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UK leads search for a pensions plan that works: Part 1

UK leads search for a pensions plan that works: Part 1 Anthony Harrington

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What to do about pensions? There is something obviously morally reprehensible about a company benefiting from the working life of an employee before punting them out as aged persons without a care in the world about how the ex-employee puts food on their table thereafter. This, as much as a paternalistic feeling of responsibility towards the workforce, is what got companies started down the defined benefit company pension route in the first place. Today, defined benefit (DB) pension schemes are the tail that wags the dog for many companies. The liabilities that have mounted up in the shape of contracted benefits to pensioners and future pensioners are often way in excess of the company's ability to pay, threatening the company itself with ruin and liquidation.

Not surprisingly, DB schemes have become anathema to many finance directors, who would dearly love to dump such schemes in favor of the far less costly defined contribution (DC) schemes, which have the huge merit, from the employer's point of view, of dumping all the risk onto the employee. However, from the employee's standpoint, very few of them are knowledgeable enough to shoulder this burden, or even to realize that the final pension pot that is likely to be delivered by their DC scheme will fall massively short of what they need to avoid penury in their old age. There is nothing inevitable about this in the structure of DC schemes; it all comes down to how well they are funded - and all too many employers do no more than the law demands from them by way of contributions to the DC scheme.

With DB and DC as the two extreme ends of the market, as it were, there should be room for a middle ground that combines the virtues of both while avoiding some of their noxious side effects. Various countries have explored various options to achieve some kind of half way house between DB and DC schemes, and now the UK is setting off down this same path in search of a pensions formula that will balance the risks rather more "evenly" between employers and employees. Alternatively, the government could simply follow the Australian model and make it compulsory for companies to pay a solid chunk, say 14% of payroll, into the company DC scheme. That would provide a reasonable pension pot for employees while avoiding dumping the investment risk back onto companies. However, many countries, the UK included, seem to feel that this would be an unwarranted tax on business that would destroy the ability of their private sector base to compete internationally.

The UK is coming at the pensions problem from two complementary directions. The first approach has seen the UK shifting to the Australian auto enrollment approach, where employees of all stripes, down to almost the lowest paid, are automatically contracted in to a DC workplace pension scheme by their employer. This approach has the singular merit of having the enormous power of inertia on its side since employees have to decide to opt out, so doing nothing commits them to saving something for the future - which is a whole lot better than nothing and inculcates the right habits, from the government's perspective. States across the globe are desperately trying to extricate themselves from the crushing burden of unaffordable benefits promises and pushing the burden off onto private individuals is really the only way of achieving this sustainably - assuming the individuals can take the strain and it doesn't simply lead to rioting in the streets!

The second approach has been to mount a consultation exercise on what a half way house between DC and DB schemes might look like. This was launched in November 2013 by the UK pensions minister Steve Webb and the various options for the half way house were grouped together under the heading "Defined Ambition" (DA) schemes (a heading that has the merit of giving us a neat set of acronyms, DA, DB and DC, to describe the options for workplace pensions).

The UK consultation paper will be explored in the light of two other options, the Dutch collective DC model and the Danish DC model, in Part Two.

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Further reading on pensions and liabilities:

Tags: Australian model , defined ambition , defined benefit , defined contribution , Dutch collective model , liabilities , middle way , pension funds
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