Emma Dunkley looks at the impact the economic crisis is having on employee benefits
The occupational pension scheme is arguably the most important employee benefit that the workplace can provide. However, over the past year employers have been increasingly freezing defined benefit plans while others have sought to reduce or even suspend contributions to defined contribution schemes, in response to the global downturn.
In the US, consultants believe that 401(k) plans, a type of defined contribution scheme, have borne the brunt of the recession and have been cut in order to make much needed company savings. Mercer principal Amy Reynolds said: “The disaster reaction to the economic downturn has been on the 401(k) side – we’ve seen around 14% to 15% of employers cutting back on their contributions to these plans since fall last year.” She explained that in contrast, it is difficult to alter DB plans in the short-term and although employers can freeze or cut back on these schemes, they cannot walk away from the cost immediately.
The concept of saving in the workplace is a strong one, and it’s also easier to educate people in the workplace
While 401(k) plans have been one of the necessary victims in order to reduce employee benefits and save costs, Reynolds warned that employees and participants should not pull back on their contributions. She added: “At the beginning of 2009, we’ve started to see employees getting back into the plan, where they had perhaps stopped making contributions at the end of 2008. We’re encouraged that employees will continue to participate, which is really key.”
Similarly Watson Wyatt senior retirement consultant Lisa Canafax explained that the 401(k) plan is relatively easy to reduce, compared with DB schemes, as it does not have as much regulatory structure encompassing it. She said: “There’s a sense that it can be suspended in the short-term and people will accept that. Suspending it can be viewed as a short-term cost saving, whereas freezing the DB plan is a bit more involved and is more of a long-term decision.”
According to a survey by Watson Wyatt, employees are not reducing their contribution levels to DC schemes, but are generally maintaining them. Canafax said: “It was a concern that employees might decrease their contributions, but if your employer is suspending your 401(k) match, you need to increase your savings rate – there is an indication that people understand the need to save.”
The survey revealed that people would pay more money for a guaranteed level of retirement benefit, such as what is on offer through a defined benefit scheme. Alternatively, the employer can provide a lower level of benefit, as long as it has a guarantee. “People who lost 30% of their 401(k) plan last year didn’t make bad decisions in assets, they were just hit by a once in a century market condition,” said Canafax. She explained that this is why having a more guaranteed level of benefit through a DB plan is important for retirement, as it offers a form of savings not entirely susceptible to current market conditions.
Indeed, the value of DB plans in removing the burden of risk from the employee while still offering an enticing retirement proposition counters some of the criticism that such schemes have endured. New York State assistant comptroller for pensions Joe Haslip said: “There have been a lot of efforts to attack DB plans and urge people to go to DC plans which are employer contributed. However, the DB plan is a major inducement to encourage people to stay within the city in employment and the government wants to maintain a skilled, qualified workforce over time.”
He explained that the challenge for DB schemes is the need to discuss restricting some of the benefits, along with the issue of how to approach investing, asset allocation, and liquidity, to also be able to guarantee the benefits. He added: “I think people regard DB plans very highly, especially as they see what’s happening with DC plans. I think there should be a great push to preserve the benefit.”
The UK perspective
In the UK, the private sector generally sees DB schemes as expensive to provide, as they require around 20% to 25% of someone’s salary per year in order to fund and pay out these obligations. Aviva Investors head of UK institutional business development Richard Warne said that liabilities of DB schemes are increasing as the estimate of how long people are living rises, meaning companies will have to pay out longer. He added that liabilities are also affected by the low bond yields which cause a lower discount rate, therefore requiring more money in order to pay out liabilities.
Yet Warne highlighted that despite the accounting and costly burden of DB plans, companies are not always seeking to reduce benefits, as they recognise the importance with which employees regard such schemes. For example, Shell continues to offer DB schemes in order to attract the best talent, explained Warne. “Nonetheless, as the future costs of these schemes rise, companies are closing them to new entrants,” he said.
On the other side of the coin, tax implications in the UK might ostensibly deter members of final salary schemes, especially following the recent restrictions on tax relief for pension contributions of those earning £150,000 or more. Schroders actuary Margaret de Valois explained that, in relation to final salary schemes, if an employee pays a 20% tax rate on their annual accrual, the employee could face a tax bill of around £4,500 a year in respect of their pension accrued on a salary of over £180,000.
