Aspirational pensions – popcorn pensions!!

DB sir- that'll do nicely

Pensions minister Steve Webb has proposed the creation of a new hybrid pension scheme that would not be subject to the same strict regulations of defined benefit schemes and offer employers more flexibility to react to market conditions.

DWP press release

Mr Webb floated the proposal for defined aspiration pensions in a recent speech to the National Association of Pension Funds.

He says the government is looking to encourage employers to offer a “third option”, as many companies continue to close their defined benefit (final salary) schemes in favour of a defined contribution scheme, where retirement income is not guaranteed.

Mr Webb said the defined benefit rulebook, which forces companies to adhere to strict funding requirements and contribute to the Pension Protection Fund, could be relaxed for defined aspiration schemes.

He said: “This type of pension could sit within a less burdensome regulatory regime and give businesses the freedom to offer the type of provision that works best for their employees.

“A defined aspiration pension could allow employers to offer a measure of security to their staff, but would have a degree of flexibility that would recognise when external factors – be it increases in longevity, or significant changes in market conditions – make a firm promise impossible to keep.”

Mr Webb said defined aspiration pensions would give employees a “greater sense” of what they will get in retirement than defined contribution schemes.

This is precisely what the nation needs and the Pensions Minister has expressed himself with characteristic clarity and good sense. Thank goodness we have such a man in charge at a time when pensions are going through a particularly hard time. Many pension ministers have seen the job as a stepping stone, Steve has dedicated much of his career to pensions and is now showing the leadership that we have been waiting for.

The big question that we need to answer is “do we need guaranteed pensions in retirement”. Put another way, “would you put up with a cut in your pension if it was decided there wasn’t enough in the pot to pay the liabilities?”

This is precisely the question the States of Jersey posed to the 60,000 permanent residents of the Island in 2005. The States run a pension fund for their staff and had previously guaranteed those pensions as final salary schemes are guaranteed in the UK today. They were not subject to the Regulations Steve Webb talks about and they decided that rather than guarantee the benefits for all time, they would promise to (aspire to) pay these benefits for ever but recognised that if conditions continued to get worse (longevity, gilt rates, equity markets etc) they might have to adjust pay-outs downwards.

The States of Jersey, for their part, agreed to keep contributions at a defined contribution of 16% of wages for the next 82 years.

The agreement between the States , the unions and the members and prospective members of the Fund, is a model of political consensus which I have pointed to many times on this blog. While members do not have the long-term protection , they have a say in the management of the scheme through its trustees which are primarily member nominated. The Pension Fund is seen as a collective asset and is cherished rather than denigrated.

This optimism is in the spirit of what I have called “Popcorn Pensions”, a mindset that looks at solutions to problems rather than pointing to reasons not to.

Undoubtedly there will be many voices who oppose Steve Webb’s idea. It is true that companies should be extremely cautious about entering into any arrangement where an aspirational promise could turn over time into a guarantee. After all, this is precisely what happened to the current DB plans that are sinking beneath the weight of the guarantees and will undoubtedly be sunk if EU legislation (SolvencyII) is lumped on top.

To protect companies from this threat, we should do well to look at the safe harbour legislation , introduced under ERISA in the USA.  A safe harbour offers companies the assurance that they will not be liable for the outcomes of their endeavours if the markets go against them and is precisely what UK sponsoring employers will be looking for the Government to provide them with.

In the USA, the safe harbour protects companies offering 401K plans, immunity from employee legal action if the plan pay out below expectations and requires the plans to invest in certain ways, keep costs down and adopt proper monitoring.

In the UK, Safe Harbour status could be granted on a similar basis but could be extended to protect companies from the risks of their employees living longer than expected, or of the money running out because of unexpectedly low investment returns and higher than expected inflation (where the aspiration is to pay inflation-linked pensions).

There is a long history of mismanagement of people’s aspirations from pensions and those who can remember “with-profits” will recall that “with profits” endowments and pensions were created for the same reasons as Steve Webb wants to create aspirational pensions.

Many years ago, to meet a liability (typically to pay off a mortgage but also to meet a string of pension payments) an insurance company would offer a premium (usually a monthly payment) that if met, would guarantee the necessary sum(s). This was a “non-profit” arrangement where the premium payer did not benefit from the profits the insurance company paid and took no investment risk. This is analogous to the position those contributing as members of UK Defined Benefit Pensions enjoy.

The trouble with the non-profit endowment was that it was too expensive and people chose other ways of paying off their debt (typically by paying it off a bit at a time – the repayment mortgage) or by taking some of the investment return in exchange for some of the investment return – “with profits”.

The “with profits” arrangement became very popular, especially when people forgot that as well as getting some of the profits (which allowed them to pay a lower premium), they also got some of the risk. While markets rose, people enjoyed the win win of low premiums and high bonuses but when markets fell from 2000 on, the bonuses fell to a level that many found their with-profits policies were no longer meeting their liabilities.

The most notorious case did not involve an individual forgetting about the risk but an insurance company – The Equitable Life- which forgot that when guaranteeing pensions, you should think not just about the growth of the assets but also the growth of liabilities.

If we are to avoid the debacle that has surrounded Final Salary Pensions, with-profits endowments or the Equitable Life’s promise of guaranteed annuities, we need to be clear not just about the risks of aspirational pensions at outset, but every year on.

The States of Jersey allow their pensioners and prospective pensioners to monitor how the Fund is shaping up. They get their fair share of nutters suggesting the fund should be invested in wacky schemes but by and large they seem to have nailed the communication issue and while all is not going as it should on the funding side, people are at least aware of the risks they are running and the likelihood of money running out.

I understand that the Dutch, who have a similar system of non-guaranteed (aspirational) pensions, are going through the pain of pension cuts this year and I’m pleased that Steve Webb, who was originally reported as being horrified by this, is now, like most Dutch members, coming to terms with the social and political consequences when times aren’t good.

There are going to be a lot of objections to aspirational pensions over the weeks and months to come, but for me they are popcorn pensions – delicious, affordable and while they may not be the haute cuisine of the guaranteed Final Salary plans pragmatic.

I like “pragmatic”

About henry tapper

Founder of the Pension PlayPen, Director of First Actuarial, partner of Stella, father of Olly and the Pension Plowman
This entry was posted in annuity, auto-enrolment, dc pensions, de-risking, EU Solvency II, happiness, Henry Tapper blog, Management, pension playpen, pensions, Popcorn Pensions, Public sector pensions, Retirement, Treasury and tagged , , , , , , , . Bookmark the permalink.

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