Topping up the piggy

Employers have had a pretty rough time in the past few years in many areas of law '“ employment law, health and safety, directors' liability '“ but pensions has probably been one of the more intractable. There are a couple of reasons for this.

The first has been the decision of the legislature to change the deal in relation to any defined benefit arrangements that have been in place, sometimes for decades. In summary, any intended defined benefit arrangements have now to be guaranteed, backed by adequate assets, reflected in company accounts as if they were a crystallised debt, and index-linked. These and other changes have made it difficult for all but the most generous and well-capitalised of employers to continue with such schemes without a great deal of effort, despite the intention of human resources' (HR) directors to be competitive for scarce labour, and the increasing desire by employees for such benefits.

The second reason has been the inexorable growth of rules and regulations. A recent study by Perspective, the leading pensions information service, suggested that whereas there were about 60 pages of legislation and government rules in the early 1970s, this had risen to over 45,000 pages by 2007. The cost of compliance has risen to levels which are not only hard to pay for, but also difficult to understand. And penalties for breach of the rules are now material.

The penalties imposed by HM Revenue and Customs for breach of their simplification exercise enacted in the Finance Act 2004 are so penal that sensible senior counsel have advised they probably breach the human rights legislation '“ and have risen from about 1,300 pages to about 3,600 pages of rules and regulations. And the introduction of a new pensions regulator, a pensions protection fund and various tribunals and other bodies has meant that enforcement has become a small industry on its own, despite the obligation of regulators to be proportionate and reasonable, which they have mostly been, at least at the senior level.

Counter-productive rules

Consequently many employers have been seeking to close to new employees, or even for existing employees, future accruals of benefits in any existing pension schemes. And counter-productive rules have meant the imposition of what are very high costs on employers that wish to close their schemes.

In some cases employers have to insert sufficient cash to enable schemes to buy benefits from insurance companies (the so-called s75 buy-outs) which are very expensive, because insurers have to largely invest in bonds (an expensive asset at the moment), and maintain solvency reserves and ensure a return on capital, not necessary or intended when occupational schemes were established in the first place.

The legislation that controls such changes now often requires an application for clearance from the pensions regulator to ensure that no personal liability will fall on the directors and advisers of corporates that re-arrange their pension funds; the clearance procedures, and the costs, delays and complexity of such requirements, are yet other factors leading to the decline of such schemes. So it is not surprising that many employers, determined to cut not only pension costs, but also legal and compliance costs, are looking at alternatives. Some of those are discussed below, and explore some of the factors that go to develop a pensions strategy for employers.

Pension provision

The first thing employers need to decide is whether they are in the business of pension provision at all. At first glance it does seem curious that employers do get involved '“ they do not provide food, housing, cars (these days) or education. What they normally provide is remuneration out of which employees can make their own decisions. And indeed many employers do just that.

The main problem is that HR directors often find they need to provide a decent pension system to recruit and retain the best employees (increasingly as pensions become more important in the hierarchy of wishes for employees) and that such benefits are best provided by employers '“ rather than say by insurers (who are expensive and whose systems often fail) or by governments.

Government (state) pensions are a major issue for employers. National insurance (NI) is expensive, and pension benefits paid for through NI are complex and difficult. Government pensions provide material income only for those at the very lowest of the income scale. The basic state pension (now in five different varieties, Class A, B, C, D and E '“ the 25p a week added to pensions for those over age 80) offers around £87 a week provided there has been a full NI record (44 years for men, 39 years for women). It will provide less for those without a full work record.

The second state pension (S2P, formerly SERPS, the State Earnings Related Scheme) is available only to the employed, involves a mixture of earnings-related and flat rate benefits, and is for all but actuaries, impossible for most employees to understand. Contracting-out of the second state pension is now particularly unattractive (because the reduction in NI contributions for electing to make one's own provision for the S2P is not adequate) that contracting out is foolish for most employers, who only continue to do so because of the costs of changing.

Government pensions also involve two more arrangements. If the first two pensions do not add up to around £120 per week, then there is a third state pension '“ this time means-tested. The application form is 36 pages and in due course around 80 per cent of the relevant population are expected to need to make application. It is means-tested the other way too '“ applicants who have made savings are entitled to a top-up as an incentive to save.

