Select Committee on Work and Pensions Fourth Report


The future of Defined Benefit schemes

149. When our predecessor Committee completed its inquiry into the future of UK pensions in 2003 it reported that most witnesses were clear that "a transition was occurring" from occupational Defined Benefit (DB) to Defined Contribution (DC) Schemes.[211] DB schemes are pension schemes where the pension is related to the members' salary or some other value fixed in advance; DC schemes are schemes where the individual receives a pension based on the contributions made and the investment return that they have produced.[212]

150. This trend has continued. The Pensions Commission considered that it was "difficult to see private sector DB provision, certainly in final salary form, playing more than a minimal role in the future UK pension system."[213] It considered that a number of factors had led to the decline of such schemes, including increased life expectancy estimates, more realistic equity return expectations, lower real bond returns, and tighter accounting standards.[214]

151. When giving evidence to the Committee, Kay Carberry, from the TUC, expressed concern about this trend, suggesting that when DB schemes closed and were replaced by DC schemes "in most instances the employer contribution goes down"[215]. However, even if the contribution were maintained, she pointed out that DB schemes provided more certainty in retirement, as in DC schemes "the risk falls onto the shoulders of the employee."[216]

152. On the other hand, it is argued that DC schemes are capable of producing high returns[217] and also that it is possible to 'manage' investment risk through a 'lifestyle-smoothing' approach.[218] The problem is that the shift to a Defined Contribution scheme is often accompanied by a reduction in the employer contribution.[219]

Contracting out

153. Contracting out is the system by which individuals can choose to forego all or part of their State Second Pension entitlement, and in return pay lower rate National Insurance contributions, and/or receive payments into their pension scheme. These reductions and payments are known as the contracted-out rebate.[220]

154. The White Paper explains that contracting out provides "a private sector alternative to the State Second Pension, but in doing so adds significant complexity to the pensions system."[221]

155. The Pensions Commission recommended "phase-out and simplification of the contracting-out rules, rather than immediate abolition:

  • For Defined Contribution (DC) occupational schemes (where contracting-in already dominates) and for personal pension schemes (where many industry experts are already advising customers to contract-in), we recommend that the contracting-out option be removed, with all people not in DB schemes becoming members of the S2P.
  • For DB schemes, we recommend the continuation of the contracting-out option for the foreseeable future. But we propose that this option be abolished by, at the latest, about 2030, the date around which, under our proposals, accruals to the S2P become entirely flat-rate."[222]

156. The Government broadly followed the Pensions Commission's recommendations in this area.[223] Contracting out is to be abolished for DC schemes "at the same time as the basic State Pension is uprated in line with earnings."[224] However, it considered: [225]

    "For DB schemes, unless changes are made to scheme benefits or to contribution levels, the reduction in the rebate would gradually increase employer's payroll costs and reduce employees' take-home pay. For a number of reasons, the decision to contract out is not so easily reversed in DB as in DC schemes. This is mainly because of the long-term nature of decisions made on contribution and benefit structures as well as funding levels. These considerations mean that a longer lead-in time is required to introduce any changes to contracting out for DB schemes. Also, as the Pensions Commission recognised, a sudden and significant change affecting DB provision is more likely to prompt scheme closure than to spur additional savings."

157. It did not intend at this stage to "bring forward additional proposals to abolish DB contracting out in the longer term". Instead, the long-term future of contracting out for DB schemes would be "subject to ongoing review."[226]


158. Both the written and oral evidence submitted to the Committee suggested widespread support for the abolition of contracting out for Defined Contribution schemes, with some arguing that the Government could have gone further and also removed it for Defined Benefit schemes.

159. The Pensions Policy Institute (PPI) commented that, as "acknowledged by the Pensions Commission, there is no evidence for how the removal of contracting-out would impact on DB provision."[227] The CBI said that "members believe abolishing contracting-out would lead to a serious shortfall in funding at a time when Defined Benefit schemes are already under significant pressure. Funding for most Defined Benefit schemes takes account of the fact that money received from the contracting-out rebate provides a significant proportion of the funds needed to pay promised benefits (15% of contributions to Defined Benefit schemes come through the NI rebate)."[228] On the other hand Christine Farnish, from the National Association of Pension Funds described contracting out as "a source of cost and complexity for people who run pension schemes, particularly occupational pension schemes." She continued:[229]

    "One of the things we are disappointed in in the White Paper, is that the Government have not picked up the Pension Commission's recommendation that DB contracting out should cease by a certain point in time. I think Adair Turner recommended 2030, but we cannot see any point in future where the Government is committing actually to wind down and eliminate contracting out altogether, which we feel would be a very good place to be."

