‘Halfway house’ pensions to share risk

Some of the country’s largest employers are preparing to introduce a new type of workplace pension scheme, which could see even more UK workers shifted out of gold-plated final-salary plans into “risk-sharing” arrangements.

“Cash balance plans” are still relatively rare in the UK – but their use is now expected to become more widespread, as employers seek a halfway house between final-salary, or defined-benefit (DB), schemes, where they shoulder all of the investment and longevity risk, and defined-contribution (DC) schemes, where the risk of not building up enough pension is borne solely by the employee.

Under a cash-balance plan, the employee and employer make fixed contributions to a hypothetical retirement savings account, with the aim of targeting a defined cash sum, rather than a level of income, at retirement.

Some cash-balance plans are based on a formula similar to that used by DB schemes. For example, the final cash sum might be calculated as a fixed proportion, say 25 per cent, of final salary, multiplied by years of service. This formula would see a man retiring after 20 years on a final salary of £50,000 receiving a £250,000 lump sum. Had he been in a final-salary scheme, he would receive an income of about £16,000 a year.

So, with the cash-balance plan, the employer still bears the risk and responsibility of investing the pre-retirement contributions, as it would under a DB scheme – but offloads the risk of generating a specific level of income when the member retires, as is the case with a DC scheme.

“These plans will be a welcome addition to the pensions landscape for many workers,” said Ros Altmann, director-general of the Saga group. “They are better than moving everyone to a defined contribution scheme, like Nest [the workplace pension scheme that employers can enrol UK workers in from 2012].”

A handful of UK companies, including Barclays and J Sainsbury have already shifted their workers to cash-balance plans.

Barclays’ scheme, called “Afterwork”, provides a guaranteed sum at retirement, but also allows employees to top up their retirement savings.

Although cash-balance plans are still in their infancy in the UK, recent changes to the pension rules mean that schemes providing a cash lump sum can seem more attractive.

“Individuals now have greater flexibility how over they use their funds with the scrapping of the annuity purchase rule,” pointed out Marc Hommel, PwC pensions leader. “This may appeal to those who, for example, anticipate working part time or want to keep more saved for when they get older, in anticipation of needing long-term care. A further advantage is that, on death, any remaining proceeds can be passed on to dependants.”

PwC says it has seen a surge of interest from UK employers seeking to convert existing DB and DC schemes into cash-balance plans. For the employers, the key benefit is getting longevity risk off their books.

However, not everyone is convinced that cash-balance plans really do represent a halfway house between DB and DC schemes.

“These schemes are just variations of defined contribution schemes, they are not aligned to DB,” warned John Ralfe, an independent pensions consultant. “Undoubtedly, pensions will be less generous in cash-balance plans.”

Unions also warned that cash-balance plans involve a great deal of risk being transferred to the member.

“This means they should be regarded as being much closer to a DC scheme than a DB scheme,” said a spokesman for Unite, the UK’s largest union.

“In cash-balance schemes, members’ pensions are not readily predictable as a proportion of their salary before retirement – and this means the loss of a key element of what members value in a final-salary scheme.”

Employers are indicating that they will offer employees a choice over whether to move into cash-balance plans. But it is likely that many more workers will be pushed out of final-salary schemes and into the new plans. “Cash-balance plans will not be appropriate for everyone but provide a useful choice,” said Hommel. “As with any options offered to members, it is important the terms are fair and the risks and benefits are appropriately communicated.”

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