THE NEW CONTRACTING-OUT TERMS

Transcription

1 THE NEW CONTRACTING-OUT TERMS BY S. A. FOX & A. R. HEWITT (A paper presented to the Society on 18 January 1983) 1. INTRODUCTION 1.1 THIS paper looks at the new financial terms for contracting-out which will operate during the 5 years commencing 6 April In the remainder of this section we briefly review the background to the terms which operated during the first 5 years of contracting-out, while in 2-6 we consider the individual elements of the new terms. In 7, we describe how projection techniques can be used to determine whether the new terms may be favourable for a particular group of employees. 1.2 The framework of the current earnings-related State pension scheme was first proposed in September 1974 in the White Paper 'Better Pensions'. The White Paper emphasized the need for an earnings-related component to build on the basic flat-rate pension, together with the need for full inflation-proofing of State pensions. 1.3 In recognition of the large proportion of the population that was already covered by 'final salary' occupational schemes it was proposed that the new State scheme should operate in partnership with such schemes. Thus occupational schemes of a sufficient standard would be permitted to 'contract-out' and accept responsibility for paying the guaranteed minimum pension (or GMP, broadly equivalent to the earnings-related State pension), the members and their employers in return paying reduced rates of National Insurance (NI) contribution. 1.4 In view of the limited degree of post-retirement escalation granted by occupational schemes at that time, it was proposed that the State should accept responsibility for increasing members' GMPs once in payment. However, it was proposed that schemes be required to revalue preserved GMPs in line with average earnings up to State Pensionable Age. 1.5 For simplicity it was proposed that a uniform contribution reduction should be assessed every 5 years. This would represent the expected cost to a typical scheme of providing its members with GMPs, the cost being averaged over all the members. Because of the accelerated maturity provided under the new State scheme in the form of higher accrual rates for older employees, the contribution reduction would become progressively smaller at each reassessment. 1.6 The Government Actuary's calculations initially indicated that a contribution reduction of 6½% of relevant earnings would be appropriate. However, following representations regarding the unfavourable age/sex distribution of 67

2 68 S. A. FOX AND A. R. HEWITT some schemes and the open-ended nature of GMP liabilities, the Government conceded as a 'risk concession' a further ½% contribution reduction. Thus the Social Security Pensions Bill which was laid before Parliament incorporated a 7% contribution reduction. 1.7 The Bill also contained provisions for the 'buying-back' of short service early leavers on payment of a Contributions Equivalent Premium (CEP) equal to the total NI contribution reduction enjoyed. For early leavers with preserved GMPs, the options were either to revalue the GMP up to State Pensionable Age in line with the rise in average earnings (under Section 21 Orders), or to restrict the revaluation to a maximum of 5% per annum in return for payment of a Limited Revaluation Premium (LRP). A subsequent amendment introduced as a further alternative the fixed rate revaluation option, involving no premium payment, the fixed rate initially being specified as 8½% per annum. 1.8 The facility for a scheme to cease to contract-out and to reinstate its GMP liabilities into the State scheme was provided in the form of 'buy-back' premiums Accrued Rights Premiums (ARPs) for GMPs not yet in payment and Pensioners' Rights Premiums (PRPs) for GMPs in payment. Originally only one set of premium tables was proposed, but in response to fears regarding the solvency of a scheme forced to wind-up at a time of depressed asset values the index known as the Market Level Indicator (MLI) was introduced in order to adjust the buy-back premiums to reflect current stockmarket conditions. A further concession that was introduced to protect solvency during times of high inflation was the option to revalue accrued GMPs at the rate of 12% per annum for the 5 years prior to winding-up, regardless of the actual rise in average earnings over that period. 1.9 Under the new contracting-out terms to apply for the 5 years commencing 6 April 1983, the contribution reduction is to fall to 6¼% of relevant earnings and a new MLI formula is to be phased in. The remaining terms, including the various early leaver options and the 12% per annum revaluation safeguard, are unchanged. 2. THE 6¼% CONTRIBUTION REDUCTION 2.1 In assessing the initial contribution, reduction for the Government Actuary assumed in particular a net rate of interest of 1% per annum up to State Pensionable Age coupled with a 9% per annum rate of interest for GMPs in payment, and a 7% loading for the expenses of contracting-out. The earnings distribution used to weight the contribution reduction by age and sex was determined by reference to statistics for non-participating employment under the old State graduated scheme, employees under the age of 25 being excluded from the overall weighting so as to allow for the payment of CEPs for early leavers with short service. The resulting 7% contribution reduction represented the theoretical reduction (6½% of relevant earnings) plus a further ½% 'risk concession'.

