CIPD - Occupational pensions: strategic issues

Pay and reward

Revised April 2009

This factsheet gives introductory guidance. It:

focuses on issues in the provision of occupational pensions
recognises that organisations are reviewing their pension arrangements in light of changes in demographics, the law, government policy and employment patterns
examines the different types of scheme
summarises the law and ongoing reforms
includes the CIPD viewpoint.

Strategic occupational pension questions

Organisations planning to review their existing pension arrangements should ask:

Why have an occupational pension scheme?

All organisations employing five or more staff have to offer access to a stakeholder pension scheme. So for the majority of employers the decision is not whether to offer access to a pension scheme, but whether to contribute to one and if so, which type. The decision will reflect the organisation's overall benefits strategy that is aligned to organisational objectives.

The objectives of providing an occupational pension scheme can include:

provision of a competitive benefits package to aid the recruitment and retention of employees
meeting the needs of employees
managing pension costs effectively.

Do employees currently value pension benefits as part of the remuneration package?

After basic salary, pension schemes are usually the most costly element of the remuneration package, especially for older workers. For a pension to be an effective benefit, employees must understand its value to them. In general, pension arrangements which are simple to understand are more likely to be valued by employees. However, the degree of flexibility and choice within a pension scheme should depend on the profile of the employees. For example, a pension scheme offering a wide range of sophisticated investment choices may be suited to a company in financial services but may not be suited to a manufacturing company. Similarly young employees may be attracted to employers offering opportunities for career advancement, work life balance and competitive salary. However, older employees may be more attracted to competitive retirement packages, health care benefits and good salary.

Is the value of the pension benefit effectively communicated?

Effective communication is essential to raise employee awareness and understanding of pension schemes. Research shows that the more effective the communication, the more a benefit is valued by staff. But most communication around pensions takes place at the recruitment and selection stage or during the induction process, rather than on an ongoing basis.

Useful communication could include:

Written information including simple explanatory booklets, annual pension benefit statements, information in pay slips, transfer values, options for paying additional voluntary contributions (AVCs) and early retirement options.
Access to telephone helplines which are direct to pension administrators or investment managers in order that employees faced with pension choices can receive direct assistance.
Face-to-face financial education progammes.
Interactive computer software to educate employees about their scheme and to show, for example, projected benefits and options.

Good communication practice includes:

Communication material should reflect the brand of the employer and its philosophy and culture.
Material should be targeted and written as plainly as possible.
Front line managers should be involved in the communication process.
Not only should the message be about what the scheme is and how it works, but why it is important to plan for your financial future.

For more information on this topic, see our guide on pension communication.

Go to Pension communications: realising the value

Are the employees financially aware?

An organisation may offer an excellent pension scheme to attract and retain staff. However, if employees lack financial understanding then this investment may be wasted. To help employers to build financial education programmes, we have produced a guide on workplace financial education.

Go to Workplace financial education: a win-win proposition

Does the organisation have high levels of flexible working arrangements?

Flexible working can be linked to part-time work, career breaks, contract work and phased retirement. Employees involved are unlikely to be satisfied by a single, rigid final salary vehicle, which is designed for long term, continuous career patterns. For example, currently, many part-time employees are incorporated into a final salary scheme by notionally adjusting their salary and service into a full-time equivalent. The complexity of the calculation can be an administrative burden and lead to confusion about pension entitlement. It may be appropriate to provide pension entitlement for contract workers where they are viewed as a regular and important part of the workforce. In these circumstances, there are other forms of defined benefit scheme which are more flexible than final salary schemes, such as those which base pensions on career-average earnings. Such arrangements automatically adjust for varying part-time employment. Alternatively, a pension scheme based on a money purchase arrangement may provide greater satisfaction to the employer and employee.

Does the organisation have high labour turnover levels?

High levels of labour turnover could mean a substantial proportion of the workforce qualify for little or no pension benefit under a final salary scheme. Conversely, such a scheme in an organisation with low turnover rewards long service with high levels of pension benefit.

The organisation should consider, in line with benefit strategy objectives, how it wishes to reward service. For example, if the organisation seeks to reward long service, then a career average or final salary scheme may be appropriate. Alternatively, if the organisation wishes to attract and encourage a highly mobile workforce a money purchase scheme or mix of pension arrangements may be more effective. An employer may offer a defined contribution scheme initially and then a defined benefit scheme after a number of years.

What culture does the organisation want to achieve?

