This is a briefing to employers and politicians from the Friends of CDC.
Target Pension Plans are a new type of pension plan for the UK. Also known as Collective DC plans, they work on a pooled basis, where members collectively share the risks and rewards of saving for their retirement. They give members higher and more certain pensions than would otherwise be available to them. Studies suggest that target, or collective pensions yield pension one third larger than the same payment made to an individual pension which is annuitised. They deliver a reliable base level of income during retirement, which helps members plan for their retirement, and will help employers with their workforce planning.
Instead of having individual accounts, under a Target Pension Plan the investments are pooled together, and managed by trustees taking professional advice. Investing collectively reduces costs and means that a longer time horizon can be taken – benefits for members will be superior to individual arrangements. The pooling process means that these benefits are more stable than individual schemes, and can smooth out the ups and downs of investment markets. Because they are managed by trustees acting on behalf of all members, Target Pension Plans do not require members to take investment decisions – decisions that many members find difficult and are unwilling or unable to take.
Target Pension Plans pay out a regular pension to members after they retire. Until this year’s budget most people used their pension savings to buy an annuity – that is a regular pension payment for life. The price of annuities can vary significantly from one year to another, and so the lifetime pension could be very different for members retiring just a few years apart. In the budget, the government decided that savers should no longer be forced to buy an annuity, and will now have full flexibility. This will make the choices even more difficult and individuals will find it very difficult to budget how much of their pension pot to spend each year. There is no need to take complicated decisions under the Target Pension Plan, which will pay out a secure income for life, with protection against the effect of inflation on the pension.
Target Pension Plans offer significant advantages for members, especially after the Budget changes, yet do not impose the onerous obligations that Defined Benefit (DB) schemes impose on their employers. Target Pension Plans offer members a higher, more stable level of income than conventional Defined Contribution (DC) schemes. Combined with a traditional DC scheme (perhaps paid for by member’s own contributions) they can deliver a very attractive combination of security and flexibility.
How does a Target Pension Plan work?
Under a Target Pension Plan, the employer pays in a fixed contribution. The assets of the plan are invested by a group of trustees, taking professional advice. Members are provided with a target pension amount payable from scheme pension age based on the contribution they have made. The pension would be targeted to maintain its full purchasing power, by receiving increases each year, both before and after retirement, in line with inflation.
Why do you talk about Target benefits?
This is a key difference between a Target Pension Plan and a conventional DB plans. Under a DB plan the pension is guaranteed, and the employer has to meet the cost of providing that benefit, whatever the experience of investment returns and longevity. Hence the cost is subject to review at actuarial valuations, and in recent years many employers have been required to pay substantial deficit contributions because initial estimates were too low. Under a Target Pension Plan there is no absolute guarantee – the benefit is targeted, backed by the assets in the plan. When the assets are more than the value of the Target benefits, the benefits may be adjusted upwards. When assets are less than the value of the Target Benefits, the indexation of the pensions, or the pensions themselves are reduced. At all times the adjusted value of the Target benefits is equal to the assets in the Plan, so there is no risk to the employer of any deficit.
Who decides when Target benefits need to be adjusted?
For most years of the operation of a Target Pension Plan, benefits will be adjusted as expected, in line with inflation. The trustees of the plan will obtain an actuarial valuation of the benefits on an annual basis, from an independent qualified actuary. It is a primary part of their duties to decide whether, and by how much, to adjust benefits. In doing this, they will follow a published set of Funding Principles. Members will be kept fully informed of any changes to their Target benefits, and the likelihood of any future changes.
Do members need to take investment decisions?
No – unlike conventional DC schemes, where members need to take decisions on how their retirement savings are invested, under a Target Pension Plan unless the member wishes to withdraw from the Plan, investment decisions are taken by the trustees, acting on professional advice. Members do not have to choose from a range of funds available – the investment is carried out at a plan level on behalf of all members. There is also no need for members to make a choice as to what type of annuity or other retirement income they need – this choice will become ever more complex after the 2014 Budget flexibilities. Research shows that many members find pension investment and retirement choices very complicated and would prefer to have these taken by others better qualified, and will see a role for their employer here. So, from the members’ point of view Target Pensions not only offer a higher and more predictable pension than individual DC, they also provide a simpler system.
Do Target Pension Plans help members deal with pension risks?