3 THE NEW CONTRACTING-OUT TERMS Using the same financial assumptions but a new earnings distribution based on the numbers of employees contracted-out in , a theoretical contribution reduction of 5 88% of relevant earnings was calculated for (before any risk concession). The pensions movement had generally expected a fall of ½%in the contribution reduction (to 6½%of relevant earnings), having regard to the lower average GMP accrual rate for , though it was now apparent that a slightly greater fall could be justified by the use of the new earnings distribution. The TUC, representing full rate contributors, supported a contribution reduction of only 6% of relevant earnings, implying a significantly smaller risk concession. In the event the Government decided to split the difference and go for the new contribution reduction of6¼%of relevant earnings. 2.3 For any group of contracted-out employees, there are many factors influencing whether the6¼%contribution reduction will be adequate to finance their GMP liabilities. The greatest uncertainty lies with future economic conditions what will be the rates of earnings revaluation under Section 21 of the Social Security Pensions Act 1975 and what rate of return will be achieved on investments? 2.4 It is therefore interesting to analyse the adequacy of the 63% contribution reduction by investigating the rate of earnings revaluation which can be supported at different levels of investment return. For simplicity, we have made use of the figures given in Table 3 of the Government Actuary's March 1982 Report (Cmnd. 8516), but with the 7% expense loading removed. The following table is based on these adjusted figures. Assumed annual rale of investment return (%) Rate of earnings revaluation supported by the new 6¼% contribution reduction (%) 10¼ 8 3 / 4 7¼ 5 3 / 4 It is important to bear in mind that the table makes no allowance for extra administration costs which may arise from a decision to contract-out. However, it can be argued that any extra cost is likely to be relatively insignificant for larger schemes, and that in any case there may be corresponding additional costs arising from a decision to contract-in. 2.5 Any comment on the likelihood of different combinations of investment returns and earnings revaluations is sheer speculation. Nevertheless, our own view is that the figures in the table present a fairly rosy picture for a typical contracted-out scheme. 2.6 If investment returns remain at a high level averaging 10% per annum or more it is clear that the new contribution reduction will support similar or even higher rates of earnings revaluation.

4 70 S. A. FOX AND A. R. HEWITT 2.7 If future investment returns average out at a lower level in the range of 7-9%, positive real investment returns of up to1¼ % per annum (in excess of earnings inflation) will be required. Is this target real investment return of 1¼j% per annum so unlikely? 2.8 Given the current employment conditions, it is possible that productivity improvements in the U.K. economy will tend to be distributed to employees more through a shorter working week than through increases in pay. This may well bring about a period when real earnings (in comparison with price inflation) rise at the relatively low level of 1% per annum or less. If this is so, recent yields on index-linked gilts would produce a real investment return (in excess of earnings inflation) in the range 1½-2% per annum. 2.9 The dividend yield on ordinary shares, as measured by the F.T.-Actuaries All-Share Index, has recently been in the range of 5-6% per annum. Given the rock-bottom level of company profits as a proportion of GNP, it is difficult to see how company profits and therefore dividend payments can continue to fall behind in real terms. Being optimistic, there may even be a reversal of the declining profitability trend of the 1960s and 1970s. Even after allowing for a number of casualties in a typical equity portfolio, a real investment return on ordinary shares at least as good as the 1½-2% per annum suggested for index-linked gilts seems probable We have argued that both index-linked gilts and ordinary shares are likely to produce at least the target real investment return of 1¼%per annum. It is reasonable to assume that investment managers will expect to earn a comparable return if they decide to hold other categories of investment The black cloud on the horizon from the contracted-out scheme's point of view is the possibility that the U.K. economy will again enjoy a period of low, stable inflation rates. However, it is difficult to see investment returns falling to an average of less than 7% per annum without there being first a sustained period of low earnings/price inflation It looks as though the first 5 years, April 1978 to April 1983, will have favoured contracted-out schemes, with high investment returns exceeding earnings revaluation rates. It will be interesting to see whether this is repeated in the next 5 years to April THE PROPOSED MARKET LEVEL INDICATOR 3.1 The most interesting aspect of the changes in the contracting-out terms for has been the decision to phase-in a new formula for calculating the MLI. Existing MLI 3.2 The current MLI formula that applies to ARPs and LRPs can be expressed as:

5 THE NEW CONTRACTING-OUT TERMS 71 where d is the gross dividend yield on the F.T.-Actuaries All-Share Index; i is the gross redemption yield on the F.T.-Actuaries 25-year high coupon government stock index (expressed as an equivalent annual rate); P 25 (i) is the price of a 25-year 13% coupon government stock corresponding to a gross redemption yield of i. 3.3 The current MLI formula that applies to PRPs is expressed as: MLI where i and P\$ are denned as in paragraph 3.2 but instead relate to a 15-year stock and the 15-year high coupon index. 3.4 The current MLI formulae are thus designed to produce values of 100 under the assumed 'standard' investment conditions of 9% per annum long-term rates of interest and 4% dividend yields. Moreover, if a scheme invests its contribution reductions in the asset distribution underlying the MLI formulae, i.e. 65% in the All-Share Index and 35% in long-dated high coupon gilts, the MLI acts in such a way as to adjust the buy-back liabilities in proportion to short-term movements in the market value of the assets. (This compensation depends on the inverse relationship between equity yields and prices; even during the 1974 stock market collapse monetary dividends, as measured by the product of the All-Share Index and the gross dividend yield, did not fall appreciably.) 3.5 However, because the MLI adjustment to the premium tables implicitly assumes that the contribution reductions are invested at an MLI of 100, the resulting effect (on a retrospective assessment) is to over-compensate schemes on buy-back if the MLI during the period of investment was substantially below 100. This has indeed been the experience of contracting-out to date. Since April 1978 the MLI for ARPs has varied between 59 and 81 and has averaged close to 70. A typical scheme which buys back at the present time would find that its premium liability would represent only about 70% of its accumulated contribution reductions. 3.6 There was general concern that if this situation were allowed to persist schemes might be tempted, despite the administrative obstacles, to realize this short-term gain by contracting-in and immediately contracting-out again. The Government has therefore adopted the simple solution of passing regulations which empower the Occupational Pensions Board to refuse the issue of a new contracting-out certificate within one year of contracting-in, except in special circumstances such as a corporate reorganization. Nevertheless, the problem of the large profit potentially available to schemes at the expense of the National

6 72 S. A. FOX AND A. R. HEWITT Insurance Fund still remains, and this profit is further enhanced when account is taken of the other safeguards built into the contracting-out terms. 3.7 Under the new terms for , the MLI formula will eventually be New MLI if Old MLI 5>= 105 if Old MLI < 105 The new formula is to be phased-in over a 5-year transition period, starting in , with the full adjustment taking effect in MLI composition 3.8 It is worth reviewing at this point the make-up of the MLI in terms of investment indices. Since the inception of the MLI, the intention has been that it should follow (rather than constrain) the investment policy of a typical contracted-out scheme. Thus for PRPs the MLI implies investment in mediumdated fixed interest stocks and this appears reasonable since a scheme is not required to escalate a GMP once in payment. 3.9 For ARPs and LRPs the MLI implies that the contribution reductions are invested 65% in U.K. equities and 35% in long-dated fixed interest stocks. An analysis of the aggregate asset distribution of U.K. non-insured pension schemes in the late 1970s shows the following broad distribution by market value: Cash and other short-term assets (under 1 year to maturity) Fixed interest Equities (including unit trusts and overseas equities) Property and other assets (including property unit trusts) %/ % It seems reasonable to exclude property assets from the MLI formula partly on the grounds of their lack of marketability and partly because of the absence of a sufficiently up-to-date property index. Excluding property and cash, the resulting equity/fixed interest ratio is about 2:1 and has remained reasonably constant in recent years (although it could be argued that part of the fixed interest assets relate to pensioner liabilities thus implying a somewhat higher ratio for active liabilities).

7 THE NEW CONTRACTING-OUT TERMS Thus we conclude that to date the MLI composition has adequately reflected typical pension scheme investment policy. However, a significant increase in the holdings of index-linked gilts may alter the balance, in which event a modification of the MLI composition would be required. Objectives of the MLI adjustment 3.12 Before examining the implications of the new MLI formula and of alternative proposals, we briefly review the development of the buy-back concept since it appears that the precise aims of the MLI safeguard have not been adequately defined. It was originally intended that the buy-back premiums should represent the estimated single premium cost of providing the GMP liabilities which were to be transferred to the State. This represents a prospective assessment of the liabilities, and it was envisaged that a review of the premium tables every 5 years would suffice (without the need for an adjustment to reflect investment conditions at the date of buy-back). This corresponds with the single premium assessment of the contribution reduction However, during the Social Security Pension Bill's passage through Parliament considerations of scheme solvency led to the present linking of the premiums to market values by means of the MLI adjustment, thus introducing an element of retrospective assessment. Considerations of the profit available on buy-back have resulted in the new MLI formula, which can be regarded as a further step towards a retrospective formulation. Aside from the technical difficulties posed by the new formula (discussed in paragraph 3.21), its introduction gives little indication of the basis which might be adopted for future reviews, and we suggest that a more durable solution should now be sought We consider it desirable that the MLI adjustment should give adequate protection against short-term falls in market values. The retrospective approach to curtailing excessive profits (or losses) on buy-back is also important. In the absence of any MLI adjustment to the premium tables large profits (or losses) could arise out of any capital appreciation or depreciation resulting from a shift in yield levels between the date of investment and the date of buy-back. A possible objective might be to remove this 'windfall' component from the overall buy-back profit (or loss). It may be argued that the profit or loss in respect of a member can be determined when payment of his GMP commences, because the GMP liability can then be matched with fixed interest investments, and on this approach the current MLI adjustment to the PRP tables appears satisfactory We now consider the existing MLI formulae for ARPs and LRPs and some modifications which have been suggested. Current formula 3.16 Adequate solvency protection is given in the short term, but excessive 'capital' profits (or losses) may arise on buy-back if the MLI during the period of investment of the contribution reduction has departed significantly from 100.

