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The Actuary The magazine of the Institute & Faculty of Actuaries

Flexible accrual pensions

In recent years a number of factors including lower investment returns, lower mortality rates, accounting changes, and changes to legislation have prompted sponsors to review their pension arrangements.
It is generally accepted that ‘alternative designs that represent a fairer share of risk for the various interested parties involved’ are required [Fleming et al, 2003”. The first report of Adair Turner’s Pensions Commission highlighted the need to encourage pension saving and demonstrated the potential future social cost of a failure to address the country’s pension provision.
A traditional final salary pension scheme promises to pay each member a fraction of his or her final salary for each year of service. This fraction is described as the accrual rate and values of 1/60 and 1/80 are common. The main variant of this design is a career-averaged revalued scheme (or CARE scheme) where the pension is based on the average earnings of the employee. In this article I consider a new kind of defined benefit design called ‘flexible accrual pensions’, which is not based on a fixed accrual rate or a member’s earnings.

How are the benefits calculated?
Each year the benefit promised to a member of a flexible accrual pension scheme is calculated by multiplying together two components: the amount of money the member contributes to the scheme and a ‘conversion rate’. The conversion rate is defined as the amount of pension in real terms the sponsor will provide at the member’s normal retirement age for each pound of contribution. The sponsor reviews the conversion rate annually.
For example, at the beginning of the year the sponsor could offer a particular member £1 of pension per annum in real terms at age 65 for every £1.50 contributed from his monthly salary.

Cost control
One major advantage of a flexible accrual pension scheme is that it allows the variation of pension costs each year to be shared between members and the sponsor. The conversion rate quoted by the sponsor would be calculated by finding the expected cost of benefits and subtracting the level of contribution the sponsor wished to make. Hence, changes in mortality, expected investment returns and even legislation could be integrated into ongoing pension promises.
Flexible accrual pension schemes could follow a range of investment strategies that, combined with the assumptions used to derive the conversion rate, would significantly affect the level of risk taken by the sponsor. However, combining a prudent conversion rate based on the yields on index-linked gilts and strong mortality assumptions with a low-risk investment strategy would provide a defined benefit alternative for sponsors who consider traditional final salary schemes too risky.

The low level of participation rates in occupational pension schemes is symptomatic of the failure of sponsors to communicate the benefits of joining their pension scheme. I am not proposing that this design is a panacea for all sponsors’ communication problems but I believe that it goes some way to addressing a number of issues.
One advantage of this design over traditional defined benefit structures is that the pension promised is described as a monetary amount in real terms. This removes the complexity associated with definitions of pensionable salary, averaging periods and methods of indexation, all of which can lead to confusion.
This method of setting pension promises demystifies the situation for people who change employer. The benefits offered would be unaffected by members leaving the scheme or stopping contributions.
The rate of contribution required by members to receive a particular level of pension would be controlled by a number of factors including the expected investment returns and mortality rates. Hence, the conversion rate quoted to members would be changed each year depending on the underlying cost factors. This may be perceived to be a serious communication problem.
I believe that although it is not necessary for every pension scheme member to understand the detail of actuarial technique, it is essential to communicate to members that the cost of pension promises depends on how long people live and what investment returns pension funds receive.
Building a culture where members understand the benefits and the sponsors’ actions are transparent is likely to lead to members valuing their benefits. Sponsors may be able to profit in the short term from members’ misconceptions but it is unlikely to be a strategy that is viable in the long run.

Nowadays employees are looking for greater choice in the way they are rewarded. Flexible benefits schemes are becoming popular, particularly with large employers.
Flexible accrual pensions empower employees to take control of their own reward. Employees who are more interested in retirement benefits have the opportunity to accrue pension quickly. The design also allows younger employees and those with lower disposable income to benefit from a pension without paying a contribution rate that they perceive to be too high.
This is a desirable feature of the benefit structure from the point of view of the sponsor. It allows benefit provision to be targeted at a wide range of different types of employee without requiring a complex array of different pension schemes.
Some sponsors find that the interaction of salaries and pension benefits in traditional defined benefit schemes make it difficult to set an appropriate overall reward package. The design outlined in this article separates these two elements of an employee’s benefits package and hence allows a greater range of options to be considered when setting reward strategy. Flexible accrual pensions would also integrate effectively into a flexible benefits package where employees make an annual review of their benefits.

Certainty of benefits
In recent years sponsors have been closing traditional defined benefit schemes and switching to defined contribution schemes. The sponsor’s cost of providing a defined contribution scheme is unaffected by investment returns and mortality experience. This makes them effective at controlling sponsors’ costs and they are less risky for sponsors than defined benefit schemes, including the proposed flexible accrual pension scheme.
However, there is a burden of both risk and responsibility placed on a member. For members of a defined contribution scheme to receive the pensions they desire at retirement they have to decide on appropriate levels of contribution and manage both the risks of poor investment performance and the factors affecting annuity prices. In theory there are a number of rules of thumb, computer packages and advisors available to help members mitigate the risks associated with defined contribution schemes. However, in practice there are doubts about the number of members who are using such tools.
According to recent studies more than 80% of members of defined contribution schemes invest in the default option [Bridgeland, 2002”. This may suggest that many scheme members are not making informed investment choices. A flexible accrual pension scheme removes the requirement for members to make these decisions.
Many actuaries believe the minimum risk investment for an individual targeting a particular level of pension at retirement consists of a portfolio of bonds of appropriate duration. Members of defined contribution pension funds are rarely provided with more than one over five-year index-linked government bond fund and an over 15-year fixed-interest bond fund. These funds are insufficient for many members to build the necessary portfolios to minimise their risk.
However, if a sponsor were to set up a flexible accrual pension scheme the trustees would have a much greater range of investments (including derivatives) available. They would also be able to obtain large economies of scale when paying for investment advice. Therefore, flexible accrual pensions could reduce both the costs of advice and the unrewarded reinvestment risk faced by members of defined contribution schemes trying to achieve a target level of benefit using a minimum risk investment strategy. This element of members’ risk reduction would have no corresponding cost to the sponsor.
The average contributions to defined contribution schemes from members and sponsors have been generally lower than to defined benefit schemes [NAPF survey, 2004”. This may suggest that members of defined contribution schemes are over-estimating the benefits they will receive when they reach retirement. Flexible accrual pensions would remove the need for members to estimate an appropriate contribution rate and would eliminate this area of uncertainty for individuals.

Although flexible accrual pensions considered in isolation are an interesting alternative to traditional defined benefit and defined contribution schemes they could also be used as a building block to create further pension scheme options.
One option would be using flexible accrual pensions to provide a top-up to a traditional final salary or CARE scheme benefit with a low accrual rate.
Another possibility would be to provide flexible accrual schemes alongside a defined contribution structure as a ‘sponsor guaranteed’ option. This would be attractive to risk-averse members but could have low sponsor costs and risks.

A viable option
Flexible accrual pensions provide new solutions to a range of problems faced by sponsors including communication and cost control. They address the needs of members by providing secure, flexible benefits that are easy to understand. Although flexible accrual pension schemes are not a universal solution to sponsors’ pension problems, they provide a viable design option for those who are looking for an alternative to traditional defined benefit and defined contribution structures.