When building future pension arrangements, consider the role the employer wants to play in employees' retirement planning.

Organisations wishing to take responsibility for employees' financial security in retirement, or provide employees with a limited choice in pension options, may feel a final salary scheme, where employers take the investment risk, is appropriate.

Alternatively, the organisation may wish to promote a culture of partnership or self reliance in retirement planning. In this case, a flexible pension scheme, where benefits can be traded within the remuneration package, and/or a money purchase pension arrangement, where employees make investment decisions concerning their retirement and are fully exposed to investment risks, may be desirable.

A halfway measure can be achieved by providing employees with a basic level of 'core benefits', combined with a limited degree of flexibility to enable them to trade benefits within a remuneration package.

A 'hybrid' arrangement could be appropriate where a final salary pension benefit is provided for older, long serving employees and money purchase arrangements for younger, highly mobile employees.

To what extent does the organisation want to differentiate pension benefits on grounds of seniority?

Older employees or senior executives may prefer a final salary pension arrangement. Organisations wishing to differentiate pension benefits could consider higher scales of benefits for senior employees and/or 'hybrid' pension arrangements.

How important is control of costs?

Both final salary and money purchase schemes can be designed so that, in the long term, they result in similar costs. However, costs for final salary schemes are more volatile than money purchase schemes - because final salary pension costs depends on a number of unknown factors, such as return on investments, wage inflation, and life expectancy.

If it is essential to control pension costs, a money purchase scheme offers greater, consistent, cost stability.

Has the organisation acquired, or does it intend to acquire, other companies?

If so, it is highly likely a variety of pension schemes operate. This can make pension management complex and limit a coherent remuneration approach. In these circumstances, a flexible remuneration strategy, including flexibility in pension level design, can be beneficial.

Is the organisation an international company?

A multinational company may wish to harmonise its pension arrangements. However, differing tax and social security laws can make this difficult to achieve. Consistent principles can, however, be applied and global companies usually need to set a framework within which retirement benefits are designed and funded world-wide. As a minimum, organisations need to ensure that internationally mobile employees are covered by coherent pension arrangements.

How should new pension arrangements be introduced?

Where possible, existing employees should be given the option to remain in their current pension arrangements, particularly employees who are nearing retirement. Therefore, a hybrid pension approach can be particularly effective during transition to new pension arrangements. Under these circumstances, different pension arrangements may be applied to existing and new employees. Employers should be alert to the potential dangers of having employees who are in very different pension arrangements doing the same work.

What are stakeholder pensions?

Essentially, stakeholder pensions are low cost personal pensions regulated by the government and provided through pension companies. All employers who employ five or more staff are required to provide access to an approved stakeholder pension scheme, and deduct and pass on employee contributions to the scheme.

All stakeholder scheme have the following features:

Employees can make contributions from their pay, tax-free, to a defined-contribution (money-purchase) pension scheme.
Pension provider companies cannot charge stakeholder members more than 1.5% of the fund per annum for the first 10 years (1% thereafter).
Employers are not required to make contributions to their employees’ stakeholder pensions.
There are two types of scheme:
- trust-based schemes - these are allowed to restrict membership to certain groups, for example trades union members, and are governed by normal pension scheme legislation
- contract-based schemes - these are open to all and must have an FSA (Financial Services Authority) authorised scheme manager.
All schemes must be registered with the Pensions Regulator – registration information is available on their website (see Useful contacts below).

As an employer, you are not required to set up stakeholder pension provision if:

you employ fewer than five workers (if your workforce increases from 4 to 5 employees, you have three months to comply with the requirements)
you already offer an occupational pension scheme that all employees (except those under 18 and within 5 years of retirement) can join within a year of starting employment or you offer a group personal pension (GPP) scheme with an employer’s contribution of at least 3% of basic pay and no exit charges.

In addition, access to stakeholder pensions does not have to be provided for employees who earn below the lower earnings limit for National Insurance Contributions or who have been employed for less than three months.

When determining whether existing schemes remove the obligation to set up a stakeholder pension scheme, the access rules of the existing provision must be taken into account. For example, if access to your occupational pension scheme is restricted to employees aged over 21, then you would be required to offer a stakeholder pension to those employees aged between the ages of 18 and 21. In these, and similar circumstances, you ought to consider whether it would be more cost-effective to extend the entry limits for existing schemes or to retain the existing scheme in its current form and introduce the stakeholder pension alongside it.

