Similar to many states in the U.S., Britain's government is putting public-sector pension reforms at the forefront of the political agenda amid one of the nation's most severe fiscal belt-tightening periods.
In a keynote speech at the National Association of Pension Funds Investment Conference 2011, John Hutton — a former secretary for work and pensions in the U.K. who led an independent commission on the public pension system — is calling for “a balanced deal for public service pension members and taxpayers.” Recent economic pressure is “requiring companies, individuals and governments across the developed world to rethink their approach to pensions,” he added
The issue was among several topics addressing fundamental changes to help secure the future of pension funds — whether defined benefit or defined contribution — discussed at the conference, held in Edinburgh March 9-11.
“It's not a question of whether we need reform — it's a question of what reforms we need,” Mr. Hutton said. “This is reform for the long term; not in response to the fiscal pressures currently facing the country, but in response to the pressures on these schemes that have built up over decades.”
The cost of public pension plans has risen by about a third since the 1950s, he said. Separate government data estimated the value of unfunded pension liabilities in the public sector at around £770 billion ($1.2 trillion) in 2008, the latest available.
“The current final-salary schemes are not suitable for a modern work force,” Mr. Hutton said. They unfairly benefit employees with higher salaries toward the end of their careers, expose taxpayers to more risks if salaries rise more quickly than expected, and “create a barrier” for employees moving from the public sector to the private sector, he said.
While rejecting a move to DC from DB — as some U.S. state governments have done — Mr. Hutton is proposing a shift to career-average plans from final-salary plans. He is also calling for an increase in the retirement age to 65 and eventually 66; current retirement age is usually around 60, but employees in certain public sectors can retire as early as 55.
To protect taxpayers, there should be a cost ceiling to ensure that future costs of public pensions are effectively controlled, he maintained. “One of the biggest risks … is longevity,” he said at a news conference after the speech. “We've got to have shock absorbers.”
While defined benefit systems remain prevalent in the public sector, about one in five — 17% — of private-sector DB plans are frozen, according to the NAPF's annual survey released during the conference. That compares with 7% in 2009 and only 3% in 2008.
“The findings point toward a new phase in the decline of final-salary (defined benefit) pensions,” according to an analysis of the survey results.
Only 21% of all private-sector DB schemes surveyed remain open to new members, compared with 88% 10 years ago. Furthermore, a third of the private DB plans are planning to make changes for existing members, such as cutting benefits or moving staff to a DC pension plan, according to the survey.
In contrast, the vast majority of public-sector employees in the U.K. are enrolled in final-salary DB plans. As in the U.S., unprecedented budget constraints are forcing politicians to implement fundamental changes to public pension provisions.
“Change on this scale cannot be achieved overnight, and the journey to full implementation may well be a difficult one,” Mr. Hutton said. “But I believe that the package of reforms I have recommended is the best chance we have of achieving a sustainable public service pensions system.”
Separately, a more efficient DC framework spurred debate among attendees at the NAPF conference. In the U.K., DC assets still lag far behind DB, but they are expanding at a much faster rate and now total about £500 billion, according to data from the NAPF.
Robert C. Merton, professor at the Massachusetts Institute of Technology's Sloan School of Management, said in a presentation that “the whole core of DC plans … is centered around the wrong goal, the wrong target.”
“What I'm proposing is the next-generation DC plan,” said Mr. Merton, co-winner of the 1997 Nobel Prize in economics for his work on options pricing. One major difference between Mr. Merton's model and current DC plans is the end goal. He proposes that the focus should be on inflation-protected annuities, priced in what he dubbed “annuity income units,” rather than a lump sum of accumulated assets.
In “Pride and Prejudice,” Jane Austen wouldn't describe “Mr. Darcy by saying he was worth £100,000,” Mr. Merton said. “She'd say that he was worth £5,000 a year. That's how we usually think of our standard of living.”
According to Mr. Merton, an efficient DC model would need to be tailored to individual needs and account for other income such as that from Social Security, defined benefits or individual retirement accounts. Furthermore, the portfolio should take into account changes such as increases or decreases in salary, inflation and interest rate risks.
On investments, Mr. Merton didn't detail specifics, but said “no plan should have, as its linchpin, alpha.”
“I'm not saying that you can't have alpha (in the portfolio), but to make that as a linchpin for the plan is aggressive,” he added. “The system should work without alpha. If you do add alpha — all the better.”
Crucially, any DC plan design “has to work even if people don't look at it,” Mr. Merton said. Current DC plans “require employees to make decisions on investments which they have not had to make in the past, are not prepared to make in the present and will not be able to make in the future, even if we educate them.”
Mr. Merton is working with Dimensional Fund Advisors, which acquired Mr. Merton's retirement-planning software company SmartNest in 2009. The DC model touted by Mr. Merton is already being used by the defined contribution plans at Philips Electronics NV in the Netherlands and Germany. The first U.K. client is expected to be announced this year.