CROYDON, England - Philips Electronics U.K. Ltd. will adopt a defined contribution plan for new employees in April 1997, one of the few British companies to make the leap to money purchase schemes.
Philips is the latest example of British companies and U.K. subsidiaries of multinational companies overhauling retirement income plans. The change has dramatic implications for corporate pension liabilities, investment managers, capital markets and plan participants.
Officials at virtually every U.K. company are examining whether to adopt defined contribution plans. Few have made the switch. Among those that have: retailer W. H. Smith & Sons (Holdings) PLC, Abington; insurer Legal & General Group PLC; and brewer Whitbread PLC, Luton. Most cover new employees, not upsetting previous arrangements.
For Philips, the impact on its retirement income and investment management arrangements are significant:
New employees joining on or after April 1, 1997, will be covered by a defined contribution plan that probably would offer a small number of investment options plus lifestyle funds as a fallback option. Current employees can switch if they choose.
Philips' internally managed 1.5 billion ($2.3 billion) final-pay defined benefit plan will be frozen. That will drive the plan's ratio of retirees and deferred vested employees to active workers as high as 90% by 2000, from 67% now, said David Fry, managing director of the Philips pension fund.
The shift in maturity level likely will cause the defined benefit fund to boost its bond holdings substantially, possibly to 50% of assets from 15% last year. In fact, Philips trustees just authorized a boost in fixed-income holdings to 35% of assets, Mr. Fry said.
The increasingly mature liability structure, combined with a shrinking asset base in real terms, might cause Philips trustees to seek external money management for part of the pension fund. Trustees are expected this month to review a study by William M. Mercer Ltd., London, as to whether investment management should be outsourced.
If outsourcing is adopted, and subsequent study results in a specialist approach, Philips' internal managers might end up focusing solely on U.K. equities. But there's a good chance even U.K. stocks might be outsourced eventually, as total equities shrink to 500 million to 600 million in real terms by 2000 - from 1.1 billion now, Mr. Fry said.
Curbing liability exposure
Three factors prompted the move to defined contribution, said Mr. Fry, who took on the task of revamping the pension fund after serving as finance director of the U.K. operation. (Philips is a wholly owned subsidiary of Dutch electronics giant Philips N.V.).
First, the company wants to limit its liability and exposure to volatility. Unlike some companies exploring the defined contribution route, cost savings are not expected to be significant.
"Philips does not like the open-ended nature and unpredictable costs associated with final salary schemes," Mr. Fry said.
Philips, whose stock is listed on the New York Stock Exchange, is obliged to report its consolidated pension fund obligations on a marked-to-market basis under Financial Accounting Standard 87. In contrast, U.K.-listed companies must report on SSAP 24, which smoothes out volatility from equity investments.
Second, the increased mobility of Philips' workers makes a defined contribution plan more desirable. Benefits generally are better for employees leaving the company under a money-purchase scheme than under a traditional final-pay plan, thus making it more attractive to younger workers.
Third, the switch enables Philips to include shift pay for blue-collar workers and commissions for sales staff in pensionable earnings. Now such earnings are not included in calculating employee pensions, although they comprise a significant chunk of regular pay for many.
Including such pay in calculating pensions in the defined benefit plan would have been prohibitively expensive because of the past-service costs involved, Mr. Fry said. By contrast, building such pay into the defined contribution plan formula involves future accruals only, while still satisfying the concerns of Philips' unions and sales staff.
Pension surplus used
What will enable Philips to engineer the change, however, is that the surplus from Philips' overfunded defined benefit plan will cover the company's contributions to the money-purchase scheme until at least 2000.
The problem for Philips in creating a defined contribution scheme, as for many U.K. companies, is that the company would have to make immediate payments to the new scheme. In contrast, Philips has enjoyed a contribution holiday to its defined benefit plan for six years.
To avoid a drain on corporate cash flow, Philips will need to design the new defined contribution plan as part of the original 1954 trust deed, instead of as a completely separate fund. That way, it will be able to transfer assets to the defined contribution scheme.
If all goes well, Philips will avoid making contributions to either plan until at least 2000. The defined benefit plan, last valued at 119% of liabilities a year ago, has seen funding levels decrease marginally because of benefit improvements.
Going to defined contribution
Creating a defined contribution scheme for Philips' largely blue-collar work force will be a challenge. The plan design process, which is being conducted with the help of Bacon & Woodrow, Epsom, won't be completed until June, and won't be announced formally until October. That gives Philips trustees six months until they "go live."
While Bacon & Woodrow has been hired by the trustees, parent company Philips engaged KPMG Actuaries & Pension Consultants, London, to separately review any retirement plan changes, recognizing the potential conflict of interests between the plan and its sponsor.
Mr. Fry expects the new plan will offer employees a number of different contribution levels, depending on their ability to save.
Also, Philips probably will offer a limited number of investment options, such as a bond and a balanced income fund, from one or more service providers able to offer additional choices down the road.
"We almost certainly will offer a default lifestyle" investment option, he said. Lifestyle funds, with differing risk profiles based on employees' ages, would enable workers who failed to make their own investment choices to be invested safely.
British workers generally are unaccustomed to making investment decisions. Mr. Fry estimated 80% of Philips' workers initially might not pick their own asset mix, and instead resort to the lifestyle option. Philips trustees also might consider appointing an independent financial adviser to educate plan participants - and to assume any potential liability for offering investment advice.
Investment management for the money-purchase scheme will be provided by outsiders - in marked contrast to fully internal staffing for Philips' defined benefit plan. Philips executives insisted on outside money management, Mr. Fry said. If assets were run internally and performed poorly, the company would have a moral obligation - if not a legal one - to put in more money, he said.
Meanwhile, KPMG is reviewing Philips' internal back-office staff, which already handles the defined benefit plan, to determine whether it is capable of administering the defined-contribution scheme.
Defined benefit changes
Closing off the defined benefit plan also suggests major changes for its management.
The growing maturity of the scheme already led Philips trustees to invest 15% of assets in index-linked gilts three years ago. In late February, trustees agreed to boost the bond component to 35% of assets, with a minimum of 25% invested in index-linked bonds. But closing the scheme will cause trustees to commission a new asset/liability study.
Meanwhile, consultants at William M. Mercer are about to hand in a study on the fund's current investment management structure. Mr. Fry speculated the consultant might call for outsourcing large chunks of the internally managed fund, and concentrating the efforts of Philips seven-person in-house investment team solely on U.K. equities.
Andrew McGaw oversees the investment team: two U.K. equity portfolio managers, one European manager, one North American manager, one Far Eastern manager and two traders.
The eventual shrinkage of the U.K. equity portfolio, however, might lead to outsourcing that portion of the portfolio as well. For Mr. Fry, overhauling Philips' retirement income arrangements probably will be his last major project at the company. After revamping the program, Mr. Fry himself will be eligible for retirement in June 1997 - after 40 years' service at the company.