Comparison of final salary and money purchase schemes

Final salary	Money purchase
Benefits defined as a fraction of final pensionable pay	Benefits purchased by accumulation of contributions invested
Benefits do not depend on investment returns or annuity rates	Benefits dependent on investment returns, contributions and costs of annuities at retirement
Employer contributes necessary costs in excess of employee contributions	Employer contributions are fixed
Employer takes financial risk	Member takes financial risk
Early leavers often suffer a loss as benefits are broadly linked to prices rather that earnings	Early leavers generally do not suffer a loss because their account remains invested within the scheme
Benefits designed for long serving employees with progressive increases in pensionable pay	Benefits designed for short serving employees or those whose pensionable pay fluctuates

Final salary defined benefit schemes and money purchase arrangements broadly represent two ends on scale of risk; the employer bearing most of the investment and life expectancy risks with the final salary, and the employee with the money purchase. However, other arrangements such as career average schemes can limit the defined benefit risk while cash balance plans can give a degree of certainty under a money purchase scheme. Cash balance plans originated in the USA. Typically the employer agrees to credit an employee's account with an amount each year - say a percentage of salary - and an interest credit, which may be a fixed rate or a variable rate that is linked to an index (eg RPI + 2%). The employee receives this agreed amount at retirement to buy an annuity so ultimately bears the longevity risk. The investment risks and rewards on the plan assets before retirement are borne by the employer. There is scope for problems with early leavers, who can find that, on transfer out, their cash equivalents are lower than the current level of cash balance of the plan.

'Hybrid' schemes can include features of both final salary and money purchase arrangements.

Pensions and the law

There is much legislation governing pension schemes - details are available from the Department for Work and Pensions.

The type and size of benefits from approved occupational schemes are restricted by HM Revenue & Customs (HMRC - formerly the Inland Revenue) limits - further details and the latest figures are available from the HMRC.

The Finance Act 2004

In the 2004 budget, the Chancellor announced a new tax regime that came into effect from 6 April 2006, known as 'A-day'. This simplified the existing eight tax regimes with their associated annual limits on contributions and limits, replacing them with a single, lifetime allowance (LTA) of £1.5 million on the amount of pension saving that can benefit from tax relief. This amount is being uprated in pre-determined stages to £1.8 million in 2010. These pre-determined increases include allowance for inflation. Thereafter, there will be a review of the lifetime allowance level and indexation every five years, with the first review in 2010. There is also to be an annual contribution limit of £215,000 for 2006, rising to £255,000 in 2010.

Other aspects of the Act which came into effect include:

a tax free lump sum worth up to 25% of LTA
death benefits will only be limited by the LTA
being able to work and draw a pension from the same employer
an increase in the minimum age (from 50 to 55) from which a pension can be drawn will take effect from April 2010; employers have the option if they wish to phase in this increase over the four year period.

The Pensions Act 2004

The Pensions Bill received Royal Assent in November 2004 and has come into force in stages. Provisions of the Act include:

A Pension Protection Fund (PPF) provides a minimum level of benefit for members of under-funded defined benefit schemes where the sponsoring employer has become, or is danger of becoming, insolvent.
A Financial Assistance Scheme (FAS) to help some members of underfunded schemes which wound up and where the employer was unable to make up the deficit.
A new proactive Pensions Regulator replaced the Occupational Pensions Regulatory Authority (OPRA).
Occupational schemes can reduce the cap on the limited price indexation pension increase from 5% to 2.5% for future pensionable service, or for future contributions to defined contribution schemes.
Relaxed restrictions surrounding contracting out for money purchase schemes and personal pension plans.
Treatment of pension contributions during paid paternity and adoption leave brought into line with such treatment during maternity leave.
TUPE legislation extended so new employers match employee contributions up to 6% for a stakeholder pension or offer an equivalent alternative where pension rights have been established - see our factsheet on the transfer of undertakings for more information
- Go to our factsheet on TUPE
Replace the minimum funding requirement (MFR) by a new scheme-specific regime.
Launch a web-based retirement planner in 2006 which will signpost users to non-governmental sources of independent and impartial advice.
Require trustees to understand relevant scheme documentation and have an appropriate knowledge and understanding of pensions and trust law.
Make it a statutory obligation for employers to consult pensions scheme members before making significant changes to future pension arrangements.
Introduce new rights for employees who leave scheme after a short time.

