The 3 rd Younger Members Convention November 2004, The Chesford Grange Hotel, Kenilworth

Pension Plan Design Alan Dorn, Watson Wyatt 30 November 2004

Agenda  Some risk sharing designs  Tailoring designs  What’s happening in the market  Legislation and future trends  Pensions and flexible benefits  Questions

Risk sharing designs

What are the risks in pension schemes?  Investment return up to retirement  Annuity rates at retirement (DC)  Salary growth  Mortality  Other demographics (eg leavers, early retirements)  Company covenant/insurer strength  Legislation

Who bears the risk?  Final salary: employer bears most of risk  Employers finding this too onerous  Money purchase: employee bears most of risk  Some employers feel this is inappropriate  What options between these extremes?

The risk sharing spectrum (Company) Cost variability Cost certainty Money purchase Final salary Cash balance Career average revalued Final salary, DC top-up DC ‘nursery’, then final salary

Revalued career average  Based on salary throughout career  Employer avoids salary growth risk only  Members don’t lose out on early leaving  Typical structure:  1/60 th of total revalued salary for each year of service  revaluation with RPI or capped RPI  other benefits similar to final salary schemes

Cash balance  Employer credit (eg 10% to 20% of salary) to DC ‘pot’  Pot revalues each year – could be eg:  guaranteed RPI  discretionary (eg targeting RPI)  guaranteed plus discretionary  Normally open market annuity at retirement  Employer avoids post-retirement risk/part of pre- retirement investment risk as well as salary risk  Less efficient – guaranteed returns/insurer’s margins

Hybrid – DB with DC top-up  Eg 1/80 th of final pay for each year, plus 5% employer contribution to DC pot  Eg 1/60 th of final pay on earnings up to a threshold, with DC on pay above threshold  Removes a proportion of DB risks from employer  Complex to administer/explain?

Hybrid – ‘nursery’  Eg DC for under 40s, option of DB after age 40  Eg DC for first 10 years service then DB  Could allow DC fund to purchase added years  Again removes proportion of DB risks  Complex to administer/explain  Could be expensive: DB for older members only and no DB withdrawal profits

Tailoring designs

Employee and employer characteristics  No universal correct design – depends on:  workforce profile  type of employer  employer’s aims for pension provision  how pensions fits into remuneration strategy  Eg: what kind of plan is ‘best value’ to different types of employees

Employee (stereo)types – ‘Climber’  Ambitious/restless  Moves jobs frequently  Strong pay growth throughout career  A final salary ‘loser’ – lots of small deferred pensions which don’t go up with pay  DC may be best ‘value’ to employee

Employee (stereo)types – ‘Plodder’  Loyal, unambitious  Stays in same job with little promotion  Pay rises not much above inflation  RCA may be best value to employee

Employee (stereo)types – ‘Company man/woman’  Loyal, talented  Rises through ranks of company  Strong pay rises  Final salary ‘winner’ so FS probably best value to employee

Employee (stereo)types – ‘Slacker’  Not particularly loyal, talented or dedicated  Gets bored/sacked and moves jobs regularly  No progression – low pay rises  RCA or DC may be best value to employee

What’s happening in the market?

The move away from final salary Source: Watson Wyatt Pension Plan design survey 2004

Why have companies abandoned final salary provision?  External factors increased burden on employer:  Pensions Act 1995  Removal of ACT credit on dividends  Solvent employer wind-up (June 2003)  Stock market crash and fall in bond yields  Some may have budgeted unrealistically following past contribution holidays  Tougher trading conditions/cost controls  Change in workforce profile – higher turnover

Types of open plans Source: Watson Wyatt Pension Plan design survey 2004

Money purchase contribution rate structure Source: Watson Wyatt Pension Plan design survey 2004

Overall average money purchase contribution rates Source: Watson Wyatt Pension Plan design survey 2004

Pension at 65 from 10% total money purchase contributions – possible outcomes Source: Watson Wyatt Pension Plan design survey 2004 LQ M UQ 5%

Legislation and future trends

Recent/forthcoming legislation – 1  Solvent employer wind-up  Makes DB plans ‘guaranteed’ so more expensive – may discourage new DB?  Few plans can buy out – may slow down closures?  Pension Protection Fund (PPF)  Levy another disincentive for DB?  Scheme specific funding  Moves balance of power towards Trustees – another disincentive for employers?

Recent/forthcoming legislation – 2  May be easier to change past service benefits  Could remove a barrier to design changes  Lifetime Allowance (LTA)  LTA is a DC-style limit – DB limit tests more complex  Simplification of GMPs  Not in Pensions Bill!

Future trends – two alternatives No more DB  Reduce/close existing DB schemes  Mainly DC for future  Some DB maintained (eg unionised companies/ Government schemes)  Low DC pensions may emerge – what next? DB maintained  Valued by employees  Differentiator between employers  Simplified?  Contracted-in?  Cheaper/less risky DB (eg CRA/hybrid) or cash balance Reality

Flexible benefits

Pensions and flexible benefits  Some employees may not want pension  could take more salary/holiday etc instead  how paternalistic is employer?  DC easy to integrate into flex programme  DB harder – eg accrual rate linked to member contribution rate – beware of selection  Hybrid plans – more complex to integrate  IT – online choice (including pensions) may be attractive to employees