Cutting defined benefit costs: top 10 tips

Employers that offer defined benefit pension schemes face massive costs and deficits. What can they do to achieve cuts? Alistair Russell-Smith provides advice.

Defined benefit (DB) pensions accrue over the course of an individual’s working lifetime (for example, at 1/60th of salary per year of service). When looking at reducing DB pension costs, you should consider accrued pensions – relating to historic employment – and future service benefits separately.

Future service benefits

These can usually be reduced quite easily. Pension scheme trustees should not obstruct future service changes, and the regulator encourages cuts in future service benefits if the scheme is becoming unaffordable.

1 Reduce future service benefits: To achieve this, employers can reduce the accrual rate, switch from a final salary pension to a career average pension, increase the retirement age, and reduce pension increase rates. Unilever, BT and Morrisons have all recently switched to career average. Employers can also increase employee contributions, although the subsequent reduction in take-home pay can make this unpalatable when done at the same time as reducing pension benefits.

2 Contract members in to the State Second Pension: Many schemes are contracted out of the State Second Pension, whereby employers and employees pay lower national insurance (NI) in return for the scheme providing members with some of their state pension. Contracting in passes this responsibility and risk back to the government, and is better value for employers and employees.

3 Salary sacrifice: This is a win-win for employers and employees, as both save the NI on the employee pension contributions. For the average pension scheme, total savings amount to around 1% of salaries.

4 Close to future accrual: Most DB schemes have closed to new entrants, but many still allow current employees to accrue future benefits. The next step is to also close the scheme to current employees, which has been done recently by Rentokil, WH Smith and Barclays.

Accrued benefits

There is significant legal protection for accrued pensions, and they cannot be easily reduced without member consent. However, employers can, with trustee co-operation, still take basic steps to ensure accrued pensions are not costing more than they need to, and they can negotiate directly with members to generate larger savings.

Basic steps

5 Apply consents and discretions rigorously: Just because discretionary benefits have been paid in a particular way for years does not mean this has to continue – for example, be careful about approving generous early retirements.

6 Review commutation terms: Members usually choose to exchange, or commute, some of their pension for cash at retirement because the cash is tax free and paid sooner. Ensure the terms are set at a realistic level that is fair to members but not too expensive.

7 Review late retirement uplifts: These are not always frequently assessed, but with late retirements becoming more popular, uplifts should be tested. Increased life expectancy and lower interest rates means fair-value uplifts are now lower than they used to be.

Larger projects – negotiate with members

8 Cap pensionable salary growth to control the impact of pay rises on DB pension costs: As both accrued benefits and future service benefits are linked to final salary at retirement, this generates cost savings on both accrued and future service benefits. It can be done outside of the pension scheme via employment contracts, so it means the trustees do not need to be involved. The current low levels of inflation can justify low caps, which will generate significant savings if inflation picks up. Marks and Spencer recently capped pensionable salary growth at 1% per annum, brewers and restaurant specialist M&B at 2% per annum, and Legal & General at 2.5% per annum.

9 Run an enhanced transfer value (ETV) exercise: Offer members an incentive over and above their statutory entitlement to transfer their benefits out of the scheme. While this has an upfront cash cost, it does generate savings as the cost of the enhancements is usually less than subsequent reduction in deficit, particularly if the scheme is being funded very prudently. It can even be possible to use agreed deficit contributions to fund the exercise. By transferring both assets and liabilities out of the scheme, it leaves a smaller, less volatile pension scheme to manage. InterContinental Hotels Group ran an ETV earlier this year.

10 Compromise accrued benefits: Accrued benefits can be reduced with member consent, as long as statutory minimums are not breached, so employers can negotiate with members on accrued benefits – for example, exchange future pension increases for an immediate one-off uplift. This will generate a saving if the uplift is less than the cost of future pension increases. It also leaves a simpler scheme benefit, which will be easier to eventually buy-out with an insurance company.

The current economic environment means that now is a sensible time to review current practices in your DB scheme and ensure pensions are not costing more than they need to. It is also an opportune time to negotiate directly with members. While this might have an upfront cost, it should generate substantial savings over time, and settle liabilities more cheaply than buying them out with an insurance company.

Alistair Russell-Smith, actuary, Hymans Robertson

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