Pension hurdles continue for UK corporates

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1 Page 1 of 6 CORPORATE UPDATE SECOND QUARTER 2011 Pension hurdles continue for UK corporates Throughout 2011 there will be no respite for employers with corporate pension arrangements. Here we look at some recent developments that require urgent action, including those expected to make an impact in 2012, for which advance planning is required. Increasing State Pension Age why have a different retirement age? The Chancellor s proposal to increase State Pension Age ( SPA ) in line with rising UK life expectancy will be viewed with interest by many private sector employers. Companies should consider linking their scheme retirement age to SPA. Whilst cost and risk could be reduced if members retire later, the challenge will be to communicate changes to employees. This week The Economist published a special pensions report, highlighting the need for later retirement patterns in rich countries read more at: In our experience of benefit changes, clear simple communication is key We look at the potential reductions in costs and risks from benefit changes linked to an increasing State Pension Age; We consider new opportunities arising from increased flexibility for those with pension benefits over 20,000 pa; Key UK Pension statistics* 31 March December March 2010 IAS19 discount rate % % % We tackle the concerns associated with equity market IAS19 RPI inflation % % % volatility, and examine an innovative approach to limiting the downside risk of equities; We discuss the implications of the Government s proposal to abolish contracting-out ; and IAS19 CPI inflation % % % Long term gilt yield 4.3% 4.2% 4.5% FTSE 100 index 5, , ,679.6 We look forward to 2012, to highlight pensions issues that must not be forgotten going into this Olympic year. *the figures shown are only indicative ranges, and different figures may apply with regard to individual circumstances

2 Page 2 of 6 Flexible drawdown from April 2011 There is a significant change in the retirement flexibility for members reaching retirement with pension income in excess of 20,000 a year. There are restrictions: the main requirement being to satisfy the 20,000 pa minimum income. This can include State pensions and bridging pensions, so for most the option becomes relevant if private pension savings are at least 15,000 a year or approximately 250,000 plus of DC funds. Instead of having to draw an annual pension for life, individuals with pension benefits in excess of 20,000 a year can now choose to have complete flexibility over how they draw the excess. This could include deferring those benefits beyond age 75; drawing the excess funds over a relatively short period; or even taking all the excess as a lump sum benefit (potentially subject to tax). This so-called flexible drawdown option gives pensioners the opportunity, for the first time, to spend their pension fund at a time of their choosing and in amounts of their choosing. For sponsors of defined benefit schemes, flexible drawdown broadens the opportunity to de-risk by offering employees with large pensions the facility to withdraw more of their benefits as cash instead of them being exposed to their remaining lifetime. Actions for the company stemming from this include: Review communications to include this new option at retirement, or if offering enhanced transfer values. Raise this with pension scheme trustees and ask them to consider allowing retiring employees to transfer the benefits in excess of 20,000 pa to a flexible drawdown policy. The pension industry s response to this new option has been mixed. However, we think that many higher earners will be keen to take advantage of this new option. At its simplest level, the flexibility may encourage additional pension savings in the run up to an individual s retirement. For employers, the opportunity to remove some of the biggest liabilities, and the concentrated longevity risk associated with them, may be especially welcome.

3 Page 3 of 6 Equity protection strategies Whilst equity markets have rallied strongly since the depths of the credit crunch, the first quarter of 2011 has ended with the FTSE 100 broadly where it began. As such, the outlook is far from certain. The political unrest in North Africa and the Middle East, continued issues with Eurozone sovereign debt, and the aftermath of the earthquake in Japan, could result in a reversal of many of the gains of the last two years. For this reason many pension schemes are looking for ways to protect against the impact of future equity falls without damaging upward potential. Self-financing protection strategies A key downside to the traditional put option is the up front premium required. But, what if there was an asset which benefits from much of the equity outperformance, has the capital protection characteristics of cash, and is free to enter into? An example of such a strategy is a put-spread collar. Such a strategy is financed by forgoing some up-side exposure (eg positive returns over 12%) to protect against the down-side (eg negative returns of more than 10%). In the example below, any pay-out from the asset is capped at 15% of today s equity prices. Funded protection strategies Funded protection strategies are similar to insurance policies. The equity investor simply pays a premium and receives a payout if the equity market suffers a loss. The simplest funded protection strategy is a put option. This provides full, uncapped, protection against market falls below a pre-defined level. The chart below illustrates the pay-off of a 90% put strategy. Self-financing equity protection strategies require no up front premium but can protect the value of equity portfolios Action: Deciding the best way forward There are many variants of both families of protection strategies. Determining which strategy meets your needs is not straightforward. The best first step is to clearly define your objectives and risk tolerances. This can then be used to prioritise equity protection strategies for consideration.

