The 3 rd Younger Members Convention 29 -30

The 3 rd Younger Members Convention 29 -30 November 2004, The Chesford Grange Hotel, Kenilworth

Pension Plan Design Alan Dorn, Watson Wyatt 30 November 2004

Agenda § § § Some risk sharing designs Tailoring designs What’s happening in the market Legislation and future trends Pensions and flexible benefits Questions

Risk sharing designs

What are the risks in pension schemes? § § § Investment return up to retirement Annuity rates at retirement (DC) Salary growth Mortality Other demographics (eg leavers, early retirements) § Company covenant/insurer strength § Legislation

Who bears the risk? § Final salary: employer bears most of risk § Employers finding this too onerous § Money purchase: employee bears most of risk § Some employers feel this is inappropriate § What options between these extremes?

The risk sharing spectrum Final salary Career average revalued Final Cash salary, DC balance top-up Cost variability (Company) DC ‘nursery’, then final salary Money purchase Cost certainty

Revalued career average § § Based on salary throughout career Employer avoids salary growth risk only Members don’t lose out on early leaving Typical structure: § 1/60 th of total revalued salary for each year of service § revaluation with RPI or capped RPI § other benefits similar to final salary schemes

Cash balance § Employer credit (eg 10% to 20% of salary) to DC ‘pot’ § Pot revalues each year – could be eg: § guaranteed RPI § discretionary (eg targeting RPI) § guaranteed plus discretionary § Normally open market annuity at retirement § Employer avoids post-retirement risk/part of preretirement investment risk as well as salary risk § Less efficient – guaranteed returns/insurer’s margins

Hybrid – DB with DC top-up § Eg 1/80 th of final pay for each year, plus 5% employer contribution to DC pot § Eg 1/60 th of final pay on earnings up to a threshold, with DC on pay above threshold § Removes a proportion of DB risks from employer § Complex to administer/explain?

Hybrid – ‘nursery’ § § § Eg DC for under 40 s, option of DB after age 40 Eg DC for first 10 years service then DB Could allow DC fund to purchase added years Again removes proportion of DB risks Complex to administer/explain Could be expensive: DB for older members only and no DB withdrawal profits

Tailoring designs

Employee and employer characteristics § No universal correct design – depends on: § § workforce profile type of employer’s aims for pension provision how pensions fits into remuneration strategy § Eg: what kind of plan is ‘best value’ to different types of employees

Employee (stereo)types – ‘Climber’ § § Ambitious/restless Moves jobs frequently Strong pay growth throughout career A final salary ‘loser’ – lots of small deferred pensions which don’t go up with pay § DC may be best ‘value’ to employee

Employee (stereo)types – ‘Plodder’ § § Loyal, unambitious Stays in same job with little promotion Pay rises not much above inflation RCA may be best value to employee

Employee (stereo)types – ‘Company man/woman’ § § Loyal, talented Rises through ranks of company Strong pay rises Final salary ‘winner’ so FS probably best value to employee

Employee (stereo)types – ‘Slacker’ § § Not particularly loyal, talented or dedicated Gets bored/sacked and moves jobs regularly No progression – low pay rises RCA or DC may be best value to employee

What’s happening in the market?

The move away from final salary Source: Watson Wyatt Pension Plan design survey 2004

Why have companies abandoned final salary provision? § External factors increased burden on employer: § Pensions Act 1995 § Removal of ACT credit on dividends § Solvent employer wind-up (June 2003) § Stock market crash and fall in bond yields § Some may have budgeted unrealistically following past contribution holidays § Tougher trading conditions/cost controls § Change in workforce profile – higher turnover

Types of open plans Source: Watson Wyatt Pension Plan design survey 2004

Money purchase contribution rate structure Source: Watson Wyatt Pension Plan design survey 2004

Overall average money purchase contribution rates Source: Watson Wyatt Pension Plan design survey 2004

Pension at 65 from 10% total money purchase contributions – possible outcomes UQ M LQ 5% Source: Watson Wyatt Pension Plan design survey 2004

Legislation and future trends

Recent/forthcoming legislation – 1 § Solvent employer wind-up § Makes DB plans ‘guaranteed’ so more expensive – may discourage new DB? § Few plans can buy out – may slow down closures? § Pension Protection Fund (PPF) § Levy another disincentive for DB? § Scheme specific funding § Moves balance of power towards Trustees – another disincentive for employers?

Recent/forthcoming legislation – 2 § May be easier to change past service benefits § Could remove a barrier to design changes § Lifetime Allowance (LTA) § LTA is a DC-style limit – DB limit tests more complex § Simplification of GMPs § Not in Pensions Bill!

Future trends – two alternatives No more DB DB maintained § Reduce/close existing DB schemes § Valued by employees § Mainly DC for future § Some DB maintained (eg unionised companies/ Government schemes) § Low DC pensions may emerge – what next? § Differentiator between employers § Simplified? § Contracted-in? § Cheaper/less risky DB (eg Reality CRA/hybrid) or cash balance

Flexible benefits

Pensions and flexible benefits § Some employees may not want pension § could take more salary/holiday etc instead § how paternalistic is employer? § DC easy to integrate into flex programme § DB harder – eg accrual rate linked to member contribution rate – beware of selection § Hybrid plans – more complex to integrate § IT – online choice (including pensions) may be attractive to employees