DB or DC?  There is another way...

With personal accounts due to start in 2012, now is a good time to beat the drum for a neglected alternative to DC, namely cash balance schemes.  Unlike either DB or DC, these can share risks between employer and member.  The employer would bear the investment risk until retirement whilst post retirement the member would bear longevity risk and usually investment risk. 

How would a cash balance scheme actually work in practice? 

Here's how one could work:

• A cash balance e.g. 15% of the actual pensionable salary received each year would accrue;
• The cash balance would receive a guaranteed investment return each year, e.g. 2% above price inflation;
• Members would contribute either a fixed rate e.g. 4% of pensionable salary with the employer meeting the rest of the cost or a share, say 40%, of the overall cost (which would vary from time to time);
• On normal retirement at say 65 the accumulated cash balance would be used to provide an annuity or annuity plus a tax-free lump sum;
• Members would choose the level of  in-payment increases and spouse's pension;
• Annuities could be secured with an external insurer, within the scheme or a mixture of both approaches;
• Different slices of the accumulated cash balance could be decumulated at different times to allow early, late or flexible retirement;

How could a cash balance scheme suit employers?

Although the ultimate cost will not be known in advance, cash balance schemes can target a set level of affordability by varying the level of benefit targeted either at the start of the scheme or during its lifetime.  Financial instruments could be used to limit the effects of poor investment return (although this might limit the extent of investment out-performance).  The employer could take on some longevity risk - larger employers might allow annuities to be secured within the scheme as opposed to being bought out with an insurer.  

A cash balance scheme could, unlike a DC scheme, encourage staff retention through a higher guarantee of investment growth for active members than deferred members.  The scheme design can be varied to suit all employers regardless of industry or size. 

Would a cash balance scheme be better than personal accounts for members?

In a cash balance scheme members could make the same level of contribution as personal accounts but have no exposure to poor investment performance before retirement.  The conversion terms on retirement would be at least as good as the annuity market that would be available under personal accounts.  A deferred cash balance fund could be easily transferred to a new scheme, although the member might lose any guarantee on future investment growth.

Other points

The administration would be not much more complicated than a normal DC scheme.  At present the governance requirements are the same as for a DB scheme, so in this respect it would be more onerous than a DC scheme to run. 

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