28 September 2017
People hoping to retire before their state pension age often find themselves trying to work out whether they can make ends meet on their non-state pension benefits until their state pension kicks in. For many people, where state pension is a significant share of their overall retirement income, the answer is often no. As a result, they are usually faced with a choice between reducing their expenditure needs until state pension age or, perhaps more likely, delaying their retirement.
How pension levelling might help
Pension levelling is an option which allows DB members who are planning their retirement to re-shape their benefits, so that the shape of their overall income throughout retirement better suits their needs.
It is achieved by giving members the choice to increase the scheme DB pension received in the years up to state pension age, in exchange for a reduction in their scheme pension beyond state pension age. The calculation is designed such that their overall income from the DB scheme and state pension is broadly level throughout retirement (with the overall value of the member’s benefits from the scheme being unchanged).
Increasing the starting level of pension, through levelling, also has the benefit to members of increasing their maximum tax-free lump sum. In a recent exercise, we found that, for many members, the impact was an increase of 25% or more.
The potential benefits of pension levelling for sponsors
With a backdrop of increasing DB deficits over several years, sponsors are quite sensibly focusing on providing flexibility to pension scheme members only if it is aligned with the wider objective of controlling DB pension costs and risks. In this regard, pension levelling is potentially a good fit.
- Levelling reduces the scheme’s long-term exposure to interest rate, inflation and longevity risk, by bringing forward pension payments. Furthermore, to the extent the option results in people retiring earlier and taking more tax-free cash than would otherwise be the case, the reduction in risk is even more significant.
- In addition, for many schemes, early retirement and the exchanging of pension for cash at retirement can lead to improvements in a scheme’s ongoing funding and accounting positions (due to the way actuarial conversion factors are typically calculated).
- These financially beneficial changes in member behaviour can potentially be recognised up front by reflecting updated member behaviour in the actuarial assumptions used to measure liabilities. This can help improve a sponsors’ accounting balance sheet and reduce future deficit contribution requirements.
When considering offering any new member option, it will be important for sponsors and trustees to weigh up the potential benefits against the potential challenges. Considerations include:
- The additional administrative complexity.
- The implications of increased cash requirements on the scheme’s investment strategy.
- Tax implications for members.
- The potential impact on PPF levies; and
- How any increase in early retirements might impact the wider business needs.
It will also be crucial that any such option is carefully communicated with members so that they can make fully informed decisions regarding their retirement (indeed as mentioned in Jonathan Camfield’s recent blog it is worth considering more widely whether members might be given access to cost-effective financial advice).
Due to some of the factors mentioned above, offering levelling will not be right for all schemes. However, for some schemes the potential benefits for members and sponsors could be significant. Therefore, it is definitely worth considering whether it should be part of your liability management tool box.
For more on pensions levelling watch our latest video
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