Money purchase schemes are slowly but surely replacing the traditional final salary schemes, but just how suitable will they prove to be?
The pensions landscape is changing and the familiar final salary scheme is being replaced by cheaper money purchase schemes.
This begs two key questions: how suitable are money purchase pensions for future pensioners, and how easy will the transition be?
Figures from the National Association of Pension Funds (NAPF) show a continuing trend over the period between 1996 to 2001 of a shift from final salary to money purchase schemes. In each of these years the number of pension schemes switching from final salary to money purchase structures has outnumbered, or in 2000 equalled, those making the switch from money purchase to final salary. In 2001, for example, the number of final salary to money purchase switches was 13, compared to just five switching from money purchase to final salary.
This trend towards money purchase schemes, NAPF figures show, is also the most significant change in scheme structures, being the most popular scheme change in each of the five years.
Closing the doors
Another growing trend the NAPF figures reveal is the number of employers closing their existing final salary schemes to new members. NAPF says that while falling gilt yields and rising longevity will be partly responsible, it is also likely the rising costs of administering such schemes, in the context of increasing legislation, are proving too high for many employers.'
Indeed the Association of Consulting Actuaries (ACA) says it was startling just how rapidly the move away from final salary schemes has become. An ACA survey conducted earlier this year found less than four out of 10 final salary schemes are now open to new members. These figures are backed up by a joint CBI/Mercer study in September that showed just under a quarter of firms closed their final salary scheme to new entrants in the past five years and 12% are considering doing so.
This would not, the ACA says, matter greatly if there were evidence that final salary schemes were being replaced by defined contribution arrangements attracting equivalent contribution levels. ACA members, who advise just under 3,000 salary schemes with 6.8 million members, report, however, that money purchase contributions are generally falling far short of those going into final salary schemes.
Government surveys also show the number of employees offered any sort of occupational pension, whether final salary or money purchase, has also declined quite markedly over recent years, says the ACA.
ACA chairman, Gordon Pollock, says while the cost of defined benefit schemes has gone beyond what most employers were anticipating and consequently some can not truly afford to maintain these schemes, there are others taking the opportunity to reduce contributions to their employees' pensions.
'A typical final salary scheme costs about 15% of an employers total payroll expenses, but a typical money purchase scheme is only around 7%,' he says.
One aspect of the money purchase scheme he highlighted is the fact that the final amount a pensioner will receive is unpredictable compared to a final salary scheme.
'Two people can work in the same company with the same salary and end up with radically different pensions depending on when they retire.' Current stock market conditions only serves to underline this fact adds Pollock.
'Looking forward, if money purchase schemes are going to be the basis on which most people save for their retirement, then they ' or their advisers ' need to seriously reconsider what they invest in,' he says.
Equities are too volatile for long-term savings that require security, he says, which suggest bonds ' rather than equities ' should be the main investment vehicle.
Lifestyling ' where an investor's funds are gradually shifted from equities to bonds as they approach retirement ' is one way of dealing with this, he acknowledges, but he did not believe this will be sufficient.
On the whole, says Pollock, money purchase schemes are not a good design for medium to low earners, a group which makes up a significant proportion of the working population. '
They need predictability and security. The only way money purchase schemes will work as the future basis for pension provision is if more money is contributed by employers, says Pollock.
'The ACA would prefer the Government to do this by tax incentives, rather than by compulsion,' he adds. 'The tax system should be advantageous for pension savings over other forms of saving. At present there is not much in it between a pension and an Isa and Isas are much more flexible.'
Alisdair Buchanan, head of communications at Scottish Life, says final salary pensions are still viable, but, 'as with any product it is going through a lifecycle and it is not attractive at the moment'.
Any argument around the merits of final salary and money purchase schemes essentially boils down to two factors. He says: 'How much money is being put into the pension and who takes the risk.'
While he accepts the average contribution towards money purchase pension schemes are generally lower than towards final salary schemes, Buchanan says this is explained by the fact that money purchase schemes are more prevalent among small employers.
This is because defined contribution schemes are more suited for smaller employers and these employers, simply as they tend to not be as rich as their larger counterparts, do not on the whole contribute as much towards their employees' pension.
The suitability of the money purchase schemes for smaller employers does not solely lie with the money needed to administer them, or the transfer of risk to the employee, says Buchanan. Another factor can be the volatility of the cost of running a defined benefit scheme.
'In a large final salary scheme the employer will roughly know what contributions will be, whereas for a small employer the effect of one or two people leaving or joining the scheme can effect contributions greatly.'
This volatility of cost can be too great for smaller employers, Buchanan says, which pushes them towards money purchase schemes. Stewart Ritchie, director of pensions development at Scottish Equitable, says final salary schemes are becoming such a burden for employers with risks that are too great that it could put them off final salary schemes for one or two generations.
The move from final salary to money purchase schemes seems to be an inevitable trend, he says, which has made the money purchase scheme more important.
And with the advent of the Statutory Money Purchase Illustration, which will present pension savings in a meaningful way to consumers, people will begin to understand that saving for retirement is not a cheap option, adds Ritchie.
'People want a steady income that will broadly support the level of lifestyle they are used to ' most people, though, do not know how much they will need for this.'
Which in turn highlights the need for a proper investment strategy, he says.
Dave Lowe, marketing manager at GE Life, says the transition to money purchase schemes will not necessarily be smooth.
'Certainly, given the reaction of the unions so far money purchase schemes will not be well received,' he says.
Lowe adds that it is not to say that defined contribution schemes do not have advantages. From the employer's point of view there is a transfer of risk and they are cheaper than final salary schemes. From the employee's point of view there is full exposure to the upside of any investment successes, greater portability, meaning the pension can be easily moved from job to job, there is greater product transparency and employees have greater flexibility and control over the timing and amount of their contributions.
'The main problem with money purchase pensions is whether the employer will make contributions equal to final salary levels. If we were in a boom market no-one would be complaining,' says Lowe.
Buchanan points out the recent union pension protests have been over the shifting of employees in final salary schemes to money purchase schemes. However, he does not see a situation where an employer closes its final salary scheme to new entrants and opens a money purchase scheme to be a problem.
'The one scenario where there will probably be successful resistance from workers is shifting them from final salary to money purchase schemes,' he says. 'The argument many companies will use will be 'it is your pension or your job,' so I do not think closing final salary schemes to new employees will be so much of a problem.'
However, counters Pollock, the unions see their role as representing future as well as present employees and may not be so content to accept this argument.
Money purchase schemes are more suited for smaller employers and these employers, simply as they tend to not be as rich as their larger counterparts, do not on the whole contribute as much towards their employees' pension.
An ACA survey conducted earlier this year found less than four out of 10 final salary schemes are now open to new members.
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