Under a Target Pension Plan the risks – and rewards – are borne collectively by the members of the plan. Investing and taking benefits collectively – the pooling of risks – means that benefits can be more stable, and superior, to those where one member alone bears the risk. Investment risks can be shared across market cycles and between generations of members. Longevity risk – the risk of living longer than one’s retirement savings – is better dealt with on a pooled basis, rather than an individual basis. Grouping together can give economies of scale, and hence bigger pensions than individual solutions.
How is a Target Pension Plan treated for an employer?
The Target Pension Plan is categorically a defined contribution scheme as far as the sponsoring employer is concerned. Once a contribution has been paid in, the employer’s obligation is complete. The employer does not have to make any additional contributions in respect of prior periods. The plan is treated as a defined contribution arrangement in the employer’s books, under pension accounting rules. There would be no profit and loss adjustments, or deficits on the company’s balance sheet, as there are with Defined Benefit schemes.
Will Target Pension Plans give better investment returns than other pension schemes?
Because the assets of a Target Pension Plan are used to pay out a pension for the lifetime of a pensioner, the assets will be invested for a longer time frame than a traditional defined contribution plan, when assets are removed at retirement. This means they can access types of investment – such as infrastructure – that are not available in conventional defined contribution schemes. Critically they do not force the member to buy and expensive annuity, but can still provide a pension-for-life by investing collectively. Target Pension Plans are invested by trustees taking professional advice, so that they can access the most appropriate investments for the members as a whole. The longer time frame, the avoidance of annuities, the professional advice and the improved speed of action all mean that Target Pension Plans will deliver superior investment returns, which will translate through into higher incomes for their members, while still delivering lifetime pensions.
Target Pension Plans – Frequently Asked Questions
Won’t employers be worried that a Target Pension Plan could turn into a Defined Benefit plan?
This is a concern expressed by many employers. They are concerned that at some stage in the future, what starts off as a Target Pension Plan could be changed – by government, or accountants or other bodies – into a Defined Benefit plan, and there will be obligations put onto employers operating these plans. There are three key protections for employers against this happening. Firstly the legislation permitting these plans should contain an explicit statement that they are not defined benefit plans. Secondly the licence to operate granted to a Target Pension Plan should confirm there is no obligation for the employer to contribute in respect of prior periods. Finally the trust deeds governing these plans should contain a provision for the automatic conversion of all benefits back into money purchase benefits immediately before any future legislation might take effect which would result in any increase in employer liability.
These sound like With Profit funds – won’t they fail the same way?
Target Pension Plan do share some of the characteristics of with-profit arrangements; though not the sharing of longevity risk. However they allow trustees to take volatile market based returns, and turn them into a steady progression in the member’s pension. However, as trustees, they must always undertake such activities in the members’ interest, not in the interest of the fund manager or sponsor. Target Pension Plans will be open to full scrutiny via a public website, as well as scrutiny and oversight by the Pensions Regulator. All of the key financial information governing the plans – their current funding position, investment returns, bonus plans and all information about financial development of the plans – will be open to public scrutiny. This will ensure that the actions of the trustees are subject to the most intense public scrutiny, and that fairness to members of the plans is being adhered to.
These plans have resulted in pensions in payment being cut in the Netherlands – won’t that happen here?
It is true that some plans that look like Target Pension Plans have cut benefits in recent years. However this has been in the face of intense pressure from the effect of low interest rates and all types of pension plans have suffered in these conditions. A feature of Target Pension Plans is that if benefits are cut, then restoring the cuts is a priority as finances improve, and this is what has happened in the Netherlands. Extensive modelling of Target Pension Plans has shown that the chances of benefit cuts are very limited and that any cuts are likely to be modest, and well flagged up in advance to members. There is no prospect of sudden, savage cuts to benefits.
Target Pension Plans can be designed so as to reduce the chances of benefit cuts for older members, without unduly transferring risks to younger members.
Don’t these plans always mean that younger members subsidize older members or vice versa?
In some countries this has been the case, and what should be risk sharing between generations has simply become risk transfer between the generations – usually from the young to the old. This is one example where the UK design for Target Pension Plans has learnt from experience elsewhere in the world. One of the principal duties of the trustees of the Target Pension Plan – when they decide on the annual adjustments to be made under the plans – can be a requirement to ensure fair treatment between different generations of plan members. Target Pension Plans can have an explicit requirement to make sure that younger members do not subsidize older members.
Don’t these plans need a constant flow of new members?
