How about limited defined benefit as the next employee attraction tool?

The war for talent is raging. Attracting and retaining skilled employees is on the agenda of almost all UK company boards. Unlimited holidays, free gym memberships, the list of benefits seems almost endless.

Except it does end when it comes to private sector employers looking to guarantee a level of income for employees in retirement. That has become ever rarer.

“It’s ridiculous to think about new defined benefit (DB) schemes”, I hear you cry. There have been harsh realities of running defined benefit schemes since the financial crisis – falling gilt rates and longer life expectancies generating sometimes crippling ‘deficits’, which companies have battled to rectify for the best part of 20 years. To meet the expected cost of that year’s accrual of new pension, it has been very common for the percentage of an employee’s salary needed to be north of 50%. Compared to even generous company contributions to the typical benefits, that is way above the typical pensions costs.

Hold on a minute though. Interest rate policy is now in a very different place with 12 interest rate rises since the start of 2022. That cost of equivalent new benefit build up might now have halved. So what if we took the lessons we have learnt over time and actually considered offering employees some level of limited defined benefit pension again. It would undeniably be a powerful attraction for catching the eye of prospective future employees. What if the new scheme looked something like this:

• A 1/100th accrual rate ?- so a career of service somewhere might get you a third of your average salary during a career’s service
• Career average earnings – avoids risks of material cost increases from late spikes in salary, subject to a cap
• Pensions without inflationary linkage where legislation allows (although my preference would be that legislation permitted possibly non-increasing pensions also), or some kind of conditional indexation only if funding allows
• Higher earners would be able to top up with a defined contribution (DC) fund to supplement a foundation level of income from the DB scheme

But surely, there is still too much risk involved, even when just targeting the foundation of guaranteed income for employees? Think about that though, and use all those lessons from the past:

• We would look to provide a foundation of benefit for employees in retirement that they can rely on and build from. There would be no ￡75k+ p.a. pensions in this kind of scheme
• Contributions for future benefit accrual could be set to move if market conditions change for employees and the company – cost sharing
• An investment strategy that hedges gilt rates as soon as benefits are crystallised – i.e. attempt to minimise volatility from gilts rates at the outset
• A single, simple benefit structure
• Limited risk from high inflation
• Rules which allow the employer to adjust future benefits if needed
• Corporate powers to return surplus on wind-up – the scheme is designed to deliver these benefits and only these benefits. If the scheme succeeds and delivers benefits at lower cost than expected, the employer has its money returned
• Extensive communication around benefits to support members’ engagement throughout

The attraction of increased certainty about at least part of an employee’s retirement income, would be a very attractive prospect for many. By considering something like this, an employer would be offering valuable support to its employees of today and tomorrow. Employers are crying out for an eye-catching way of attracting and retaining new employees and this would be a way of doing that.

Currently the benefit described might incur a cost of around 18% of the employee’s salary. If a member paid 7%, it would then be 11% for the employer. Benchmarking data from Aon would suggest the median employer contribution rate available as the maximum for a typical UK DC scheme is around 10%. I’d therefore conclude this isn’t necessarily any more expensive than your ‘typical’ DC scheme, based on current market conditions.

Members living longer brings risk, but if anything, sadly our estimates in the last 10 years are proving optimistic in terms of over-estimating longevity. There is risk associated with this of course, but as there is with leaving valued employees with DC pensions that can be volatile and at risk of poor retirement outcomes.

Am I expecting a revolution?

Not necessarily – though I would be delighted if some employers would consider the option. I’m not saying for example that the risk of legislation changes is not there. In my opinion we have generally made operating legacy DB schemes too difficult for employers. I feel this links back to how we govern DB schemes now and continue to operate them.

We weren't intending to pay for insurance policies for all members; rather it was supportive employers looking to attract and retain employees with a guaranteed income in retirement, within a company run pension scheme. I have tried to think how a modern benefit design could look to mitigate these risks with lower-risk assets, minimised exposure to inflation and a focus on a guaranteed base income for a wide range of employees.

There is of course a natural middle ground here from the evolution of collective DC, stopping short of guaranteeing incomes but targeting certain benefits with pooled risk between members.

Hindsight is a wonderful thing, but let’s look forward. I am asking the question whether it is possible to learn the lessons of the last 40 years and to provide something that can cost-effectively deliver guaranteed incomes - at some level - for people in retirement. I think some organisations could do this and there is a strong commercial imperative for them to consider it.