discussed in the consultation paper as presenting an opportunity to resolve the funding problems that they currently have. But we would not suggest that risk-sharing on the lines discussed in the paper represents the single solution to funding problems.
Q7 Would this greater flexibility encourage employers who are considering a move out of DB provision to continue to bear some risk rather than moving fully to DC?
Despite the on-going trend towards DC schemes, we consider that, at least in certain business sectors, there remains a feeling that DB schemes are superior to DC schemes and reflect better on the sponsoring employer, thus enhancing its recruitment and retention capability. In this light, it has become widely understood, by employers and employees alike, that employer funding rates in DC schemes are generally lower than they are in DB schemes and that even where employers start off paying higher contributions they very often decline. We would also argue that the predominant charging mechanism adopted by the industry for DC schemes, namely the annual percentage charge, has an impact on the relatively poor performance of DC schemes as compared to DB schemes, causing over the long term a significant drag on performance, with little or no value added. The recognition of such factors is, in our view, responsible for the retention of a residual respect for DB schemes among employers which may, if other issues are addressed satisfactorily, lead to a renewal of interest in sponsoring them.
Q8 Would employers currently offering DC schemes consider a move to a risk sharing arrangement?
We are aware of individual companies that are either considering moving back to DB or have already done so, but we would not suggest that the incidence of this is great.
To conclude, we think the Government was right to consult further on this issue since in our view the models put forward are not, in themselves, likely to amount to a decisive development in the trend away from DB schemes. They may prove helpful in a minority of cases but, where they were used, they would lead to a significant detriment for scheme members, especially those already in retirement.