The United Kingdom Pension System - Case Study Example

Pensions: Financial Analysis and Risks Executive Summary Recently, it has been seen that employers prefer to switch from Defined Benefit (DB) pensionscheme to Defined Contribution (DC) pension schemes for their new employees, and also a gradual transition for old employers. Many regulations and difficult financial situation of pension funds has accelerated this trend. Employers see a lot of advantages in switching to DC schemes. The investment of pension funds into several equity, debt, and hedge fund instruments is also being explored to ensure that employees benefit from the switching of schemes. A pension is a steady income promised to a person, usually after retirement. They can be in the form of a guaranteed annuity or a cash balance that an employee can draw upon at retirement. A pension that is created by an employer for an employee is known as an occupational pension. The government or other organisations may also sponsor pensions. Pension plans are a form of deferred compensation. The United Kingdom pension system is characterised by three tiers. The first tier is that of Basic State Pension (BSP) which is provided by the state. There are several pension schemes in the second tier. The state, employers, or private sector financial institutions provide these schemes. These pension schemes may be divided into two broad types: Defined Benefit (DB) pension schemes, and Defined Contributions pension scheme (DC). The DB schemes include the State-Earning-Related-Pension Scheme (SERPS), and occupational pension schemes provided by employers. The DC schemes include the contribution pension schemes offered by employers, and the personal pension, or a stakeholder pension fund held with a financial institution. The third tier of UK's pension system is voluntary and it takes the form of additional voluntary contributions (AVCs and FSAVCs) into occupational or personal pension schemes. DB and DC schemes The pension schemes we need to focus on behalf of the company are occupational pension schemes. A Company in UK can offer their employees a Defined Benefit Final Salary pension, or a Defined Contributions Pension scheme. A traditional pension plan that defines a benefit for the employee upon that employee's retirement is a Defined Benefit pension scheme. In the DB pension scheme, the retirement pension benefits are related to the member's final salary upon retirement, and length of service. This is a "funded" plan in which both employer and employee contribute towards the pension fund. A DC pension scheme is a scheme that provides an individual account for each employee participant. The benefits are solely on the amount contributed to the account, gains, expenses and losses allocated to the account. The plan contributions, which are fixed for both the employer and employee, are paid into the account for each member. These contributions are invested and the returns are also credited to the individual's account. On retirement, the member's account is used to provide retirement benefits. This is usually through the purchase of an annuity that provides regular income post retirement. The members also have the option to draw a certain lumpsum amount before purchasing annuities. These plans also may offer the facility to members to select the types of investments towards which the pension funds would be allocated. Relative Merits of DB and DC Schemes The contributions in case of DB schemes are higher to keep up with the cost of providing the defined retirement benefits. It is even higher for employers relative to employees. DB plans offer less mobility than the DC plans because the transfer costs and difficulty in transfer of funds is very high for the DB Plans. DC plans offer higher portability. Both the DB and DC plans offer tax relief on contributions to employers. Tax relief is usually higher in case of DB plans due to higher contributions. Unlike the DB schemes, in a DC scheme a member cannot predict his pension at the time of retirement, as it is difficult to predict what capital he will accumulate at the time of retirement. Individuals with higher earnings benefit more from the income tax relief on contributions in DB schemes. DB schemes are more attractive to employees with higher income growth, low-income risk and longer job tenure. In case of a company with this category of employees, the DB schemes are better subscribed by employees. DC schemes are preferred by individuals with higher job mobility or shorter job tenure. Individual with high earnings also like to subscribe to DC pension schemes, but they are not much preferred by employees with low earnings as they turn out more costly for them due to high set-up and administrative costs. Advantages and Disadvantages of Switching from DB to DC Scheme The switch from DB to DC has more advantages than disadvantages for a company. More and more firms are switching to DC schemes. This is a trend that has become strong over the last several years with many companies opting to switch to DC schemes. This is due to several factors as outlined below. Today the trend is towards earlier retirement. Increased longevity added to this means a longer period of retirement. This means unexpectedly large cost burdens for firms. The members drawing pensions today is larger than those contributing to the pension fund. For each older worker, the contributions need to be larger. This increases the cost to companies. Running a DB scheme entails high costs and increasing uncertainty of those costs. Planning cost controls is very difficult with DB, as there is no certainty of investment returns, salary inflation, longevity and government regulations etc. With the maturing of DB pensions, there are no surplus or contributing holidays that can be enjoyed by the company. According to regulations today, surplus' of DB scheme is taxed while shortfalls have to be made up totally. This is a deterrent to savings of surplus, and leads to difficult times during deficit years. Numerous legislative changes on DB pensions have increased the cost of compliance and of paying pension to a huge extent. These changes have also increased the complexity of DB schemes and made them expensive to run. The risk of low investment returns and inflation are borne by the employers solely. The introduction of FRS17 accounting standard have taken away the ability to smooth market movements, making the liabilities values look bigger than the asset values in certain years. When the EU Discrimination legislation comes into force in 2006, the costs would further increase by a huge amount. Governments are often tempted to impose extra tax burdens, in the form of taxes or regulations, on DB schemes when they are in surplus. Such actions weaken the scheme. Costs of maintaining the DB pension