Issued: November 2008
If the costs of running your pension scheme are spiralling, the governance requirements are getting out of hand and the funding and investment risks are causing sleepless nights, then closing the Scheme might be an attractive option. This article looks at some of the options you face and some of the issues taking such action raises.
Closing a pension scheme is a major decision with potentially far-reaching implications for the sponsoring organisation, and its current and future employees. A fundamental review of the Scheme is essential to ensure that the key issues are identified, options for dealing with them are explored and solutions appropriate for the organisation are implemented.
Reviewing your scheme
A review begins with some fairly simple questions, but it’s surprising how little attention is given to them. What are your organisation’s pensions objectives and what benefits does the pension scheme bring in meeting these? Is it a valuable recruitment/ retention tool? What is it costing, and how much, realistically, can you afford to spend on pensions? What risks does it present to the business, and can these be managed satisfactorily at an acceptable cost? How does it appear to donors? What options are available for employees’ future pension provision? For some of these questions the charity’s officers, its governing body and the Trustees of the pension scheme may have different answers.
Who will conduct the review? The issues can be very complex and regulations seem to be changing all the time. The cost of engaging a pensions consultant to carry out the work should be money well spent, but you shouldn’t do this until you know what your objectives are. Indeed, you may find that you answer the questions and come up with the solution yourself.
If you decide to close the Scheme, you will need to call upon the services of your professional advisers and fees can quickly mount up. The Scheme Actuary may have to provide some costings, and together with a pensions lawyer will certify that any proposed scheme changes comply with legislation. An employment lawyer’s opinion on proposed changes to employees’ contracts and terms and conditions may also be required.
A detailed review can take some months to complete, and the findings are the basis for discussion between officers, the charity’s governing body and pension scheme trustees. Once an acceptable way forward is identified, consultation with employees is usually required before decisions can be finalised and changes implemented.
Let’s assume you’re closing your final salary scheme, what are your likely outcomes?
Outcome 1 – keep defined benefit provision
If the organisation wishes to continue to provide a pension linked to earnings for current and future employees, it may be possible to keep the current scheme open – maybe in a different format - if costs and risks can be controlled satisfactorily.
The review may identify cost savings from reducing the Scheme’s benefits for employees’ future pensionable service – either by reducing the accrual rate (say from 1/60th to 1/80th) or switching from the ‘final salary’ design to a ‘career average’ design where benefits are based on members’ career earnings rather than on earnings close to retirement. This design can reduce the volatility in costs that has led many employers to move away from final salary schemes.
Until legislation allows ‘risk sharing’ pension arrangements to be set up, either the employer takes all the investment and funding risk (with a defined benefit scheme), or the member takes all the risk (in a defined contribution scheme).
The one exception is a ‘cash balance’ design. The employer promises a lump sum at retirement – say 15% of pay for each year of service – which is used to secure a pension for the member. Up to 25% of the retirement pot can be taken as an optional tax-free lump sum. Whilst this benefit design has been around for a long time, it is seeing a growth in popularity (albeit from a very low base). This is a benefit design which may be attractive to employers uneasy about moving from conventional defined benefit provision to the opposite extreme of defined contribution.
In a cash balance scheme, the employer takes the funding and investment risk until retirement – the lump sum must be provided – and at retirement the member takes the risk of what the market will pay as an annuity in return for the lump sum. Annuity rates are influenced by interest rates, general trends in longevity, and increasingly by the member’s own health and lifestyle.
Whichever form future benefits might take, this solution helps to avoid the two-tier workforce as far as pensions are concerned and uses the existing systems and scheme, which are already in place – reduce, reuse, recycle, as it were.
As an alternative to a single employer scheme, an ‘industry wide scheme’ offers a one-stop shop approach which can bring significant economies of scale. FRS17 financial reporting requirements can be much less onerous in some industry wide arrangements. The cost of withdrawing from a multi-employer pension scheme means that joining must be regarded as a very long-term commitment.
However, providing any form of defined benefit pension scheme carries investment and funding risks for the sponsor. Some of the more tailored investment and insurance strategies which larger pension schemes can use to manage these risks are not readily available to smaller funds (unless they are able to pool their resources with other organisations) due to relatively high costs or lack of critical mass. If the risk of rising costs is unacceptable to the organisation, then a more radical solution than reducing the defined benefits promised for the future is required.
