Cicero Policy Briefer

Issue 22, March 2008

Will greater risk-sharing save final salary pensions?

By Mark Twigg

Following recent stock market turbulence and the news that falling values of investment portfolios have re-opened the funding deficits faced by UK firms on their corporate pension schemes (albeit temporarily), it seems inevitable that the pressure on firms to adapt those arrangements to reduce exposure to risk and volatility will continue unabated.

It is also clear that this process won't proceed without some degree of social strife. In February, Britain's biggest rail union, the RMT, warned that strike action was inevitable if Network Rail pressed ahead with the imposition of what it called “an inferior pension scheme”. No stranger to a good rant, the union's general secretary, Bob Crow, accused Network Rail of acting in a “unilateral” manner when announcing that it was to launch a new defined-benefit scheme. We are used to union threats when DB schemes are earmarked for closure, as the BAA case illustrated last year, but in this case the employer is keeping the DB scheme open. The unions' resolve in fighting any kind of pension reform seems to be hardening, just at a time when consensus for sensible reform is what is required. For those of us who live in the real world—unlike the RMT leadership which, rather like the character Sam Tyler in TV's Life on Mars, seems to think it is still 1973—the prospect of enjoying access to any sort of final salary pension scheme, even an “inferior” one, would no doubt prompt an office party, rather than being viewed as something to go on strike about.

Fortunately, times have changed since 1973, and for the better. Though unfortunately, the costs of running final salary pensions have ballooned and the view that everyone, notably the employee, needs to make more of a contribution if we are to salvage any degree of high-quality pension arrangements is well-established. The Association of Consulting Actuaries (ACA) recently called for greater risk-sharing as one option. As Ian Farr, the chairman of the ACA and a highly regarded practitioner in the field, highlighted recently when giving evidence to the Pensions Bill Committee hearings, while there is no requirement on firms to offer final salary schemes, there is little scope where they do to share out the risks (such as longevity, investment or income progression risk). There currently is no halfway house. Employers either accept all the risks, or pass all the risks to employees.

While there are some things employers can do, and indeed are doing, to reduce the costs and risks associated with final salary schemes, such as moving from final salary to career averages, in reality under the current overly-prescriptive approach many firms would rather close the scheme altogether and move towards a defined contribution arrangement. Faced with such sweeping reforms, the ACA's big idea of conditional indexation would represent more of the halfway house to which I was referring, enabling sponsoring employers in future to link increases in the value of benefits to the performance of the fund. Under current rules, employers are forced to increase the value of both deferred benefits and benefits in payment in line with statutory minimums. The current Pensions Bill is looking at lowering the revaluation cap for deferred benefits and similar reforms were contained in the Pensions Act 2004, though critics argue such measures offer too little, too late in Britain’s efforts to save what remains of its final salary pensions provision.

Up until recently there has been no consensus on whether a move towards conditional indexation would actually make a difference in slowing the general trend towards defined contribution schemes. Clearly, it has been cited as having a positive impact in other countries such as the Netherlands—though that country has many other features which mark out its final salary provision as being very different to that of the UK, such as the presence of more cost-effective industry-wide schemes and a national culture of national pay bargaining. Direct comparisons may therefore be misleading. Nonetheless, it is notable that the UK employers’ organisation, the Confederation of British Industry (CBI), has come out more in favour of the move. However, even with broader support, it is still not likely to satiate everyone, not least in the trade union movement, parts of which are clearly itching for a fistfight—whether about government pay deals, pensions reform, the impact of private equity, you name it.

Faced with such a lively debate, the Pensions Minister Mike O'Brien had initially signalled lukewarm support for the ACA's proposals, announcing that though they would not be considered within the current Pensions Bill, they could be considered thereafter. Now, finally, he has backed up these words with the promise of a public consultation in the summer. He has also signalled that this may generate the need for further legislation in 2009. So we are now a little closer to working out what it will take to restructure existing final salary provision in a way which ensures that everyone—employers and unions—will be happy with the outcome. All eyes will be on that consultation paper to see just how bold the Government is prepared to be.

Mark Twigg can be contacted on +44 (0)20 7665 9537 or click here to email.