schemes can push the weak employer to insolvency. DB is not as flexible as DC. Workers can't choose their retirement age in DB schemes. Workers who are highly mobile tend to lean on transfer value calculations when they move. These calculations are not transparent. Hence it is not favoured by workers. Advantages of adopting DC Schemes In DC schemes, the risk of inadequate income at the time of retirement and investment shortfalls rests with the individual rather than the company as in DB. There is more certainty and control of costs of pension provision (no promise of pension by employers). There are fewer problems of compliance with regulations like LPI, WFR, FRS17 etc. Increased visibility of contributions to employees. It increases the ability of the employers to offer more flexible benefit packages e.g. guaranteed scheme, market-linked scheme, option to employee to exchange lower pension contributions for higher salary, health cover etc. The most important advantage for an employer to opt for a DC plan is the opportunity it offers to reduce costs by lowering contributions. The only disadvantage of a DC scheme for an employer is the inconveniences and costs of setting up and administering the new scheme. Also, while in a DB scheme the investment performance of the pension fund affects the security of the pension, but in DC it affects the amount of the pension. Risks and Returns of Investing in Equity and Bonds The world over, pension fund managers recognise the importance of investment returns in real terms. The long vesting period during the working life of a participant means that unless accumulated contribution grows at a real rate, the workers may face destitution after retirement. The contributions are also subject to post-retirement hyperinflation. To address the two issues of returns and inflation, investment in equity stocks is a viable option. They can provide high returns on investment as well as hedge the risks from inflation. Equities are inherently risky and are not suitable for those with lower risk tolerance. Excessively risky investments also entail less diversification of assets such that asset allocation decisions become very critical. The world over it has been shown that over long tenures, equities provide higher returns than risk-free options. So it is imperative that funds invest in equity. The investment should be diversified to reduce the risk. Investing in indexed securities is also an option. Even with stock market volatility, the medium term average return is higher than market-based return on bonds. Currently in UK, about 62% of pension funds are invested in equity. This is higher than other European countries. It has declined in recent years. Bonds The risks involved in investment in bonds are less than that of equities. Bonds provide a fixed return to investments. But these returns are much less compared to investment in equities. The risk from inflation is also very high because they do not provide hedge against inflation. Long-dated bonds are not available so the reinvestment risk of government bonds is very large. Adding inflation linkage to the pension liabilities, it may make a solvent pension fund insolvent in the future. In case of marketable bonds, the returns are quite volatile. In case of a limited supply of bonds, additional demand for bonds from pension funds could result in pricing distortions and overemphasis on public sector bonds. This could hamper allocation of pension savings to growth-enhancing investments. Market based return on bonds is lower than in equities. A portfolio invested completely in government securities has higher risks than a portfolio that includes both debt-equity mixes. Risks and Returns from Hedge Funds Hedge funds are private investment partnerships in which the general partners make a substantial personal investment. There are several benefits to investing in hedge funds: Hedge funds provide help to lower the volatility in a portfolio through diversification. Hedge funds are flexible investment options and can invest in a variety of instruments like stocks, bonds, currencies, commodities and gold, while using lots of leverage. Derivatives are used only for hedging purposes. They also are usually tax-free. Many hedge fund strategies hedge against downturns in markets being traded. They benefit by weighing hedge fund managers' remuneration towards performance incentives. Performance of many hedge fund strategies is not dependent on directions in bond or equity markets, and so are not 100% exposed to market risks like bonds or equity. The favoured hedge fund strategy for pension funds is Fund of Funds, which shows very low volatility while providing very high returns. There are certain conditions which make hedge funds a viable option for pension funds: Much more due diligence is required on the part of trustees to understand the working of hedge funds. There are certain risks like operational risk, keyman risk, counter party risk, and other specific risks associated with hedge funds, which the trustees should take account of while investing in hedge funds. Recommendations A switch from DB pension scheme to a DC pension scheme is desirable for a company in today's scenario, with assurance of certain safeguards to ensure the welfare of workers. The investment of pension funds should contain an equity-debt mix in its portfolio, so as to allay risks from volatility and inflation or low returns. Hedge funds are a good option for investment, but only if the pension fund is large, there is an option of a long lockup period, and there is a strong reason to justify paying huge hedge fund manager fees. To reduce inflation risks investment should lean more towards equity. The employees should be informed about the risks and benefits of investment in DC schemes. They should also be encouraged to contribute well in the pension schemes so as to secure their future after retirement. References Cocco, J.F. and Lopes, Paula. " Defined Benefit or Defined Contribution An Empirical Study of /Pension Choices" 4 Jul. 2004. [Online] "Defined Contribution Pension Arrangements: Choosing the right one for your staff." National Association of Pension FundsLimited. [Online] "European Institutional Market Pplace Overview 2006." Mercer Investment Consulting. [Online] www.mercerIC.com Friedman, Dion. "About Hedge Funds Strategies." 2001. [Online] http://www.magnum.com/offshore/hedgefunds/mystery.asp Liang, Bing. "On the Performance of Hedge funds." May 1998. [Online] http://www.edge-fund.com/lian98.pdf> "Occupational Pension Schemes 2004: the twelfth survey by Government Actuary." Jun 2005. The Government Actuaries Department. [Online] www.gad.gov.uk/Pensions/Final_Report_Jun2005.pdf Ray, Udayan. " Should Pension Funds Invest in Equity."16 Oct.2003. [Online] www.outlookmoney.com Read More