8 74 S. A. FOX AND A. R. HEWITT Rebasing 3.17 At each 5-yearly review the MLI (calculated under the existing formula) could be adjusted by a constant multiplier so that the new 'par' level of 100 corresponds to average past experience. Thus the contribution reductions invested to date would be broadly adjusted for changes in yield levels over the following 5 years, but the disadvantage of the existing formula would remain in so far as contribution reductions received during these next 5 years may be invested at a (new) MLI which differs from the new par level of 100. In recognition of this point (which would be of particular concern in if yields move to lower levels from those of ) the par level of 100 could be pitched somewhat above that which a strict average would indicate. Short-term solvency protection would continue under this method A similar approach would be to adjust the two components of the MLI separately to correspond better with average past experience. For example, if the standard equity and fixed-interest yields in the MLI formula (described in paragraph 3.2) were revised to 5% and 11½% this would result in MLIs approximately 25% higher than at present A practical disadvantage which could gradually develop under either method is the difficulty in maintaining a fair balance between schemes which have been contracted-out since 1978 and schemes only recently contracted-out. New formula 3.20 The effect of the formula set out in paragraph 3.7 when fully phased in will be as follows: Current MLI New MLI The new formula will have the effect of increasing the MLI by around 15-30% during investment conditions similar to those recently experienced Objections to the formula focus on the change in the solvency protection which will be given during times of low market prices. In order to maintain adequate protection under the new formula, a scheme could phase-in a 'matched' investment policy for its GMP liabilities comprising 50% cash, 32½% equities and 17½ %fixedinterest stocks (and presumably switch out of cash whenever the MLI rises above 105!). A more interesting proposal would be to substitute index-linked gilts for the cash proportion, though the total amount of such stocks is at present clearly inadequate for this suggestion to be adopted en masse. Furthermore, the volatility of these stocks under extreme market conditions is as yet untested A suggestion has been made that the new MLI formula should be restricted to a ceiling of, say, 1-25 times the old. This is illustrated below:

9 THE NEW CONTRACTING-OUT TERMS 75 Such a modification would reinstate the solvency protection during times of high yields, when the old ( ) MLI is below 70. However, when the old MLI is around 100 the situation would not be materially improved and this could be of particular concern to a newly contracted-out scheme with no 'cushion' from the favourable pre-1983 experience. Automatic MLI averaging 3.23 Under this approach, the existing method of calculating the MLI would be retained, but for buy-back purposes the GMP accrued in each tax year would be adjusted to reflect the change in yield levels. The buy-back liability would be expressed as This method would satisfy most directly the objectives put forward in paragraph A major advantage is that because each year's GMP accrual is independently adjusted, the method is equitable between both new and long-established contracted-out schemes. Controlled MLI averaging 3.24 A simpler variation on the method described above would be to calculate the buy-back liability as