160. However, she made the point that in order for the abolition of the DB rebate to be effective schemes would need to be able to adjust the level of benefits so it was cost-neutral to them: "That would actually help to de-risk what is left of DB schemes in this country and make them more sustainable, and not less sustainable, in future, but also make the whole deal much simpler." [230]

161. Stephen Haddrill, from the Association of British Insurers took the view that "it is a bit odd to do one thing for DB and the other thing for DC."[231] Deborah Cooper, from the Actuarial Profession, told that Committee that the Profession "would have no objection to contracting out being phased over a shorter period of time." [232]

162. The Secretary of State emphasised when he gave evidence to us that he agreed with the conclusion the Pensions Commission had reached:[233]

    "I think it would be too destabilising for DB to take away the rebate at this moment in time, and that is why Turner did not recommend it and why we have agreed with him."

163. He continued that the Pensions Commission "did not recommend we did anything before 2030 on this, and I think that is where we are."[234]

164. Christine Farnish, while maintaining the NAPF's support for abolition of the DB rebate in order to fund a Citizens' Pension, told the Committee "Our preferred position would still be that; although, in the interests of building a consensus, we are not lobbying strongly on that point at the moment."[235]

165. We recommend that the Government should set a date when the future of contracting out for DB schemes is to be reviewed. This could form part of the further independent review we recommend should be commissioned by the end of the next Parliament.

A rolling deregulatory review

166. The White Paper proposed a "rolling deregulatory review of pensions regulation, which will feed into DWP's simplification plan, to be published later this year" possibly including a re-examination of matters such as mandatory indexation of pensions in payment, member-nominated trustees, administrative and internal control requirements, restrictions on changes to accrued rights, payments to employers where surplus funds exist, deemed buy-back and internal dispute resolution.[236]

167. It noted that "Reforms in some of these areas (for example, further reform of the requirement to apply price indexation to pensions in payment) could have the scope to make a significant difference to the costs of running an occupational pension scheme."[237]

168. We agree that in the current climate of DB decline such a review is prudent, but some aspects of reform could be particularly sensitive and must be dealt in a way which is fair to those involved. Giving oral evidence to the Committee, Christine Farnish from the NAPF agreed with the Government's list, commenting:[238]

    "The sorts of things that we have suggested could be looked at are exactly the same things that are in Chapter 2 of the Government's White Paper … We are not talking about robbing people and taking away their benefits, we are talking about trying to get back to a saner regime for the future, because I fear, if we do not, these things are going to become of historic interest only."

169. She added:[239]

    "I think there is a big issue as to whether we want a world in future where the majority of people might be able to benefit from a good pension scheme provided by their company, or whether just a tiny minority might get a wonderful pension benefit but everybody else gets nothing more than 8%."

170. The Occupational Pensioners' Alliance was concerned about the possible implication of further reform of the requirement to apply price indexation to pensions in payment for existing occupational pensioners. It said that a "further reform" that diminished the value of retirees' pensions in payment generally would not be merely an adjustment to what has gone before. "It would be a U-turn, a break with principle and justice."[240]

171. Asked about the scope for reducing the pressures on Defined Benefit schemes, David Norgrove, the Pensions Regulator, told the Committee:[241]

    "That would be a matter for Government to decide. To do it retrospectively is always extremely difficult, both in principle and socially. Whether prospectively that would be a sensible thing to do is a matter for the Government; but clearly, yes, one of the factors here has been the way in which, for what seemed sensible reasons at the time, the safety valves around DB schemes have been shut."

172. James Purnell MP, Minister for Pensions Reform, gave the Committee additional details of the review on 28 June, stressing that it would seek to strike a balance between cost and protection. He added that a group would be formed to make recommendations to Government, involving representatives from Which? and the TUC, as well as employers.[242]

173. While we welcome the Government's decision to set up a rolling deregulatory review of pensions regulation, we note that it will have to maintain fairness to those who have already accrued pension rights and effectiveness in terms of ensuring that DB schemes do not close because of unnecessary costs and provision. We welcome the fact that a group has been established to make recommendations to the Government, including employer and employee representatives. We ask the Government to outline the timetable for this review including interim progress updates.

Review of role of Pensions Regulator

174. The White Paper also states that the Pensions Regulator and the Pension Protection Fund are considering how they might contribute to the simplification process. It gives the example of the Regulator "reviewing its information and data requirements in the widest sense and looking at where it can use information already gathered by other organisations - government or commercial - rather than requiring schemes to submit it".[243]

175. David Norgrove, the Pensions Regulator, told the Committee that:[244]

    "The trouble is, as the last year or two has shown, pensions are a data free zone. It is astonishing how little we all know about the true situation with pensions, and it looks as though the investment banks and the actuaries have an industry of adding up the numbers - every other day a different number comes out […] So as scheme funding comes in over the course of the next few years we will start to get a better handle on what the true level of deficit is."

