LONDON - Large U.K. companies might adopt hybrid pension schemes to take advantage of a cost-cutting loophole in new government contracting-out rules.
Major U.K. employers - such as Guinness PLC, Bass PLC, GKN PLC and Nestle UK Ltd. - are exploring the option, which could save large employers millions of pounds.
By installing a money-purchase feature in their existing defined benefit plans, employers with older work forces could save 1% to 3% of payroll, said Paul Greenwood, a research actuary with William M. Mercer Ltd., Chichester.
If adopted widely, the loophole could cost the U.K. government 1 billion to 2 billion annually ($1.55 billion to $3.1 billion) in rebated National Insurance contributions, he estimated. That's equivalent to 3% to 6% of the government's 1996 deficit, and probably is a cost the government might not be willing to bear for very long, experts said.
Some pension experts also believe adoption of hybrid schemes may lead British employers further down the road of replacing their defined benefit plans altogether with defined contribution schemes, because they already will have to create individual record-keeping systems for the hybrid plans.
Installing a money-purchase element is "a bit like putting a toe in the door," said Tony Thurnham, a partner with the law firm of Linklater & Paines, London.
"It is something we are looking at," said David Coles, group pensions manager for West Bromwich-based Bass.
"We're right in the thick of thinking of this right at the moment," said Chris Lewin, head of group pensions at Guinness, Edinburgh.
The regulations, issued in early July, affect plans that contract out of the U.K.'s State Earnings Related Pension Scheme, and thus provide benefits at least as good as those from the supplementary state scheme.
Under last year's Pensions Act, employers have to make a new election as to whether to contract out between Jan. 1, 1997 and Jan. 31, 1998. In reality, employers will need to decide by the fourth quarter of this year, Mr. Greenwood said.
For the first time, the pensions law enables employers to combine defined benefit and defined contribution elements in the same plan on a contracted-out basis, known as Contracted Out Mixed Benefit Schemes.
Not only that, but the law also changed the basis on which rebates from National Insurance are calculated. Currently, employees chip in 10% of annual pay between 3,172 and 23,660 to National Insurance to cover pension contributions, while employers contribute on a sliding scale up to 10.2% of an employee's total pay.
Until April 1997, both defined benefit and defined contribution plans will receive a flat-rate rebate of 4.8% of eligible earnings when they opt out of SERPS. After that date, rebates from final salary plans have been trimmed to 4.6%.
But the big change is that rebates from defined contribution plans now will be tied to employees' ages.
Rebates for money-purchase schemes will range from 3.1% for employees who are 15 to 9% for ages 47 and over. (A flat rate of 3.1% will reduce employer and employee National Insurance monthly contributions while the additional 0% to 5.9% would be rebated at the end of the government's fiscal year.)
That means an employer with an older work force can gain substantial savings by adopting a money purchase feature to provide floor benefits, topping them up to promised levels with the defined benefit plan.
Benefits consultants predict companies with older work forces could save 100 to 200 a year per employee. For a 10,000-employee company, that could mean savings of more than 1 million a year.
Some consultants believe the money-purchase rebate will lead scores of large British companies to adopt a defined-contribution feature. "People who stay with the flat-rate rebate will be motivated by inertia," said Alan Jenkinson, policy director for Sedgwick Noble Lowndes Ltd., Croydon.
Ronnie Sloan, partner for Scotland for consulting actuaries Punter Southall & Co., Edinburgh, said the rebate is less important than providing an alternative for companies whose final salary plans encounter problems meeting the government's new test for defined benefit schemes. Establishing a money-purchase element might be cheaper than improving benefits, he said.
Regardless of the motivation, establishing a money-purchase element within the defined benefit plan has its attractions. The employer's pension contribution should not be any greater than before. Assets still could be commingled, thus enabling pension funds to maintain their high equity exposures. In contrast, a separate defined contribution plan likely would have a greater weighting in lower-returning fixed-income vehicles, thus driving up employer costs.
However, there are a few snags that may make employers pause.
The biggest obstacle is the additional administrative costs from creating individual accounts, though experts said the rebates should more than offset these costs in companies with older work forces.
Other potential pitfalls exist.
Pension executives need to figure out what returns to attribute to the money purchase element.
Guinness' Mr. Lewin said the money-purchase portion could use the return for the pension fund as a whole, or might seek a more stable basis that would smooth out volatility. Bass' Mr. Coles said the notional return could be tied to the Financial Times All-Share Index or the fund's return.
Establishing a money-purchase floor also might not be attractive for employers still enjoying a holiday from pension contributions, since they would be required to make a minimum payment into the money-purchase element. But the trend is toward ending pension holidays.
Certain restrictions also apply to money built up in individual money purchase accounts, said Martin Slack, senior partner at Lane Clark & Peacock, a London-based actuarial firm. For example, assets can't be withdrawn before age 60 and cannot be distributed in lump sums, in any case, he said.
The biggest long-term risk to employers is that government will wake up to costs and cut the money-purchase rebates.
"The government didn't intend for defined benefit plans to do this," Mr. Sloan said.
Theoretically, the government's Department of Social Security could trim the rebates with a year's notice. But the rebates are set on a five-year basis, and experts believe it would be politically unpopular for the government to change its policy before that time period elapsed.
"In reality, (the government) wouldn't be likely to change (the rules) until they see how many people are likely to take advantage" of them, Mr. Sloan said.
For the longer term, experts said there is significant risk that rebates for money-purchase schemes might be lowered eventually, thus eliminating the cost advantage for some plans.
"One must reckon it won't last forever," said David Morgan, group pensions manager for Nestle UK Ltd., Croydon.
In that case, employers need to decide whether the money-purchase element is appropriate for their plans.