10 76 S. A. FOX AND A. R. HEWITT Thus the most recent 5 years' contribution reductions would on average be adjusted for changes in yield levels, while any earlier contribution reductions would be regarded as having been invested at the average MLI of the past 5 years. The effect would be similar to that of a rebasing method which uses only recent experience to determine the rebasing, and this may prove unsatisfactory under certain conditions. Consider, for example, a prolonged period during which the MLI remains close to 100, followed by a sudden fall to a new level of 70. The factor by which the premium tables are adjusted would gradually increase from 70/100 at time Xto 70/70 at time X+ 5, at which point the capital loss which was incurred 5 years previously would have to be fully recognized (even on a subsequent recovery to an MLI of 100) To overcome such difficulties, the controlled averaging method described in the above paragraph could be applied only to that part of the GMP accrued after the latest review date (currently March 1982), with the averaging period extending from the latest review date up to the date of buy-back. The rebasing method described in paragraph 3.17 would be used for any GMP which accrued before the latest review date (i.e. during the period April 1978 to March 1982) A general point concerns the implications of a change in the basis of the contribution reduction. Suppose, for example, that at the next review the basis were weakened overall (perhaps in response to a period of increasing real returns) giving rise to a smaller contribution reduction than would otherwise have occurred. A corresponding weakening in the basis of the standard premium tables, with consequent increases in the profits available on buy-back, might be considered undesirable. On the other hand, the continued application of the old premium tables to GMPs accrued under the new contribution reduction would presumably be equally undesirable. A solution would perhaps be to build an appropriate adjustment into the MLI formula.

11 THE NEW CONTRACTING-OUT TERMS THE 12% PER ANNUM REVALUATION SAFEGUARD 4.1 The 12% per annum revaluation safeguard and the MLI adjustment to the buy-back premiums were introduced into the contracting-out terms early in 1975, in response to employers' (and actuaries') doubts regarding the solvency of GMP liabilities during periods of excessive in flation and falling market prices. The experience of 1974, when high earnings inflation coupled with the stock market collapse led to very high negative real rates of return, was obviously a major influence at that time. Are these two safeguards taken together unnecessarily favourable on buy-back? Could the 12% rate be substantially increased and still provide adequate protection? 4.2 The justification for the revaluation safeguard will be more readily apparent if its function can be isolated from that of the MLI adjustment. Much has been spoken of the negative real returns experienced during the 1970s. The figures given in Table 1 of the Government Actuary's March 1982 Report (Cmnd. 8516) show that relative to earnings increases ordinary shares have achieved average returns of 1.5%per annum over the period June 1970 to June 1980 and 9.5% per annum over the period June 1970 to June However, a significant part of these negative returns actually relates to changes in the level of dividend yields over the period. If the buy-back premiums were to be adjusted to reflect this shift in yields (as described in paragraph 3.14) this element of the negative return would be eliminated from the buy-back cost. This is illustrated below: (I) Period (2) Return relative to earnings increases % p.a (3) Ratio of dividend yields (4) Annual return equivalent to (3) % p.a (5) Adjusted 'real' return on buyingback (2) + (4) % p.a. Thus even in the exceptional circumstances of only a modest negative return would have been experienced on buying-back (in practice the position would not be quite as illustrated because of the effect of the fixed-interest component of the MLI). 4.3 The revaluation safeguard is intended largely to provide a 'breathing space' in which an employer can make arrangements to cease contracting-out during inflationary conditions. But the example above indicates that recent experience would provide little justification for such protection at the 12% per annum level, assuming a suitable MLI formula is developed. 4.4 The revaluation safeguard also applies where, instead of buying-back, arrangements are approved either to preserve the accrued GMP liabilities in the

12 78 S. A. FOX AND A. R. HEWITT scheme or to purchase annuities. It is probable that in either case advantage would be taken of the fixed rate8½%per annum revaluation option, especially if rates of inflation were expected to remain high, and we see little justification in these circumstances for giving the further benefit of the 12% per annum revaluation safeguard. 4.5 In the absence of further statistics regarding investment returns during sustained periods of high inflation it is difficult to suggest an appropriate rate to replace 12%. Should it be 15% or eveb 20%? 5. REVALUATION OPTIONS FOR EARLY LEAVERS 5.1 The Government recently announced that it intends to introduce regulations in the first half of 1983 which will prohibit the practice of'franking' GMP revaluations in relation to pension rights in the future. 5.2 Without franking, the revaluations on the GMP at the date of leaving become a clear-cut additional liability for contracted-out schemes. It therefore makes sense to have another look at the revaluation options for early leavers. 5.3 When a person leaves service, his GMP can be revalued up to State Pensionable Age by one of three methods: (i) Full revaluation in line with Section 21 Orders, as for contracted-out employees in service, (ii) Limited revaluation at the rate of 5% per annum (or in line with Section 21 Orders if this is lower), subject to the payment of an LRP. (iii) Fixed revaluation at the rate of 8½% per annum. 5.4 Contracted-out schemes in the public sector have tended to use the full revaluation method, presumably because revaluations in line with the cost-of-living are already being applied to the preserved benefits of early leavers. In the private sector, most contracted-out schemes have chosen to use either the limited or the fixed revaluation method. 5.5 A comparison between the relative costs of the fixed and limited methods obviously depends on future investment returns and future levels of the MLI (since the MLI affects the cost of the LRP). Given that early leavers tend to be at the younger ages, our own calculations have indicated that, unless one is gloomy about future investment returns, the fixed revaluation method will prove to be cheaper than the limited method. 5.6 Apart from the cost comparison, the limited method has had other relative disadvantages. Why pay the LRP if'franking' can help finance 8½% revaluations on the cheap? The LRP may also be a complete waste of money for persons retiring early with an immediate pension, particularly if the pension in payment is going to receive regular cost-of-living increases. A complicated integration offset would be necessary from State Pensionable Age to recoup the cost of the LRP (this integration on top of the contracting-out requirements would seem to be the worst of both worlds!).

