By Leo Bland Final salary schemes are suffering under increasing pressures, from stakeholder to fund...
By Leo Bland
Final salary schemes are suffering under increasing pressures, from stakeholder to funding shortages, which has caused speculation on the future of defined benefits.
Howard Flight, Shadow Economic Secretary to the Treasury, predicts over the next five to 10 years defined benefits (DB) share of the occupational pensions market in terms of individuals in schemes will shrink from 80% to 50%. Flight believes the main problem is the advent of stakeholder, which he sees as likely to lead employers to shift to cheaper money purchase schemes from final salary arrangements.
He said the main driver behind this will be for companies to save money and also to reduce the impact final salary schemes have on the volatility of corporate profits.
Employers take the investment risk with DB schemes and if investment returns are poor, it is the company which must pay out to ensure that pension liabilities are met, with a resulting impact on profits. In money purchase, it is the pension scheme member who shoulders investment risk. Flight said: "There are a lot of companies that were looking to convert before stakeholder but were delayed because the rules were not clear. But my view is there is going to be a pretty massive rate of conversion from final salary schemes to money purchase once stakeholder legislation is enacted."
Flight added employers could see savings of around 5% of payroll by moving to money purchase from DB.
He said the typical employer contributions are 15% to 20% of salary for defined benefits schemes, which goes down to between 10% and 12% for money purchase schemes. Steven Cameron, manager, pensions development at Scottish Equitable also believes the advent of stakeholder pensions may contribute to the decline of DB schemes.
Although Cameron agreed defined benefit schemes are facing increased pressures he believes the death of DB has been exaggerated.
He said: "The Government is hoping the advent of stakeholder pensions will increase the number of people who join a pension scheme. Of those who are encouraged to join, the majority will move into money purchase arrangements. Employers are unlikely to set up a new DB scheme so the number of members in money purchase schemes will rise. I would say the defined benefit market is in slow decline and I would stress the slow."
It is increases in the costs of running DB schemes that are cited as a main reason for employers becoming less keen on them. Reforms brought in by the 1995 Pensions Act, such as the Minimum Funding Requirement seen, have been seen as increasing the burden on companies.
Paul Smith, head of pensions development at AXA Sun Life, agreed the defined benefit market is in slow decline and added this is occurring on the back of existing final salary schemes becoming closed to new members rather than schemes shutting down.
He said: "Many defined benefit schemes are becoming closed schemes and over a period of many years will cease to exist at all. The introduction of stakeholder is likely to accelerate that process. There are some companies which have a final salary scheme which is not open to all employees and rather than extending membership to all employees, employers will set up a stakeholder scheme or other pension arrangement.
"But I see no evidence to suggest there is a winding up of defined benefit schemes to any great extent."
Cameron added: "We are still in the market for defined benefits schemes and following our acquisition of Guardian Employee Benefits we have a significant book of final salary business which we are looking to expand."
Alasdair Buchanan, head of communications at Scottish Life, is also upbeat about the prospects for DB schemes despite the pressures they are under. He believes defined benefit schemes, particularly from the larger firms, which are currently coping well with the increased costs imposed on them, are likely to continue to offer final salary.
He added: "In the 1970s and 1980s many DB pensions schemes were running huge surpluses as they got the benefit of higher than expected investment growth. The same may happen again in the future. In the long term there is no reason why defined benefits cannot continue to be a significant part of the pensions sector. I think the increase in costs for DB schemes may have stabilised - there is less scope for increases in costs for these schemes in the future."
The introduction of MFR in the 1995 Pensions Act was a trigger for companies to start to move away from final salary to money purchase schemes because of the increased costs involved.
Cameron said: "Now, three to four years on we are beginning to see from the first MFR valuations that some defined benefit schemes are not as well funded as they thought they were. But the MFR is not the culprit as such. It costs the employer more to fund the same level of benefit than it once did. Buying a pound's worth of pension costs more than it did 10 years ago because annuity rates have fallen."
Smith added the increased prevalence of defined contribution schemes will mean pension scheme members will have to gain more understanding of investment risk, which is borne by them and not the employer, and also annuity purchase. He added the increase in importance of money purchase schemes, which cover around 20% of those in occupational pensions, will lead to increasing demand for annuities.
The shortage at the long end of the gilt market has already driven down annuity rates and Smith said product innovation will be needed for people to get a better stream of income from their pension fund.
Scottish Life is also seeing increased interest in insured defined benefit schemes in the market, suggesting there is still a good deal of business to be done in this area.
Buchanan added: "We have been noticing a bit of an uptake recently in defined benefits schemes as there are a f
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