The Middle Way

Introduction

1.   The advantages and disadvantages of four alternative designs for risk-sharing schemes are summarised here, to assist employers' choices.    All four designs guarantee a minimum pension (MP), which is particularly important for lower-paid members.   Only the fourth design - a conditionally-indexed scheme - would require changes in the law.   To facilitate administration, each scheme could be a ring-fenced section of an existing closed defined-benefits (DB) scheme if desired.   Risk benefits on death or ill-health retirement could continue in some designs.  

DB+DC

2.   This design provides about half the target pension through a traditional fully-guaranteed DB scheme (giving, say, 1/120ths of salary).   The remainder comes from a separate insured DC scheme with similar contributions.  

Advantages:  

• The employer's future cost increases if experience proves unfavourable would be only half those required by a DB scheme providing the whole pension;
• Simple in concept, and easy to communicate and establish.

Disadvantages:

• The likelihood of the employer experiencing future cost increases is not reduced;
• MPs are relatively low at only about half the expected pension.

Scheme funded beyond the promise

4.   This is a DB scheme which aims to provide targeted benefits (e.g. 60ths of salary) but does not guarantee them, though the normal contributions are calculated prudently to provide them.   The scheme just promises to pay lower guaranteed benefits (say 80ths of salary) and will only pay more if scheme finances permit.   The employer will not have to pay extra contributions unless the experience becomes so bad that even the lower level of benefits cannot be afforded.

Advantages:  

• It is unlikely that the employer will ever have to pay extra contributions.
• Members will have substantial MPs.

Disadvantages:

• Care must be taken to prevent members confusing promises and expectations.

With-profits pensions

5.   Contributions are applied annually to purchase deferred pensions which are calculated on an ultra-cautious basis dependent upon age.   The scheme is DB and guarantees to pay these pensions from a specified age, with cost-of-living increases thereafter.    Upon retirement members may be awarded terminal-bonus pensions out of surplus.  

Advantages:

• Contributions can be "flexed".
• It is unlikely that the employer will ever have to pay extra contributions.
• Members will have substantial MPs.

Disadvantages:

• No simple relationship between pension and salary.

Conditionally-indexed scheme

6.   A DB scheme is prudently funded to provide post-retirement increases but does not guarantee this.   If finances prove insufficient, future increases may be reduced or cancelled     

Advantages:

• It is unlikely that the employer will ever have to pay extra contributions.
• The member can rely on getting the full promised pension (though not necessarily the increases).

Disadvantages:

• If increases are reduced or cancelled, complex "catch-up" arrangements might be needed later, should experience become favourable again.

Conclusion

7.   Simple risk-sharing designs can provide attractive and sustainable alternatives to both DB, where all risks are assumed by the employer, and DC or personal accounts, where all risks fall on the member.

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