13 THE NEW CONTRACTING-OUT TERMS On balance, we have preferred the fixed method rather than the limited approach. But with 'franking' soon to be prohibited and with the prospect of lower inflation rates, fixed revaluations at the rate of 8½% per annum do not appear to be very attractive either. At the 8½% level, the power of compound interest is indeed mighty! 5.8 The full revaluation method remains to be considered. In the past, private sector schemes may have rejected this option on the grounds that the risks inherent in full revaluation are too high. But with falling inflation and possibly lower investment returns, the other two methods also involve risks. In particular, fixed revaluations at the rate of 8½%per annum may turn out to be very expensive to finance if investment returns fall significantly. 5.9 In our view, the full revaluation method may well come into favour for both private and public sector schemes. The continuing new issues of indexlinked gilts are building up a selection of investments for matching full revaluations of GMPs. If these can provide real investment returns (in excess of earnings inflation) in the range of 1½% per annum, contracted-out schemes should have no difficulty in financing GMPs for early leavers under the full revaluation method. To facilitate the financing of GMPs and of generally better benefits for early leavers, we suggest the Government might consider issuing a suitable spread of zero-coupon index-linked gilts (perhaps linked to earnings rather than prices). 6. CONTRIBUTIONS EQUIVALENT PREMIUMS 6.1 A number of schemes have decided to pay a CEP whenever possible, i.e. for all early leavers with under 5 years' service, and justify this practice on the grounds of the administrative saving which arises from not having to preserve a GMP. However, we expect that in many cases this decision will prove to be expensive, since the cost of preserving a GMP for a typical early leaver may represent a considerable saving over the cost of paying a CEP. (A CEP effectively represents the cost of GMP provision averaged over all employees, whereas early leavers tend to be younger than average and have correspondingly lower GMP accrual rates.) 6.2 Before taking into account any additional administration expenses, the cost of preserving a typical early leaver's GMP under the full revaluation method may be as low as half the cost of the corresponding CEP. This is on the assumption that a real return of 1½--2%per annum should be possible using index-linked gilts to match the GMP liabilities. 6.3 For a typical early leaver with 1 year's service and a salary of 5,500 per annum, a saving of about 125 might be expected from preserving the GMP. Looking at a scheme of say 10,000 members with perhaps 1,000 short-service withdrawals each year, an annual saving of 125,000 might be achieved by preserving GMPs for all early leavers. A saving of this magnitude should be more than adequate to meet the extra administrative expenses of preserving the GMPs.

14 80 S. A. FOX AND A. R. HEWITT In fact, it may be possible to keep these expenses to very low levels because many of the ensuing GMPs should be wholly commutable (assuming the Inland Revenue's limit on trivial commutation is revised from time to time in line with earnings). For small GMPs, there is clearly a trade-off between preserving and paying the CEP. For many schemes the optimum cut-off point for CEP payments may be 1 year or less. 7. ANALYSING THE NEW TERMS 7.1 The various elements of the contracting-out terms have been discussed in 2-6. In this section, we describe how projection techniques can be developed to analyse the contracting-out terms for a given group of employees. 7.2 In reviewing the contracting-out terms, the following questions must be asked: (i) Is the 6¼% contribution reduction large enough to cover the cost of new GMPs accruing in future years? (ii) Are the new GMP safeguards reasonable? (iii) On contracting-in, new ways of financing accrued GMPs become available. Will one of these be cheaper than the cost of financing accrued GMPs on remaining contracted-out? (iv) Does any profit from contracting-in outweigh possible on-going profits from remaining contracted-out? (v) Which revaluation option should be chosen for the GMPs of early leavers? (vi) Should CEPs be paid for the full 5 years, for a shorter period, or not at all? 7.3 None of these questions can be answered without making assumptions about the future, in particular on future economic and investment conditions. A computerized projection program enables assumptions varying from year to year to be made on both earnings increases and investment returns. Such a program can be run a number of times to provide a sensitivity analysis of possible economic scenarios. The assumptions can be varied to test the 12% revaluation safeguard and the effect of phasing-in the new MLI formula. For example, a stockmarket crash can be projected for April 1988 to test whether the new MLI formula is adequate, taking into account any 'cushion' provided by more favourable experience in earlier years and by the 12% revaluation safeguard. 7.4 By using select withdrawal rates, it is possible to test the CEP and GMP revaluation options for early leavers, again on various alternative economic scenarios. 7.5 It is necessary to build up a notional fund which receives the NI contribution reduction (or whatever equivalent figure is considered appropriate) and pays out GMPs and State scheme premiums. This gives a reference point for comparing the on-going contracting-out profits with the corresponding profit which may be available on contracting-in.

