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Defined Contribution

U.K. experts: Just say no to capital buffer requirement

Reserve cited as worry for sponsors moving to collective DC structure

Steven Taylor is no fan of the capital buffer but said its absence could adversely affect retiree benefits.

Any final design for a collective defined contribution plan structure in the U.K. should not require a capital buffer fund, many retirement experts told the government.

In an effort to help employers make the transition to defined contribution arrangements from defined benefit, the U.K. government in November asked executives at U.K. retirement plans, money managers and consultants to describe an optimal CDC plan design that could be universally adopted by the majority of plan sponsors. The deadline for responding to the government's consultation was Jan. 16.

This type of employer-sponsored plan pools savings and investments, and shares risk across plan participants. CDC plans do not promise a specific benefit, but have a target payout amount.

The aim of the consultation was to find a consensus on plan design so wording to facilitate the offering of CDC plans then could be worked into a pension bill, should the government decide to move forward on crafting enabling legislation.

Under a CDC structure, plan participants' retirement outcomes could be 30% higher than under other DC designs, according to a U.K. Work and Pensions Committee paper published July 11, which cited research by Aon.

One thing that came through in executives' responses was their opposition to a capital buffer that has been integrated into CDC systems in other countries, including the Netherlands. But finding a way to protect the target benefit without such a reserve fund is a concern.

A buffer account is funded by employer contributions and is used to make good on the targeted payout during economic downturns so participants don't see a reduced benefit.

Executives responding to the U.K. consultation request agreed that a CDC design using a classic capital buffer such as in the Netherlands would be detrimental to plan sponsors. Any U.K. design, they said, should leave out the buffer.

Periods of poor performance could deplete the buffer in the short term (as happened in the Netherlands) and result in benefit cuts, experts said. Instead of using the buffer to soften market impact, they said benefit targets should move in line with inflation, which would protect these benefits from being cut at a later date.

Another reason to leave it out is the issue of intergenerational fairness.

"We agree in relation to single-employer plans that no explicit capital buffer should be incorporated. If there was one, it would be intergenerationally unfair, for example, because such a buffer will be built up in the early years for the benefit of those joining later," said Kevin Wesbroom, principal consultant, and Matthew Arends, head of U.K. retirement policy at Aon, both in London, in response to the consultation.

Steven Taylor, London-based partner at Lane Clark & Peacock LLP, said in the firm's response: "The exclusion of capital buffers is a key design feature that we agree with, but has the potential effect of increasing the volatility of target benefits."

"In periods of poor performance, this (lack of a capital buffer) means that future indexation (of pension benefits) effectively takes the role of absorbing shocks, resulting in lower target benefits, and if poor performance is sustained for long periods, accrued benefits could also be cut back," Mr. Taylor said.

The U.K. Association of Consulting Actuaries, in its response, pointed out "the lack of a capital buffer is likely to increase the level of volatility in target benefits. Each year, the target benefits will change based on investment returns achieved and best estimates of the future. There would be no scope to smooth results (by) using part of the capital buffer in bad years and then replenish the buffer in better years." Hugh Nolan, chairman, ACA's defined contribution committee, said in a telephone interview that "there shouldn't be a buffer in a Dutch sense." But, Mr. Nolan said, "there should be a safety margin" in the plan design and "high enough value of expected benefit increases."

Royal Mail example

One U.K. employer, Royal Mail PLC, London, already is considering a CDC plan. The plan sponsor of the 9.6 billion ($12 billion) Royal Mail Pension Plan developed a CDC arrangement with an alternative capital buffer for employees of its mail services group — a model of which the U.K. government is fond.

Simon Eagle, director, retirement at Willis Towers Watson PLC in London, said "the Royal Mail design features an alternative mechanism (to a capital buffer) designed to reduce volatility of pension increases, and reduce the risk of cuts."

In this design, the funding will be spread over the long term, Mr. Eagle said. "The contributions include a material amount of 'headroom' funding for future increases, and as long as the assets are not well behind track, there would not be a pension cut."

This headroom funding is gradually spent on providing increases to benefits, rather than being held back to mitigate a potential future cut, Mr. Eagle added.

But some sources said Royal Mail's plan, which doesn't formally use the term capital buffer, is indeed following the approach.

Michael Johnson, research fellow at the Centre for Policy Studies, a think tank in London, said in his response to the consultation that even though the Royal Mail's proposal is "careful" to avoid the word buffer, it does refer to "headroom."

"(The headroom) is manifested as the present value of future pension increases through indexation. Consequently, it would be an artificial construct determined by long-term assumptions about the future investment returns or longevity," Mr. Johnson said, warning the reserve would be even less resilient in this format than a classical buffer.

"Royal Mail seeks to avoid intergenerational issues when managing asset value volatility by applying the same percentage increase or decrease to the annual rate of escalation for all members' pensions," Mr. Johnson wrote.

He argued that Royal Mail's proposed flat-rate contribution of 13.6% of pay is not allocated equally across the generations.

A spokesman for Royal Mail declined to comment about the issue around the capital buffer.

Even with no buffer built into the plan design, should enabling legislation move forward, the question remains about how intergenerational fairness would be addressed in the optimal CDC structure for U.K. employers.

One option is that employers could adopt different tiers of benefits depending on age, with smaller target benefits accrued by older members than younger members for the same contribution rate.

Acceptable

"This is acceptable from a non-discriminatory point of view because the basic premise of this design is equality of contribution rate and therefore this model for CDC should be expressly permitted," Aon's Messrs. Arends and Wesbroom noted in their response.

However, for U.K. employers to truly embrace CDC, retirement industry experts say, any forthcoming legislation would need to specifically state the plans would not be treated as defined benefit funds in the future.

And that employers would not potentially be on the hook for past benefits.

The current lack of clarity in existing U.K. regulations means employers fear they might find themselves liable for any shortfall in the target benefit, unless specific legislation is passed.

"Employers will not want to commit to this new pension arrangement if there is such a risk. Therefore, non-legislative options are not viable in making clear where CDC schemes fit into the current pensions framework," Messrs. Arends and Wesbroom said.

The government's response to the industry suggestions will be published between late February and late March, according to a U.K. Department for Work and Pensions spokesman. In that response, "we will discuss the government's plans for the next stages," the spokesman said.