Improving governance and best practice in workplace pensions - Work and Pensions Committee Contents

8  Risk-sharing and Defined Ambition pension schemes

131.  This chapter explores the Government's ideas for introducing a new form of pension schemes which takes a different approach to sharing risk, in what it terms "Defined Ambition" schemes.

Risks associated with pension saving

132.  Government, pension providers, employees and employers all share the market and longevity risks involved in pension saving to some extent. However different types of schemes share risks between employers and employees to varying degrees. In DB schemes, employers bear the risk of low investment returns, and of scheme members living for longer than expected. Conversely, in most DC schemes, it is the scheme members who bear the risk of poor investment returns, low annuity rates at the point of retirement and longer than expected longevity, factors which could potentially result in a lower income in retirement.

133.  The proportion of people saving in DC rather than DB pension schemes, in the private sector, has increased over recent years as employers have found it prohibitively costly to continue to offer final salary-related pension schemes. This growth in DC scheme membership will be accelerated by the large number of new savers who will be introduced to pension saving as a result of auto-enrolment. This means that, in future, many pension savers, especially in the private sector, could bear many of the risks of pension savings themselves.

Sharing risks between employer and employee

134.  The decline of DB pension schemes in the private sector and the shifting of risk to employees has raised the question of whether new ways can be found to share risk more equally between employers and scheme members and has led to discussions about whether the greater use of the type of risk-sharing schemes which are more common in some other European countries is worth exploring in the UK. Some risk-sharing schemes "have elements of current DB schemes, but with greater sharing of risk; others may start from a DC standpoint, but with increased certainty for members."[146] For example, a "hybrid scheme" is a type of risk-sharing scheme in which employees accrue benefits in both a DC scheme and a DB scheme at the same time.

135.  Collective Defined Contribution (CDC) schemes are a type of risk-sharing scheme which shares risks between members. They are in widespread use in the Netherlands. CDC schemes are Defined Contribution schemes in which:

  • Members' contributions are pooled into a collective investment fund, rather than each individual owning a personal fund
  • members pool their risk and diversify their investments more widely
  • members share risks with each other rather than with the employer
  • members subsidise each other in the case of poor investment returns or increases in longevity
  • in-built annuities can operate, which pay benefits to members from the fund or can give members lump sums at retirement with which to purchase an annuity.

136.  Saving in CDC schemes can result in higher incomes in retirement than saving in individual DC pension funds:

[...] by enabling riskier investment strategies, self-annuitisation and cost efficiencies, collective DC schemes can deliver outcomes for individuals 37% above pure DC pensions (the government's own evaluation in 2009 estimated the average benefit would be 39% higher).[147]

This is illustrated in the chart below.

Chart 2: Defined Contribution vs. Collective Defined Contribution[148]

Example of the potential difference in Mr Smith and Miss Snow's weekly annuity income at point of retirement after contributing the same amount to a pension for 40 years

137.  Some witnesses supported the idea of CDC and there was general agreement that CDC could produce higher retirement incomes for individuals and offer consumers greater protection without pushing an unreasonable burden of risk on to the employer.[149] However, other witnesses expressed concerns around potential legal barriers to introducing CDC schemes in the UK. It was suggested that CDC might not work in the UK unless membership was compulsory. The general view expressed was to question whether there was sufficient social appetite for the cross- and inter-generational risk-sharing and subsidisation underlying CDC schemes.[150]

Defined Ambition

138.  In November 2012 the Government published a strategy paper, "Reinvigorating Workplace Pensions". Amongst its proposals, it outlined ideas for risk-sharing under the banner of "Defined Ambition" pensions. The paper discussed the potential benefits and limitations of the various current forms of risk-sharing pension schemes including CDC schemes. The Government stated that its objective was to "Enable industry innovation and development of new products including those which will give people more certainty about their pensions and encourage more risk-sharing." The Government concluded by promising to:

[...]work closely with industry and consumer bodies to develop possible models and designs for DA pensions. [...]. Our planning assumption at this stage is that an early outcome of this work is likely to be a publication outlining a framework for DA pensions, possibly jointly with industry. Any proposals for legislative or regulatory change will be subject to a formal impact assessment and consultation. [151]