Because of the risk sharing nature of these plans, they do work best if there is a wide range of ages in the plan, and a long-term investment horizon. But this is not an absolute requirement, and a Target Pension Plan can adapt to a changing membership profile. In an extreme case, if no new members joined a plan, it would likely look to merge with another continuing plan, or would gradually over time adjust its investment portfolio so as to take less risk, and so have less variability of members’ benefits. In effect, the plan as a whole would behave like a “lifestyle” scheme for any one individual member. There will be no immediate cuts to benefits, and targets would be adjusted progressively over time to reflect the new circumstances of the plan.
Would members be locked into Target Pension Plan?
Not at all – there would be an ability to switch between Target Pension Plans and other types of pension plans. Any transfers into or out of a Target Pension Plan would take place on the basis of a fair share of the assets – so that the Target Pension Plan is unaffected by transfers in or out, and members always know they receive the fair share of the assets that back their pension. The transfer terms are designed to be fair to both those who stay and those who leave or join – there is no ability to “game the system” by leavers or joiners.
Won’t the target part be difficult to explain to members?
Target Pension Plans will need to communicate regularly with their members – but that is no bad thing. The communications will focus on the level of the target pension – but also the target nature of the benefit, and the fact that it depends on unknown future conditions and investment returns. The benefits communicated to members will be significantly less variable than comparable communications under individual defined contribution plans, and should enable members to plan for their retirement more effectively. The fact that benefits are not guaranteed will need to be stressed regularly, but not to the extent that it overrides basic messages about the benefits of the plan. For sophisticated groups of members, messages could be communicated using probabilities and chances of future events, but for most this will be more than they need and more simple messages will be sufficient.
After the Budget announcements, surely these plans are not needed?
The Budget in March 2014 took away the need to purchase an annuity with the proceeds of a defined contribution plan – but not the need (for many members) to generate an income in retirement from their pension savings. Target Pension Plans offer an exceptionally efficient mechanism to generate a regular income in retirement – a pension – from defined contribution saving. In effect a Target Pension Plan could become the replacement for an annuity, since it has the ideal characteristics that are needed for an income in the new era of flexibility. Target Pension Plans will generate higher returns than annuities, since they take investment risk across market cycles and across generations. More importantly they deliver pension benefits that are payable as long as the member lives – individual members do not have to work out a plan to make sure they do not outlive their pension savings. We expect many employers will use a Target Pension Plan to generate a base level of retirement income for their staff, but could offer an individual DC plan to “sit on top”. The conventional DC plan – which might be paid for entirely by individual member contributions – can take advantage of the full budget flexibilities, secure in the knowledge that the employer has helped deliver a secure stable retirement income through the Target Pension Plan.
Will it be onerous and expensive to set up a Target Pension Plan ?
To work effectively a Target Pension Plan needs a large number of members – certainly into the thousands. This is both to ensure that the risk sharing is working most efficiently and also to ensure that the overheads are spread over large population and so are reasonable for each member. For many large employers, they will have the size to be able to implement this for themselves. For others it will make sense to join an industry wide arrangement or to join a multi-employer set up, such as a master trust. The governance structures are central to the efficient operation of Target Pension Plan – trustees need to be well informed themselves and to have access to the best advisers. This does not come cheap and is why Target Pension Plans should serve large numbers of members.
Won’t employers be concerned at being the first to set up a Target Pension Plan?
There will always be a reluctance to be the first to set up any new type of employee benefit. But the case for Target Pensions is compelling – they can deliver bigger, more stable pensions for their workforce, without any additional financial risk for themselves. Even if an individual employer is afraid to be at the front of the queue for a Target Pension Plan, we see that industry wide arrangements and mastertrust plans will be a more obvious way to encourage employers to offer these benefits to their staff as part of their overall reward package and without the cost overheads associated with setting up their own individual plan.
Are there reputational risks for employers with Target Pension Plans?
The biggest fear that has been expressed for employers is that, in times of financial difficulty when benefit expectations are not being met – or worse still when benefits are being cut, they will feel obliged to top up the Target Pension Plan. We believe this fear is much over stated. These circumstances are likely to rare – and will come at a time when all types of pension savings are under extreme stress. There is no evidence that employers have increased their contributions over the past five years to traditional defined contribution plans, even though the benefits for members have been steadily eroded. If employers are part of an industry wide arrangement or master trust it will be clear that this is a systemic issue – not something that is specific to their own position as an employer.