The type of pension benefits being made available by employers is changing. We are seeing this in practice. In the early days of pension provision only the public sector and banks offered pensions. Larger employers followed suit. The pension promised was of a defined benefit (DB) or 'final salary' nature, linked to the employee's salary at date of retirement. Under such plans, the employer funded the retirement costs of the workforce in a standalone pension scheme, kept separate from the employer's assets. As benefit design evolved, members were increasingly required to contribute to their pension schemes.

In the past ten years or so, the cost of providing DB pension schemes has become disproportionately expensive for employers. Several reasons underpin this phenomenon: low interest rates, salary inflation, longevity, the pensions' regulatory environment and financial reporting rules.

Many employers have been gradually closing their DB pension schemes to new members and setting up defined contribution (DC) plans or providing access to personal retirement savings accounts (PRSAs), which are standalone money purchase contracts. Some employers have also closed their DB pension schemes and transferred their members to DC plans or PRSAs.

This is quite tricky to implement from a legal perspective as various points of pensions, trust and employment law arise. We have been involved in many cases where an employer has moved its pension benefits from DB to DC and have guided employers on how to accomplish these objectives. We have also provided advice to trustees on the issues affecting them and their members where the employer wishes to take such steps.

Under DC plans, the employer (and usually the employee) pays a fixed rate of salary into a pension scheme. The amount of pension available to each member will depend on the amounts paid in for that member during his or her working life and the investment return earned on those contributions during the period. The member bears the investment risk.

Statistically, it appears that a pattern has emerged of low contribution rates to DC plans. It is evident that low contributions are likely to result in a small pension. There has been a lot of media commentary about DC 'adequacy', but this is an issue that most members are choosing to ignore.

Inadequate DC provision is storing up problems for the future. The public debate on pensions adequacy also involves the political issue as to whether or not employers ought to be required to provide some level of pension benefits on a mandatory basis. Successive ministers have muttered about introducing this, but to date our voluntary system remains in place.

As DC plan members approach retirement, employers may well be put under pressure to make extra contributions to these plans as well as permitting their staff to stay in service for longer. Interestingly, once again, the larger employers are taking the initiative and are taking steps to make sure that this does not happen. The larger unions are also lobbying for change in this area.

We help employers implement creative solutions as an alternative to the 'all or nothing' shift from DB to DC plans. Career average or cash balance plans as design alternatives are being considered. The most popular alternative is to provide a capped DB benefit (arranged on a balance of cost basis, where the employee will pay a fixed percentage of salary and the employer will fund the rest), which is then augmented by a DC benefit (to which both employer and employee will contribute). Under the hybrid model, the member has the comfort of knowing that the employer will fund a reasonable minimum level of retirement income, which will be topped up by the DC element. In this way, the employer and employee are working together to share the investment risk.

We expect to see more hybrid pension plans being set up to address defined contribution adequacy and that, as before, the steps taken by the larger employers will trickle down to those employers in growth.

For further information please contact Fiona Thornton.


Summer 2007.