Employer appetite for risk-sharing

139.  There was some support from witnesses for the Government's plans for risk-sharing and a recognition that risk-sharing schemes could be more beneficial to members than pure DC schemes.[152] However, some witnesses cautioned that employer appetite for offering these schemes may be low because of the greater risks involved in running DA schemes, rather than offering access to pure DC. There was a feeling expressed by some witnesses that the Government did not support employers enough in keeping their DB schemes open, and were in some ways instrumental in forcing their closure.[153] Towers Watson explained:

If the Government wishes to encourage employers to sponsor risk-sharing pension arrangements, it will first need to convince them that aspirations and best endeavours will remain just that. Employers have had their fingers badly burned with defined benefit pension provision. This has proven far more costly than they anticipated, due in large part to UK Governments, over a period of many years, turning soft goals into legislative commitments.[154]

140.  However, the Association of Consulting Actuaries (ACA) claims that they and others have conducted attitude surveys which they believe "show that there is indeed demand from employers for the freedom to offer new risk sharing pension options". But they warn that the Government is not doing enough to enable employers to introduce risk-sharing schemes and could do more in terms of making the legal and regulatory environment more open for risk-sharing schemes.[155] This may become particularly relevant in 2016 when the Single-tier State Pension is likely to be introduced and people will no longer be able to contract-out of the State Second Pension, reducing scheme income. DA schemes may offer an alternative to employers who are considering moving away from DB, as a result of the ending of contracting-out.[156]

Response from stakeholders to the DA proposals

141.  EEF suggested that the Government should encourage greater use of risk-sharing through non-legislative means such as providing forums for sharing examples and strategies and stimulating the commercial sector to develop new products.[157] Age UK, while welcoming the Government's plan to investigate DA further, made the point that this should not distract the Government from ensuring that DC schemes are held to high standards:

Whilst we look forward to seeing these deliberations we are keen that this debate does not detract from what we see as the immediate priority—ensuring that DC schemes, be they contract or trust based, offer good value for money for consumers. [...] DC schemes are still likely to predominate pension provision for the foreseeable future, so the focus should be on ensuring that competition in the DC market acts in the interests of consumers in delivering better quality products.[158]

The TUC also emphasised the need to focus on DC scheme delivery and believed the Government should "consider how a greater degree of certainty in retirement outcomes can be achieved within a pure DC model given the numbers of people that will be automatically enrolled into pure DC schemes over the next few years."[159]

142.  Risk-sharing schemes can give their members greater certainty over retirement benefits and can help rebalance risk between the employee and the employer. We welcome the Government's intention to develop plans for Defined Ambition (DA) risk-sharing schemes. The Government should continue to explore ways to encourage employer appetite for DA schemes and to take the necessary steps to remove legislative and regulatory barriers to DA schemes by the time the Single-tier State Pension is introduced and contracting-out ends in 2016. This may provide employers with an attractive alternative to DC that could potentially offer employees better outcomes in retirement.

143.  However, we also recognise that many millions of people will be auto-enrolled into DC schemes in the future and that joining a DA scheme may be an option for only a small minority of employees. We therefore recommend that, while it investigates options for DA, the Government remains focussed on ensuring that people are being enrolled into DC schemes which offer high standards of governance and reasonable and justifiable charge levels.

146   Department for Work and Pensions, Reinvigorating Workplace Pensions, November 2012, p 4. Back

147   Ev 238 Back

148   Data supplied by David Pitt-Watson, assumes 40 years of contributions (at any level). Back

149   Q 29, Q 60 [PPI], Q 227 [Aon Hewitt], Ev 129  Back

150   Q 124 [Fidelity].  Back

151   Department for Work and Pensions, Reinvigorating Workplace Pensions, November 2012, p 30 Back

152   See for example Q 193 [EEF], Q 226 (Aon Hewitt, ACA, Mercer] Back

153   Ev w84, Q 226 Back

154   Ev 226 Back

155   Ev 128 Back

156   See Fifth Report, The Single-tier State Pension: Part 1 of the draft Pensions Bill, HC 1000, paras 90-98. Back

157   Ev 149 Back

158   Ev 106 Back

159   Ev 237 Back

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Prepared 25 April 2013