In case this is all too simple, a fourth state pension is to be introduced in 2012; personal accounts will involve a contribution of 4 per cent from an employee, 3 per cent by the employer and 1 per cent by the government so that 8 per cent will be paid into a private account. Its future is uncertain and may suffer the risks that many very large computer systems may undergo '“ and may be inappropriate for many lower-paid employees. In the meantime employers have to enable employees to be able to make their own contributions through stakeholder pension systems in the payroll systems.

With this as a background, what is it that employers should do now, with a complex and possibly dysfunctional state system, and a complex and expensive private regulatory framework?

Options for employers

The options available for employers depend on the objectives; retention and recruitment, paternalistic objectives, a desire not to be approached for financial support by longstanding employees in later years, and easier redundancy programmes where employees can afford to retire. Option one, of course, is to do nothing. There is no obligation to make pension provision outside the social security system.

Option two is to continue (or even establish) a defined benefit scheme. Even at modest levels these are increasingly attractive to employees who are particularly worried about their increasingly longevity (improving at a rate of about two-and-a-half years for every decade, or six-hours-a-day) and need some top up to a complex and inadequate state pension. The risks for employers are not always easy to manage at the higher levels of benefit, but modest accrual rates are still manageable for most employers '“ and if the scheme is registered overseas, as is now possible under the IORPs (or European Pensions) Directive 2003, the UK prohibition against risk-sharing schemes can be avoided.

Such schemes give an intention to make defined benefit arrangements '“ but without having to give a guarantee that might affect the balance sheet of the employer.

Option three is to establish some variety of defined contribution scheme. These are simply a form of tax-neutral savings arrangements, with the proviso that the savings can only be used to protect against the financial consequences of living too long. There seems to be an infinite variety of these schemes, but there are two main possible arrangements.

One is to establish an occupational pension scheme, with trustees, but with much lower compliance costs, and simply provide a fixed amount, say 5 per cent of salary, or perhaps matching employee contributions up to a maximum amount. Unless contributions totalling at least 15 per cent of salary over the lifetime are placed in a pension, the benefits are likely to be modest and provide only a modicum of income replacement.

Contributions can be placed with a wide range of insurers or asset managers, and the system can be very cost effective '“ and attractive provided some part of the sponsor's budget is put into communication about the advantages. Alternatively group personal pensions can be organised, perhaps with the employer picking up the tab for administration costs, and the employee the investment management costs. For higher paid employees, versions of self-invested personal pensions (SIPPs) are attractive.

Keeping it simple is critical. And having an eye to what may happen on a change of control of ownership is also sensible. Although the TUPE rules now apply to pensions, they do so in an unthreatening way, and usually pose few challenges to an acquirer. More contentious is where there is a defined benefit scheme in place, it is underfunded to some degree, and a purchaser proposes to acquire the sponsor and run it as a much less capitalised operation, perhaps by increasing its borrowings '“ a favourite private equity strategy. Such a procedure leaves the sponsor enfeebled to such an extent that it concerns the trustees about the future ability to maintain the scheme and meet already acquired liabilities. Under the post-Pensions Act 2004 rules, trustees can in many cases demand substantial payments, at a level which can prejudice the deal. Now that the Pensions Regulator can impose personal liability for deficits on company directors or their financiers and advisers, such practices would best be managed by seeking a clearance certificate from the Regulator that the transaction is not one that he considers is one that was intended to allow a company to walk away from its pension obligations.

Decade long challenge

Pensions have proved a major challenge to employer sponsors in the past ten years; and the state system does not help in determining corporate pensions policy. But there is no doubt that pensions are becoming ever more important to employees, and that the opportunities for decent pension provision without excessive governance costs are now improving. Campaigns to reduce the obnoxious, excessive and unnecessary HMRC rules are likely to prove successful in the medium term, and the Department for Work and Pensions has an exercise in progress to make life simpler on the general regulatory front.

The opportunities offered by the European pensions directive to register UK schemes outside the oppressive UK regime are attractive and still being explored, and the work offered to lawyers by continuing investment, trusteeship and corporate issues seems unending.

Until we work out ways of knowing how long we are going to live, corporate pension provision will remain an attraction to both employers as a way of attracting the best employees, and to employees as the most efficient way of making provision for retirement income for an uncertain lifetime.