Close to new entrants
Taking account of the sponsor’s attitudes to risk, the review may recommend that the defined benefit scheme should be closed to new members or to future accrual for all staff. In either case a replacement pension arrangement will have to be put in place.
If a key objective of the review is to reduce the organisation’s pension costs, employers need to understand that closing a defined benefit scheme to new entrants is very likely to increase costs in the short-term.
Leavers will no longer be replaced with new (usually younger) members, so the age and earnings profile of the membership will increase as time goes on, the Scheme Actuary will have to revise the method used for valuing the Scheme, and costs will go up.
The investment strategy is likely to change as the membership matures and this too can have implications on funding costs as employers and scheme trustees look to reduce volatility in investment returns. Schemes are funded by contributions and investment returns. A lower risk/lower return strategy means employers may have to pay higher contributions to the Scheme. So, you have to bear in mind that it may take a few years for scheme costs to reduce. However, if the organisation’s pension spending is calculated as a cost per employee, savings should emerge sooner.
If maintaining a defined benefit arrangement is not sustainable for the future, the alternative is a ‘defined contribution’ or ‘money purchase’ arrangement. This includes stakeholders and group personal pensions offered by insurance companies, occupational arrangements overseen by trustees and the proposed Government scheme of Personal Accounts which is due to open in 2012.
The big question to ask is whether to opt for a stakeholder (contract-based arrangement) or operate a trust-based arrangement, using the existing trust. The trustee approach will be the adopted in the new Personal Accounts system using this for your scheme is another example of ‘reduce, reuse, recycle’ - and all employees would have the benefit of trustees looking after their interests.
Stakeholder (personal pension) arrangements are often considered as a least-risk option by employers. This is fine, but if you’re going to do this, then remember that some of the ‘trustee’ functions will have to be undertaken, including a regular (every couple of years) review of the provider and the investment options open to members. If you’re not able to do this, then you will need to call on the services of a consultant.
While they allow employers to fix their contribution rate at an agreed percentage of salary, these schemes effectively transfer all the risk to the member – the risk of poor contribution rates, making inappropriate investment choices, low investment returns and the cost of buying a pension at retirement.
Death-in-service benefits may represent an additional cost for the employer, as will the provision of financial advice to employees. When these costs are factored in, the savings may be lower than anticipated, but the aim of reducing the pensions risk to the charity has been achieved.
Closing the Scheme to future accrual
Closing a pension scheme to future accrual of benefits may have serious consequences for the organisation. Recent legislation requires solvent employers to provide full benefits to members if a scheme is to be wound up. It’s worth checking the Scheme’s Trust Deed and Rules very early in the proceedings. If a scheme is closed to future accruals, winding up may be triggered automatically, putting the pension scheme trustees in the driving seat. While the ‘buy-out market’ has increased exponentially in capacity in the last two years, the cost of securing members’ benefits via insurance policies or similar arrangements can be very high. Employers may find themselves in a difficult position if the trustees demand several million pounds to secure members’ benefits.
It is possible to run a closed scheme in paid-up form indefinitely, but an exit strategy will eventually be required. It makes sense to draw up a plan for winding up the Scheme at some future date. It may be prudent to consolidate – ‘bundle’ – the Scheme’s service providers to manage costs. Insurance companies and some consulting firms can offer these services.
Consultation
If there are more than 50 ‘affected members’ (scheme members and employees who are eligible to join), consultation is required before certain changes can be made; employers who don’t comply can be fined up to £50,000. The Occupational and Personal Pension Schemes (Consultation by Employers and Miscellaneous Amendment) Regulations 2006 apply if there are proposals to:
• increase the Scheme’s normal pension age;
• close the Scheme to some or all new members;
• stop future accruals in the Scheme to some or all members;
• introduce or increase contributions for some or all members;
• change the Scheme to provide money purchase benefits;
• change the basis for determining future accruals (for example from final salary to career average); and
• reduce the rate of future accrual of benefits.
Consultation must last at least 60 days so it is effectively a project within a project, and decisions cannot be finalised until it is complete.
In summary, reviewing and changing a pension scheme is a challenging and costly exercise. There are no quick fixes, and organisations may experience some short-term pain before the benefits of a review emerge.