176. Evidence to the Committee by the Pensions Regulator suggests that the new information being gathered through scheme returns is needed to improve understanding of the current situation regarding occupational pensions.

Risk-sharing schemes

177. Adrian Waddingham, of the Association of Consulting Actuaries (ACA) stated that the ACA "would very much like to see encouragement, support, help for new types of schemes, rather better than NPSS, which would allow the employee and the employer to share the retirement risks."[245] Lawrence Churchill, Chairman of the Pension Protection Fund, said when giving evidence to the Committee in March that he was hopeful that more of these type of schemes would come forward.[246]

178. In a speech to the ACA in 2003, Lord Turner said that: "The big problem with DC schemes is the irrational volatility of return […] If we want to maintain an element of private provision which is Defined Benefit at least in the sense of not being exposed to equity price volatility, we are going to have to think flexibly and creatively about the precise risk-sharing balance between employers and the individual."[247]

179. Kay Carberry from the TUC told us:[248]

    "Unions have been talking to employers to try to maintain DB schemes, or at least maintain them to existing members, where it is not possible to keep them open to new accruals, and clearly it is better for some sort of hybrid scheme to replace a DB scheme where there is a sharing of risk than to go completely to a DC scheme where the employee is going to bear all the risk."

180. However, several employers groups, such as the CBI and EEF described such schemes as a "minority sport".[249] David Yeandle explained that it was possible for only the:[250]

    "larger, more sophisticated companies, with a lot of resources, both internally and externally, to communicate the change and to implement, because these are quite complex messages to get across to individual employees, and indeed sometimes quite complex changes to be made."

181. Any employer setting up a new risk-sharing pension scheme will be concerned about future liabilities. Employees will need reassurance that they are fairly treated and that what is essentially a deferred wage is properly protected and managed. We recommend that the Government considers whether more needs to be done to create an overall level playing field in which risk-sharing schemes, as well as DC and DB schemes, can all develop to their full potential, and encourage higher levels of contribution to whichever form of scheme is chosen.

211   Work and Pensions Committee, Third Report of Session 2002-03, The Future of UK Pensions, HC 92, para 69 Back

212   Pensions Commission, Second Report, November 2005 Back

213   Pensions Commission, Second Report, November 2005, p 48 Back

214   Pensions Commission, First Report, October 2004, p 92-3 Back

215   Q 386 Back

216   Q 387 Back

217   Q 473 [Mr Saunders] Back

218   Q 474 [Mr Saunders]; Q371 [Mr Stanley] Back

219   Ev 192; Q 69 Back

220   White Paper, Volume 2, para 3.7 Back

221   White Paper, Volume 2, para 3.7 Back

222   Pensions Commission, Second Report, November 2005, p 26-7 Back

223   White Paper, para 2.16 Back

224   White Paper, para 2.21 Back

225   White Paper, Volume 2, para 3.21 Back

226   White Paper, para 2.23 Back

227   Pension Policy Institute (2006), Transition Trade-Offs: Options for State Pension Reform, p 43-4 Back

228   Ev 356, para 16 Back

229   Q 476 Back

230   Q 478 Back

231   Q 477 Back

232   Q 172 Back

233   Q 299 Back

234   Q 300 Back

235   Q 478 Back

236   White Paper, para 2.42 Back

237   White Paper, para 2.43 Back

238   Q 479 Back

239   Q 479 Back

240   Ev 418 Back

241   Oral evidence taken before the Work and Pensions Committee on 22 March 2006, HC (2005-06) 1008, Q 12 Back

242   Uncorrected transcript of oral evidence taken before the Work and Pensions Committee on 28 June 2006, HC (2005-06) 1362, Q 108 Back

243   White Paper, para 2.38  Back

244   Oral evidence taken before the Work and Pensions Committee on 22 March 2006, HC (2005-06) 1008, Q 23 Back

245   Q 158 Back

246   Oral evidence taken before the Work and Pensions Committee on 22 March 2006, HC (2005-06) 1008, Q 10 Back

247   Lord Turner, speech to the Actuarial Profession on The Macro-economics of Pensions, 2 September 2003, reproduced in ACA response to Pensions Commission Second Report. Back

248   Q 389 Back

249   Q 440 Back

250   Q 440 Back

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