Julian Webb discusses how the corporate adviser can add value when managing the change from defined benefit to defined contribution
With the financial system under unimaginable stress and recession stalking businesses up and down the country, firms are inevitably looking at their cost base. After first-class travel has been axed, entertainment downgraded from restaurants to pubs and the stationery budget frozen, more difficult long-term decisions must be taken. There are ways that corporate advisers can support their clients through this uncomfortable process.
Warren Buffett's (Forbe's wealthiest man, first half of 2008) view is that "a really good manager does not wake up in the morning and say 'This is the day I'm going to cut costs,' any more than he wakes up and decides to practice breathing." His point is that cost management is a deep-rooted commitment; a discipline that should filter throughout the organisation.
Administering a cost base
Managing a cost base over the long-term is, of course, about more than just cutting or eliminating simple expenses. Measures that contain long-term liability and expense are equally desirable. This point has been one of the driving forces behind the widely-reported shift from defined benefit (DB) to defined contribution (DC) pensions in the last decade. As employers have sought to free themselves from the increasing burden of fixed liabilities, DC pensions have offered an acceptable alternative to traditional pensions; the money purchase pension is a flexible product that reflects the changing needs of today's employers and their staff.
Many employers undertook this transition by creating a DC scheme for new employees while retaining existing members' entitlements within a closed DB scheme. Of course, because the received wisdom is that DB is 'better' than DC, the story that surrounds this activity suggests a two-tier pension arrangement has emerged. One where long-serving employees luxuriate in the comfort of their guaranteed benefits, looking down on the poor DC members as their retirement pot floats up and down on the tide of investment markets.
However, that received wisdom is wrong. A well-conceived and robustly funded DC plan is a match for any DB pension. This is why when many people's investment decisions are more to do with defensive wealth preservation than accumulation, some employers are considering switching some of their remaining DB members into a DC plan.
Under an operation recognised by the Pensions Regulator, it is possible for trustees to transfer (with the consent of the individual) deferred DB members out of the existing scheme into a new or existing DC arrangement. Deferred members - those that have left the company, but remain members of the pension scheme - are often the first consideration for trustees.
The member is offered a valuable incentive to take this option.
Given the choice, many people's immediate reaction to surrendering their cast-iron DB benefits for the uncertain entitlements offered by DC schemes would be a resounding 'no'. However, managed and presented in the right way, it is possible to illustrate the flexibility and potential that a DC scheme offers. Crucially, the member's outcome need not be compromised. Alongside this, the immediate benefits to the employer of the transfer should be obvious. Each member that accepts the offer to transfer ceases to remain a future liability.
Choosing the right provider
Among the big decisions for an employer is their choice of provider so this is where the adviser can add the most value. The right provider will make the difference to all involved in the detail of their product and service proposition.
Trustees will be keen to safeguard member's prospects so a provider with a long-term track record and future commitment to the market should be sought. That provider should offer a broad and relevant selection of investment funds with the aim to offer members a core of quality diversified investment products and a good selection of appropriate self-select investments that balance the need to diversify a portfolio with return-seeking specialist funds.
This exercise might well be done in a cost-conscious environment, but cost alone should not be the sole criterion in provider selection. Clients should recognise that they get what they pay for. A quality provider might be more able to evolve as time passes and offer new services and products. Their investment in fund performance and quality of service should be self-evident. Since the member's dealings will, in future, be directly with the provider, how they and the member communicate is of great importance. A heavily discounted provider may not be able to compete in this arena and over the long-term therefore the member's prospects may be compromised.
Aside from the selection of the provider, the employer will be required to calculate a member's critical yield. This is the rate of asset appreciation the member requires to match their DB benefits in retirement; in cricket it would be the run rate. Essentially, if this is an unrealistically high figure, there is no incentive for the member to switch. Each member's critical yield will differ depending on their age, salary and other benefits.
The viability of each transfer is dependent on the realistic chances of achieving the critical yield. Of course, those chances will be dictated to a greater extent by the investment decisions the member takes. Independent advice plays a critical role here and the Pensions Regulator makes a specific point of recommending that advice is offered to members who switch: "Given the complexity (of the decision), we strongly recommend the member taking independent financial advice." In our view, this should be at the employer's expense.
With the right investment decisions and an appropriate incentive offer, transferring from a steady final salary scheme can be a beneficial decision for the member and employer. For the adviser it makes good business sense. Operating in an environment of considerable uncertainty where some businesses will need to make radical decisions to stay afloat, the strongest advisers will need to be sympathetic to their client's situation and able to make practical suggestions to support their business. This is one of those.
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