Next government should simplify pensions - Mercer

Mercer is calling for the next government to drastically simplify the legislation that applies to pension schemes.

The consultancy believes that the middle ground in pension-scheme provision - the sharing of risk between employer and employee - will fail to develop as a logical alternative to traditional defined benefit (DB) and defined contribution (DC) schemes if the legislation remains unchanged.

Mercer believes that recent market conditions have exposed the weaknesses in the two extremes of pension-scheme design - final salary DB and pure DC.

To ensure that future generations of employers and pension-scheme members are not exposed to the volatility created by accounting rules on the one hand and the vagaries of investment markets on the other, more emphasis should be put on the middle ground.

However, the UK's complicated and over-prescriptive legislative regime means that many workable designs that are being embraced in Europe will not be considered by UK employers.

Chris Sheppard, a principal at Mercer, said: 'It is important for companies to move to reduce their pension risk exposure and rising costs, but in the stampede to more affordable pensions, DC has taken pole position while the middle ground has limped on in pursuit, hobbled by inflexible legislation.

'Such middle-ground solutions more fairly balance the risk and reward trade-off between the employer and employees.

'From an employee perspective, a move from a final salary to a DC scheme is a hospital pass - all the risks pass from the company to employees in one swift move.

'The lack of alternative options to final salary and DC, however, encourages companies to treat DC as the default option when reviewing pension provision.

'Adopting some of the European approaches could provide a range of new choices and reinvigorate the industry,' Sheppard added.

According to Mercer, there are three main hurdles facing the development of a strong middle ground: compulsory indexation of benefits on leaving service and once in payment; reduction in pension payments; and clarity over the requirement for 'middle ground' schemes to pay levies to the Pension Protection Fund (PPF).

Indexation of benefits - the protection of benefits against inflation, up to a limit - is compulsory for UK DB arrangements.

Members of DC arrangements, on the other hand, are permitted to purchase non-increasing pensions - and most do, leaving them exposed to inflation risks.

The UK is the only country that mandates increases to DB pensions both in deferment and in payment.

An alternative adopted in some countries, such as the Netherlands, is for increases to only be provided if favourable investment returns, for example, generate sufficient assets to pay for them.

'Moving to a discretionary approach, within a regulatory regime that makes it clear how the discretion will be exercised, would allow defined benefits to continue to be provided.

'They would be affordable again and, because the core benefit provided would be lower, they would expose the employer to less balance-sheet volatility,' Sheppard added.

Once in payment, UK pensions provided via a defined-benefit scheme cannot be reduced, ruling out the incorporation of an element of 'profit sharing' during retirement.

'Members could opt to receive a "flat" pension - similar to choosing a cautious investment policy - or opt instead to have a pension that will go up if investments do well, but could fall back again during years when markets fall - a facility that is already possible within a DC environment,' Sheppard continued.

The PPF has been designed as a safety net for final-salary schemes and the design of the compensation and the calculation of the levy that eligible schemes are required to pay reflect this.

Currently, any scheme with some defined-benefit provision will be required to pay a levy to the PPF, part of which is required to finance deficits that the PPF has inherited due to legacy liability problems of existing final-salary arrangements.

'Although the PPF levy is often a small part of the overall cost of providing a pension scheme, it can be material for some employers and is often perceived as unfair, particularly for those schemes that have taken steps to reduce their accrual.

'The PPF must become more flexible to ensure that any levy that new middle-ground schemes are required to pay is proportionate and does not cross-subsidise schemes targeting higher benefit levels,' Sheppard finished.

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