Accounting for Pensions Survey 2002
The fate of the defined benefit scheme


What’s new? Falling equity markets, low bond yields, increasing life expectancy, FRS17…these are just some of the things that have led a large number of companies to close their defined benefit pension schemes.

Leaving aside the artificial constraints imposed by FRS17, defined benefit schemes have become intrinsically more risky and more expensive than they used to be. Legislation has progressively increased the proportion of the benefit that is guaranteed, which has increased the risks for the sponsoring company.

It is no wonder that some companies have said “enough is enough”. But we would caution against closing defined benefit schemes on account of FRS17 alone.
Business objectives The question should not be simply “defined benefit (DB) or defined contribution (DC)?”. The process should begin with an analysis of the sponsoring company’s objectives, which may include targeting benefits to the employees they want to reward, redistributing the risk, or simply reducing underlying costs.

Traditional final salary DB schemes and DC schemes represent extremes of risk distribution. With a final salary DB scheme, the company bears all the risks, particularly in relation to investment returns and life expectancy, whereas with a DC scheme the employee bears these risks. Whilst one of these two extremes will be appropriate for many companies, there is also a range of “middle ground” alternatives, so-called “hybrid” schemes. Many such schemes are now appearing in FTSE 100 companies as they address the particular objectives of those organisations.
Cash balance AstraZeneca runs a “cash balance” scheme, in which the benefit is a specified percentage of salary at retirement in lump sum form. This is used to secure payments to the employee at retirement, as both a lump sum and an annuity.

In such an arrangement, the company bears the investment risk up to the point of retirement, but all the risk passes to the employee at the point of retirement. In particular, the mortality risk (the risk that the employee will live a long time in retirement) is taken away from the company and passed to the insurer providing the annuity.
Career
average		 Tesco and Safeway both run “career average” schemes, which are defined benefit schemes but where each year’s benefit is based on the salary earned in that year rather than on salary at retirement.

Such arrangements are only modestly less risky than traditional defined benefit schemes, as the company continues to bear the mortality and investment risks. They are often suitable for an inherently mobile and/or part-time workforce.
DB/DC combinations There are other ways of finding middle ground between DB and DC. For example, Sainsbury offers DC for younger employees and DB for older employees. Other alternatives include DB on salary up to a limit and DC above that limit (common for directors of UK companies), or a low level of DB provided by the company, with any employee contributions going to DC.
Don’t forget
the old
scheme		 Closing the DB scheme does not remove the problem. A closed DB scheme matures rapidly and its funding can become increasingly volatile. It may be necessary to review the investment strategy and eventually the scheme will be wound up.
Look before
you leap		 Nowadays, companies worried about the risks that their final salary schemes pose should be comforted to know that they do not have to run from one extreme to the other. There are innovative ways of structuring benefits to balance their needs with those of their employees.