4 Page 4 of 6 Abolition of contracting-out the final final straw for DB sponsors? The recent budget proposed a complete overhaul of the current State pension system, with one of the headlines being a proposed flat-rate pension of around 140 per week replacing the various State pension benefits people can currently be entitled to, possibly from 2015/2016. For the vast majority of DB pension schemes, the ending of the State Second Pension ( S2P ) will mean they are no longer able to contract out of it. Employers and employees who are currently contracted-out will therefore have to brace themselves for higher national insurance contributions (or income tax levels if the two are combined) in the medium term, equivalent to around 5% more of relevant salaries going to the Revenue. In addition, schemes with either a Pensionable Salary definition that has an offset for the Basic State Pension or a similarly-linked deduction from benefits will have to be careful there is a danger members could see their accrued pension rights dramatically reduced if the offset were to increase from around 100 per week to 140 per week. This will need careful communication. Action: Employers of schemes accruing benefits for employees therefore need to review the benefits being offered, and whether or not changes to the benefit structure are called for. Olympian 2012 pension changes And finally: The grandstand event in October 2012 will be the launch of the new pensions Auto-enrolment regime, under which employers must make arrangements for nearly all employees to become active members of an automatic enrolment scheme providing a minimum level of benefit or contributions (perhaps using the Government backed NEST arrangement). There will be big challenges around selection of the auto-enrolment vehicles, benefit design, administration and implementation. Contracting-out for DC schemes will reach its finish line, as this will not be permitted after April Sponsors of such schemes will need to review whether to make changes as a result of the end of NI rebates, since contribution rates, and costs, may increase accordingly. We will see a dive in employer NI rebates for contractedout DB schemes from 3.7% to 3.4% from April 2012 (employee rebates fall from 1.6% to 1.4%). Sponsors of such schemes need to review appropriate benefit levels urgently, due to the proposed abolition of contracting out. Finally, a difficult hurdle for high earners is the expected reduction in the Lifetime Allowance the lifetime limit on pension savings after which extra tax charges apply from 1.8m to 1.5m, effective from April This follows on from the changes to the Annual Allowance on pension savings effective from 6 April 2011.

5 Page 5 of 6 Future LCP events We hold a range of events that provide clear information and analysis on important pensions and investment topics. Our events receive excellent feedback and provide attendees with helpful information to make informed business decisions. Forthcoming events include: Notes If you would like any assistance or further information on the issues raised, please contact Alex Waite, Alex Whitley or the partner who normally advises you at LCP via telephone +44 (0) or by to enquiries@lcp.uk.com Specific contacts: Global Pensions Conference, 19 May Auto-Enrolment breakfast briefing, 12 July Annual Pensions Conference, 6 September Data Management breakfast briefing, 12 October Linking retirement age to SPA: Alex Waite or Colin Haines Drawdown options: Ian Gamon or Peter Clarke Equity protection strategies: Ian Mills or Gavin Orpin Changes in 2012: Tim Box or David Everett For more information or to register to attend for free please see or enquiries@lcp.uk.com. This LCP Corporate Update is based on our current understanding of the subject matter and relevant legislation which may change in the future. Such changes cannot be foreseen. This document is prepared as a general guide only and should not be taken as an authoritative statement of the subject matter. No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this Corporate Update can be accepted by LCP. Special report on pensions in The Economist this week, visit

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