15 THE NEW CONTRACTING-OUT TERMS As an example, we show the results of a projection which was designed to answer two of the questions in paragraph 7.2. Year ending 5 April Capital Value of contribution reduction received during the year (1) millions Capital Value of GMP liability accrued during the year (2) millions On-going profit (1)-(2) (3) millions These results show that the contribution reduction is large enough to support the accruing GMP liabilities in the 4 years up to April 1986, but not in the last 2 years. The projection in fact demonstrates a scenario of falling investment yields implying high investment returns in the early years as stockmarket prices rise, with lower returns later on. The following results show whether there may be a relative profit available on contracting-in. Year ending 5 April Profit on contracting-in at the end of each year millions Profit on remaining contracted-out accumulated up to the end of each year millions If you believe the projection assumptions used in this example, the question of contracting-in in March 1988 is obviously worth investigating. Account would of course need to be taken at that time of the new terms announced for As a further illustration of the application of these techniques a number of 10-year projections have been made to demonstrate the effects of some of the modifications to the MLI described in 3. The projections use investment returns and rates of earnings inflation corresponding with the period , on account of the wide diversity of economic conditions experienced in the 1970s. For the model fund an investment policy broadly consistent with the MLI has been assumed, i.e. 65% equity/35% fixed interest, with no allowance for the expenses of adjusting these proportions at the end of each year. (The F.T.-Actuaries 20-year government securities index has been used for the period up to 1976, and the over 15-year government stock index substituted thereafter.)

16 82 S. A. FOX AND A. R. HEWITT 7.8 We have effectively regarded the contracting-out terms as having applied from 1 January 1970 (rather than 6 April 1978), and we have therefore accumulated a contribution reduction of 6¼% for the period and 6¾% for the period (this represents 7% less the extra¼% 'windfall' contribution reduction which arose from the use of old earnings distribution statistics at the time when the contribution reduction was originally assessed). No allowance has been made for the extra expenses of contracting-out. The parameters of the membership projection have been chosen so that the distribution of earnings by age and sex remains stable throughout the projection period, corresponding with that underlying the calculation of the contribution reduction for Payment of CEPs for early leavers with under 5 years' service has been assumed, together with fixed 8½% per annum revaluation for leavers with longer service. 7.9 The graphs on page 83 show the MLI (for ARPs) under the current formula, together with the following ratio calculated at each 31 December: Solvency Ratio Accumulated Contribution Reduction Buy-back liability where the buy-back liability is calculated using different MLI adjustments, with no account taken of the 12% per annum revaluation safeguard. In the projections, this solvency ratio reaches a maximum on 31 December because a further Section 21 Order revaluation would apply on winding-up on the next day, 1 January. (The new F.T.-Actuaries fixed interest indices are only available from June 1977 and so when calculating the MLI for earlier months we have applied the formula set out in paragraph 3.2, substituting the 20-year government stock index for the 25-year high coupon index, and dispensing with the 5-day averaging written into the formula.) In the following paragraphs we comment on how various modifications to the MLI would have stood up to the experience of the 1970s. Existing MLI formula (paragraph 3.16) 7.10 The buy-back profit initially remains small but is greatly enhanced in the second quinquennium because contribution reductions have been invested at an MLI considerably below 100. It is interesting to note that the MLI averaged over the first quinquennium amounts to 97, and so a rebasing method (paragraphs ) would still result in high profits towards the end of the decade. New MLI formula, fully phased-in (paragraphs ) 7.11 The lack of solvency protection afforded during the 1974 stock market collapse is clearly demonstrated. Thereafter, however, a more acceptable level of buy-back profit is established. The introduction of a 25% ceiling on the current

17 THE NEW CONTRACTING-OUT TERMS Solvency Ratios December MLI formula (paragraph 3.22) is of no assistance at December 1973, but begins to 'bite' as the MLI falls further so that the loss at December 1974 is minimal. Automatic MLI averaging (paragraph 3.23) 7.12 The buy-back profit remains more stable under this method but increases in the last 3 years of the decade because high investment returns are achieved relative to earnings revaluations, even after allowing for the change in yield levels. Controlled MLI averaging (paragraph 3.24) 7.13 Under this method, we have taken the averaging period to be 5 years (or a period from 1 January 1970 to the date of buy-back, if shorter). The level of buy-back profit is less stable than under automatic averaging, but is significantly reduced relative to that under the current (unadjusted) formula.