Age discrimination legislation

The new age discrimination regulations which came into force in October 2006 have had a wide impact in many areas of employment. For general information on this, see our factsheet on age issues in the workplace. CIPD members can also see our factsheet on age discrimination in reward issues.

Further pension reform

In 2002, Adair Turner was appointed Chairman of the Pensions Commission and was asked by the Government to consider the case for increasing compulsory saving for pension provision. The Commission’s first report¹ gave a thorough analysis of the UK pensions system; the second report², published in November 2005, gave policy recommendations. A final report³ published in March 2006 dealt with some of the issues raised in the second report.

The two main recommendations were:

to encourage more saving for retirement by creating a national Pension Savings Scheme
for the basic state pension to be indexed to earnings instead of inflation, and that the state pension age should rise to 66 by 2030, to 67 by 2040 and to 68 by 2050.

The Government has taken the broad thrust of the Pensions Commission. The Pensions Acts of 2007 and 2008 include:

Between 2012 and 2015, the basic state pension will be re-linked to average earnings. The state second pension will be reformed to become a simple, flat-rate weekly top to the basic state pension by 2030.
From 2010, reform of the contributory principle by streamlining contribution conditions to the basic state pension, reducing the number of years need to qualify to 30.
Extending working lives, gradually increasing the state pension age in line with gains in average life expectancy. There will be a rise from 65 to 66 over a two year period from 2024, then again by one year over a two-year period from 2034 and from 2044.
Abolishing contracting out for defined contribution schemes at the same time as re-linking the up-rating of the basic state pension to average earnings.
Reducing burdens on schemes by bringing forward legislation to allow schemes to convert guaranteed minimum pension rights into scheme benefits.
From 2012, a new scheme of ‘personal accounts’ to which employees will contribute 4% of earnings between the lower and upper earning limits. Employers will make minimum matching contributions of 3% on the same earnings band. A further 1% will be contributed via normal tax relief. There will be support for all employers during the introduction of compulsory employer contributions: contributions will be phased in over a three-year period, at the rate of 1% a year. The contribution rate will be set out in primary legislation. The Government will consult on transitional support for the smallest businesses and whether a longer phasing period is needed for them. There will be automatic enrolment for employees into either the new national savings scheme or their own employer’s occupational pension arrangements provided it meets a minimum standard. Employees will be able to opt out of this provision, in which case the employer does not need to contribute.
Creation of the Personal Accounts Delivery Authority (PADA), setting out its constitution, functions and how it is to be managed. Initially, PADA will be set up to act as an advisory body, providing advice to Government on policy development before the planned introduction of personal accounts in 2012.

CIPD viewpoint

CIPD recognises that occupational pension provision is a significant strategic issue for organisations. In many organisations, access to an occupational pension forms an integral and valuable element of the benefits package. During much of the post-war period the mainstay of occupational pension provision has been the final salary or defined benefit structure. The pressures of an ageing population, greater flexibility in working patterns and retirement age, the changing balance between private and public pension provision and increased pension regulation are all having an impact on traditional ideas about pension provision.

Organisations face a range of challenges, including:

providing cost effective occupational pension schemes which meet both employer and employee needs, and offer long term stability
communicate and educate staff about their pension scheme (greater emphasis on non-state provision places further responsibility on individuals to plan for retirement- regular and accessible information is critical to inform retirement choices and the success of the pension scheme)
managing occupational pension schemes within the law's parameters (regulation has provided pension holders with greater protection, but made pension scheme management more complex - organisations should ensure they keep abreast of legal developments to protect members and avoid risk of liability).

CIPD and the Pensions Management Institute (PMI) caution that the area of pensions is complex, and recommend no action is taken to change existing arrangements without professional guidance.

Useful contacts

Department for Work and Pensions – pension reform overview
HM Revenue & Customs
The Pension Service - part of the Department for Work and Pensions
Pensions Information Line: tel: +44 (0) 845 731 3233
Pensions Regulator
Personal Accounts Delivery Authority
Pensions Management Institute (PMI)

References

PENSIONS COMMISSION. (2004). Pensions: challenges and choices. London: The Commission. Available at: http://www.pensionscommission.org.uk/publications/2004/
annrep/index.asp
PENSIONS COMMISSION. (2005) A new pension settlement for the twenty-first century. London: The Commission. Available at: http://www.pensionscommission.org.uk/publications/index.asp
PENSIONS COMMISSION. (2006) Final report. London: The Commission. Available at: http://www.pensionscommission.org.uk/publications/index.asp

Occupational pensions: strategic issues