What is a defined ambition pension scheme and why is it necessary?Although we have two types of workplace pension scheme in the UK - defined benefit and defined contribution - neither are ideal for both employers and employees.
With a defined benefit scheme, the employee is promised a certain amount of retirement income, typically based on the their final salary or, more recently, their average career earnings. But the employer bears all the risk of providing this income: if the investments held by the pension fund perform badly or scheme members live longer than expected, the employer has to ensure there is enough money in the pension scheme to pay out the income due.
About the expert
Chris Curry is Director of the Pensions Policy Institute (PPI), an educational charity which provides non-political, independent comment and analysis on public policy on pensions and the provision of retirement income in the UK.
The PPI publishes regular research notes and briefing notes on its website.
Defined benefit schemes are regarded as very good for employees, but the expense, uncertainty and regulatory burden has encouraged many employers to close them, offering their staff defined contribution pensions instead.
The defined contribution scheme is at the other end of the risk spectrum. The employee bears all the risk, not knowing how much income they will get until they retire. If the pension fund performs badly, or annuity rates are low at the point of retirement, the employee may suffer a low retirement income for the rest of their life.
Proposals for the defined ambition pension aim to share these risks more fairly between employer and employee, or different groups of employees, so that employers are not faced with unaffordable pension liabilities, and employees have some certainty about the income they will receive on retirement.
How will a defined ambition pension scheme work?
The Department for Work and Pensions (DwP) has suggested several ideas to illustrate the concept of a defined ambition scheme in its
consultation paper, some based on existing schemes used in the Netherlands, Canada and Sweden, and some that are completely new.
These include guaranteed defined contribution schemes, which could protect the value of an employee's pension pot to ensure a better income. The consultation paper suggested four ways of doing this, ranging from a money-back guarantee that ensures the value of the pension pot should never fall below the amount that has been contributed by the employer and employee, to a pension income builder, where part of the employee's pension contributions are used to buy deferred annuities every year.
The Government is also legislating to allow collective defined contribution schemes, which pool the employer's and employee's contributions with those of other employees rather than being paid into their own individual pot. On retirement, they would receive an income paid from this pool.
What are the advantages and disadvantages?
Defined ambition schemes might provide an attractive alternative for those companies that want to close their existing defined benefit schemes. The 'halfway house' option is likely to appeal to paternalistic employers, as it offers a potentially much better outcome for employees. It can also help with staff retention and the management of an ageing workforce: there will be more certainty about the size of pension income that employees will enjoy, enabling them to retire and free up positions for younger employees.
Importantly, this type of pension also offers considerable scope for pooling and managing longevity risk, either through a fully collective scheme or a plan that is defined contribution in the accumulation phase but has collective elements in retirement. "Trust in pensions is particularly low in the UK at present"
But defined ambition is not without problems, not least communicating how a scheme works and what members can expect out of it. Contractual agreements and members' expectations must be fully aligned from the outset, and there must be full transparency about the measures that could be taken by trustees in relation to changing the shape of benefits.
In 2012, funding gaps caused by the global financial crisis forced 117 Dutch defined ambition pension schemes to demand capital injections from their employer sponsors, an increase in employee contributions and, in the worse cases, cuts to the pension rights of those still working and reduced benefits for pensioners. People were not expecting their pension rights and income to be cut, resulting in huge anger and resentment towards their employers.
Trust in pensions is also particularly low in the UK at present, and any misunderstanding of how these new schemes work could undermine trust in retirement saving still further.
What next?
Legislation to enable the introduction of defined ambition schemes has cross-party support and is expected to be complete by Easter. It would be possible for the first UK schemes to be launched during 2015.
Public sector schemes, excluding the
Local Government Pension Scheme, are unfunded, making it hard to see them switching to this structure. We are also unlikely to see any employers who offer defined contribution schemes taking on more risk.
But the introduction of the new-style basic state pension and the ending of contracting out in 2016 will make funding of defined benefit schemes even more expensive for employers. For the private sector employers that still offer these generous schemes, defined ambition could well be something to consider.
Defined pension schemes in numbers
Membership of private sector defined benefit schemes in 2012 (4): 1.7m
Number of defined benefit schemes remaining open to new members (1): 789
Membership of defined contribution (DC) schemes in 1997 (4): 2.2m
Membership of DC schemes today (4): 4.2m
Membership of DC schemes increased by 15% in 2013 alone (4)
Collective pension schemes currently exist in the Netherlands, Denmark, Sweden, and New Brunswick Province, Canada (4)
Number of collective defined contribution (CDC) schemes operating in the Netherlands (4): 400
A study by Aon Hewitt concluded that their CDC model would have outperformed the average DC scheme by 25% between the years 1955 and 2011 (4)
Average male life expectancy from age 65 in 1975 (2): 13.3 years
Average male life expectancy from age 65 in 2014 (2): 22 years
Proportion of UK employers interested in defined ambition (3): 28%
Sources:
1. The Pensions Regulator
2. National Association of Pension Funds 40th Annual Survey
3. Pensions Minister Steve Webb
4. DwP