18 84 S. A. FOX AND A. R. HEWITT 8. CONCLUSIONS 8.1 The first 5 years, April 1978 to April 1983, are turning out to have been extremely favourable for the typical contracted-out scheme. Provided investment returns remain above 7% per annum in money terms and above l¼% per annum in real terms (in comparison with earnings inflation), the next 5 years to April 1988 should also prove to be favourable. In 2, we argued that both index-linked gilts and ordinary shares are likely to produce at least these returns. 8.2 Ideally, the MLI adjustment to the buy-back premiums should give adequate protection against short-term falls in market values of investments, as well as ensuring that no excessive profit (or loss) is made on buying-back into the State scheme. Neither the original MLI for nor the proposed MLI for satisfy both these conditions. In 3, we considered a number of modifications to the MLI adjustment which have been put forward. 8.3 In 4, we concluded that the 12% revaluation safeguard, when taken together with a suitable MLI adjustment, is unnecessarily favourable on buy-back. 8.4 With franking of GMP revaluations soon to be prohibited, with the prospect of lower inflation rates and with further issues of index-linked gilts, the full Section 21 revaluation method for early leavers may well come into favour. We also considered in 5 the disadvantages of the limited revaluation method. 8.5 In 6, we argued that CEPs can be a very expensive way of financing GMPs for short service early leavers. For larger schemes, it may be considerably cheaper to preserve GMPs for most, if not all, early leavers. 8.6 The various elements of the new contracting-out terms were brought together in 7. We described how projection techniques can be used to analyse the new terms for a particular group of employees and to demonstrate the relative merits of various suggested modifications to the MLI formula. ACKNOWLEDGEMENTS We would like to record our thanks to Pauline Lewis for her work in developing a computerized projection technique for analysing the contracting-out terms. We are also grateful to our colleagues for many of the ideas and suggestions developed in this paper. The opinions and conclusions are of course our own. POSTSCRIPT Since this paper was discussed, Regulations have been made (SI 1983 No 380) which have the effect of restricting the MLI under the formula to a maximum of 125% of that under the old formula, as described in paragraph 3.22.

19 THE NEW CONTRACTING-OUT TERMS 85 GLOSSARY ARP: Accrued Rights Premium A premium payable on winding-up to reinstate into the State scheme a GMP not yet in payment. CEP: Contributions Equivalent Premium A premium payable to buy-back into the State scheme an early leaver with less than 5 years' contracted-out service. GMP: Guaranteed Minimum Pension A pension based on a member's earnings between certain limits (currently per week and 220 per week) revalued in line with national average earnings ('Section 21 Orders'). The accrual rate ranges from l/196th for males under age 16 on 6 April 1978, up to l/80th for members who on that date were within 20 years of State Pensionable Age. LRP: Limited Revaluation Premium A premium payable in respect of an early leaver so as to limit the liability for the subsequent revaluation of his GMP to a maximum of 5% per annum. MLI: Market Level Indicator A factor applied to the standard tables of ARPs, LRPs and PRPs to reflect stock market conditions at the date of premium payment. NI: National Insurance PRP: Pensioner's Rights Premium A premium payable on winding-up to reinstate into the State scheme a GMP in payment. BIBLIOGRAPHY White Paper 'Better Pensions (Cmnd. 5713), Social Security Pensions Bill Report by the Government Actuary on the Financial Provisions of the Social Security Pensions Bill 1975 (Cmnd. 5928). Social Security Pensions Act The Contracted-out Employment (Notifications, Premium Payment and Miscellaneous Provisions) Regulations 1976 (SI 1976 No 143). The State Scheme Premiums (Actuarial Tables) Regulations 1978 (SI 1978 No 134). Reports by the Government Actuary in accordance with Sections 28 and 46 of the Social Security Pensions Act 1975 (Cmnd. 8516), Reports by the Secretary of State for Social Services in accordance with Sections 28 and 46 of the Social Security Pensions Act 1975 (Cmnd. 8518), 1982.