Employers who have wound up or stopped final salary pensions for new employees are typically slashing their employees' future pension accrual by 33%, according to research undertaken by UPS
Employers that close their final salary pension schemes and replace them with a money purchase arrangement typically slash the value of their employees' future pension accrual by 33%, according to a controversial report published by the actuarial consultant Union Pension Services (UPS). Pension Scheme Profiles 2003 makes direct comparison possible between final salary and money purchase pension schemes on a case-by-case basis for the first time.
A comparison with UPS's 2000 guide confirms that where an employer has closed the final salary scheme over the past three years and replaced it with a money purchase arrangement, the value of the new scheme is significantly less in almost every case.
In the most dramatic example, the new Sainsbury scheme represents a 45% drop in value.
The guide, published every three years, summarises the pension benefits provided for new employees by over 250 leading employers. It enables advisers to compare different employers' schemes and to assess the value offered by individual schemes by comparing them with a benchmark that sets what UPS regards as an appropriate target for retirement provision. The target scheme is shown in Table 1. Tables 2 and 3 list the top and bottom 10 schemes compared with the target.
It is no doubt comforting for MPs debating the big pensions issues to note that their own final salary scheme, the Parliamentary Contributory Fund, is as secure as it gets and is among the top three in the UK in terms of generosity.
Bryn Davies, director and actuary of UPS, says: 'Since 2000, there has been a general decline in pension benefits partly in terms of quality ' for example money purchase schemes represent a much higher level of risk to the employee than final salary schemes ' but also in terms of quantity. The stark truth is that the contributions employers pay to money purchase schemes fall short of those required to provide the same benefits as the final salary schemes they replace.'
The guide includes 207 final salary schemes, five career average earnings schemes, and 60 money purchase schemes. The number of money purchase schemes in the last survey was just 23, highlighting the speed with which employers are closing their traditional arrangements. Only schemes that were open to new members at the time the survey took place are included in the guide and the assessments are based on scheme booklets provided to members. The survey quantifies the value of scheme membership to the employee by calculating the cost to the employer based on a range of benefits. This is why it is possible to make meaningful comparisons between specific final salary and money purchase schemes. The benefits assessed include the member's pension, death in service benefits, the spouse's pension, the rate of annual increases, and the treatment of early leavers and ill health early retirements. The assessment is expressed as a ratio compared with the target scheme, which represents 100%.
Money purchase schemes are assessed mainly on the level of the company contribution, as this is the biggest employer cost and one of the major factors that will determine the size of the employee's pension fund at retirement.
Davies explains that the ratio provides an overall picture of the schemes' generosity. 'Schemes provide a package of benefits and it is possible that high standards for certain features may be offset by a lower standard elsewhere,' he adds.
The ratios, therefore, represent a broad overview of scheme value and should be used in conjunction with the case-by-case guide to individual schemes, which provide a breakdown of the ratio for each feature.
Davies says: 'It is important to appreciate that what represents good value for a single person who lives to age 95 might be much less valuable for a member who is married with children and is forced to retire early on the grounds of ill-health, for example. What we have to look at is an average.'
Based on the overall ratios, Davies can demonstrate that where a scheme that scored 90% of the target benchmark has been replaced, the new scheme typically scores 65%, representing a fall in value of almost a third.
Some cuts are even larger. Had the Sainsbury final salary scheme remained open to new members, for example, it would have scored 96% against the target scheme, whereas the replacement money purchase scheme scores only 53%, representing a fall in value of about 45%.
The guide may prove to be a useful weapon in the trade unions' fight to retain final salary schemes. Until now, unions have criticised money purchase schemes largely on the grounds of lower employer contributions and higher investment risk for the member but generally they have failed to make direct comparisons because the structures of the two types of scheme are so different.
Davies believes such comparisons are possible and provide essential information for employees and the industry. 'The single purpose of both types of scheme is to provide benefits on retirement or death in service and there is no reason why these potential benefits should not be compared, using standard actuarial techniques,' he says.
The basis for the calculations is similar to that set out in the Technical Memorandum issued by the Faculty and Institute of Actuaries for statutory money purchase illustrations (SMPIs). The only significant difference is that the UPS calculation includes an assumption for general increases in earnings (RPI plus 2%), whereas the SMPI calculation only takes account of retail price inflation.
'Such an assumption is required to put the comparison between defined contribution and defined benefit schemes on an equal footing,' Davies explains. 'To do otherwise would make any comparison unreasonably favourable to DC.'
Where employees have a choice between a final salary and money purchase scheme it is vital that they compare their options carefully and they recognise that where a scheme requires a higher contribution it may well represent better value.
Kingfisher's schemes illustrate this point. The company's final salary arrangement compares very well with the target scheme at 93% and, unusually, it is still open to new members, who pay an annual contribution of 5% of salary. However, the company has also tried to do something for employees who are reluctant to save for retirement and unwilling to pay the 5% contribution.
In this case they can join the contracted out money purchase scheme (Comps), which is non-contributory for employees, has a small employer contribution of 1% and aims to provide a better pension than the state second pension (S2P).
It also provides life cover. While the scheme only scores 25% compared with the target, it is still a valuable benefit that is cost-free to employees who otherwise would make no private provision.
The guide shows that the value offered by money purchase schemes varies considerably and the top schemes in this category ' CGNU (105%) and Vetco Gray Hughes (101%), for example ' achieve a higher score than most of the traditional schemes. But Davies says that even a high scoring money purchase scheme exposes members to greater investment risk than a final salary arrangement, despite the recent uncertainty over the security of the latter.
'In the light of recent events it is clear that final salary schemes are not as secure as most people once thought and that when the going gets tough they are no safer than a promise from the sponsoring employer. However, even now this still means greater security than is available from a money purchase scheme,' he says.
Further information: UPS Pension Scheme Profiles 2003, price £295 (www.unionpension.co.uk).
DC and DB schemes can be compared based on the cost to the employer.
Replacement DC schemes are generally worth only two-thirds the value of DB schemes.
The MP's final salary scheme is among the top three most generous in the country.
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