She said that although this may look like a hefty bill, along with extra income tax, it is still much less than the cost of replicating this final salary benefit in a defined contribution scheme. She said: “While clearly a further blow for higher earners, tax on employer contributions to final salary schemes is unlikely to deter high earners from actively accruing benefits in final salary schemes.”
With companies coming under pressure from a cost perspective, many are looking at re-broking elements of employee benefits with fixed costs, said Aegon corporate pensions head of sales Adam Potter. He said: “If a company offers income protection, rather than offer this through to someone’s retirement day, it could introduce benefit reductions to make cost savings.”
He added that a lot of companies are also seeking to re-launch the pension scheme with a better charging structure, including salary sacrifice which will save the company a substantial amount of money while delivering an income. “Nowadays, companies have flexible benefits packages which offer many different perks. By trimming some of these, rather than the pension benefits, the company can still save.”
Similarly Vebnet director of consultancy services Richard Morgan explained that there is a need to look at the overall reward and benefits structure, rather than viewing pensions in isolation. “This will prevent a kneejerk reaction to pensions which can upset the balance for the rest of the reward package,” said Morgan. “What companies would like to have is a fixed budget for benefits, so they know the costs.” He explained that employees can then allocate a portion of this to their pension fund.
He added: “It’s about being paternal and looking after the employee, versus attracting them by offering relevant benefits.” For example, a graduate may be more attracted to a home purchase scheme, which is arguably a more immediate financial need than a pension.
Friends Provident head of corporate pensions sales Russell Welsh also explained that when people enter employment, their first concern is not necessarily putting money into a pension fund which will then be locked away for 40 years. He said: “If there’s a way of facilitating savings in the workplace that are easier to access during their employment, it would be more attractive to employees.” He added: “We’re trying to educate people that they should not depend on the state for their pension. The concept of saving in the workplace is a strong one, and it’s also easier to educate people in the workplace.”
Countdown to auto-enrolment
With auto-enrolment and personal accounts due to be rolled out in 2012, the concept of saving through the workplace is certainly topical and is at least placing the pension debate at the fore. AWD Chase de Vere Consulting corporate consultant (specialist pensions) Liz Kane said that auto-enrolment is compelling employers to review their current schemes to see how they can be improved to satisfy these requirements.
She said: “I don’t think many companies are looking to enhance their benefits; I think many are asking what is the minimum they can do to satisfy the legislation.” For example, if a DC scheme pays 8% and the employees pay 2%, the employees will need to pay more, rather than the employer boosting its contribution, she said.
Morgan at Vebnet added that although companies are seeking to reduce pension costs, 2012 will likely see an increase in costs through auto-enrolment. Consequently, there will be greater interest in salary sacrifice schemes, which will help to mitigate additional costs for employers and employees, he said.
Yet Warne at Aviva highlighted that auto-enrolment envisages a certain contribution rate which could become the industry benchmark. This could have adverse effects, if it is less than the rate used by many companies, he said. Another issue with personal accounts, and certainly defined contribution schemes in general, is the adequacy of the default fund option. He said: “PADA is undertaking a consultation process, which includes what the default fund would be. Diversified growth funds using strategic asset allocation models are very important for all pension schemes.”
Rubicon investment consultant Fiona Daly explained that the situation is similar in Ireland. She said: “Around 90% of people go into the default option and for many schemes, the default is a balanced fund. Some schemes don’t even offer any choice. Trustees don’t seem to realise that if they don’t offer any choice, they’re leaving themselves personally liable for performance.”
She added that trustees need to ensure they offer choice which spans a range of risk levels and should at least have a lifestyling strategy, where all members are moved out of equities to bonds for protection as they approach retirement.
Indeed with personal accounts around the corner in the UK, companies are at least reviewing their pension offering, by either enhancing their existing schemes or preparing to launch new plans. Nonetheless, the issue of cost saving is being addressed across the board, with salary sacrifice schemes and flexible benefits being implemented. While cuts in 401(k) schemes and freezes on DB plans have occurred, the good news is employees still value the importance of schemes in the workplace and are maintaining their contributions.
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