UK: Trends In Post A-Day Executive Pensions

Last Updated: 2 November 2005

Article by Bill Cohen, Orlando Harvey Wood, Feargus Mitchell & Neil Campbell

Introduction

With just six months to go before the start of the new simplified tax regime for UK pensions on 6 April 2006 (A-Day) many employers are currently working to develop policies for post A-Day executive pension provision.

For some organisations, pensions simplification is viewed as merely a tax change and the focus of their attention has been on a tax analysis of the available alternative options. For other organisations, however, pensions simplification raises more fundamental questions about the role which executive pension provision should play in overall executive remuneration.

Remuneration committees are increasingly aware of the need to be satisfied that packages offered are consistent with corporate objectives. As a result, this has led to many of the elements of executive reward (i.e. bonuses, options, performance share plans, etc.) being linked to corporate or individual performance. The balance between fixed and variable pay is also becoming an area of particular focus. However, executive pension provision is rarely brought into this equation.

There is also a surprising inequality of pension provision for executive directors across FTSE350 employers and sometimes within the same employer, suggesting that pensions are rarely taken into account for benchmarking purposes. Our own research1 earlier this year indicated that executive pensions are typically worth between 20% and 70% of basic salary and sometimes more, with additional diversity in the type of arrangement on offer.

The way in which employers address the challenges posed by pensions simplification will determine whether or not these anomalies continue.

One of the main challenges in developing new policies for A-Day is trying to understand general trends and in particular what policies are being implemented by defined peer groups. In practice this information will only become available through disclosures in annual accounts after A-Day.

At this crucial stage of policy development we have carried out research to ascertain how employers are proposing to respond to pensions simplification and what, if any, alternative arrangements are being proposed for remuneration committee approval. This report sets out the findings which have emerged from our survey.

About our respondents

This survey was put together to give a snapshot view of how companies are managing the impact of pensions simplification and what stage they are at in the overall process. The survey was sent to a wide range of Deloitte clients and contacts in mid August 2005. There were responses from 77 companies, which can be categorised as follows:

We have not broken down the responses across these categories because they indicated a consistent approach across all the organisations that responded, regardless of which of these categories they fell into2.

Headlines

  • Most organisations have identified individuals likely to be impacted by Pensions Simplification and most are planning to implement a policy to provide alternative benefits after A-Day.
  • Retaining key talent is the most important driver in the planning process, closely followed by the need to manage cost implications. Given the increasingly high profile of pensions with investors along with increased public scrutiny, the challenge is to balance these and other objectives.
  • Cash compensation is the most popular alternative benefit being proposed. While cash is risk free and straightforward, other alternatives may be more tax efficient.
  • There is no clear practice emerging as to whether cash alternatives are being calculated on an individual or a collective basis. However, we expect companies to move, over time, to a collective basis rather than setting benefits on an individual basis.
  • Where companies are providing alternative benefits, the cost of providing these is often less than the current disclosed costs of providing defined-benefit pensions. We have observed historic costs in the range 20%-70% of salary (the median is 30%-50%) for executives, whereas the cost of proposed alternative arrangements is generally less than 35%.
  • Companies are using a range of different methods to communicate post A-Day alternative benefits policies, with many companies using more than one method. This is understandable as the issue is a complex and important one for employees to consider.
  • Things may still change before A-day, as most companies are still in the planning stages.

Impact of pensions simplification

Individuals will be adversely impacted by pensions simplification where their aggregate registered pension benefits on retirement exceed the new Lifetime Allowance (2006/07 – £1.5m) or where the annual increase in the value of pension benefits after A-Day exceeds the new Annual Allowance (2006/07 – £215,000 pa). Where this happens, the individuals concerned may be required to make additional tax payments.

Since 1989, pension benefits in approved UK schemes have been based on a pensionable salary which is restricted by the earnings cap (currently £105,600 pa) for individuals joining schemes after this date. In response, many organisations have put in place unapproved arrangements to provide benefits based on salary above the earnings cap.

Under pensions simplification, the earnings cap restrictions are removed and all executives whether in occupational schemes or with employer contributions to personal pension arrangements, will be subject to the same tax regime.

Unsurprisingly our survey indicates that most employers have identified that they have an issue to address (including all respondents from the FTSE100).

For smaller employers, lower salary levels mean that in some cases this is likely to be less of an issue. However, of all the respondents to our survey, 76% indicated that they employed people who were likely to be adversely impacted by pensions simplification.

Alternative benefits

Unlike the 1989 earnings cap, the A-Day changes do not restrict the level of benefit which can be paid but, rather, impose an additional tax charge where benefits exceed the new allowances. This means that one possible response to pensions simplification is for companies to take no action, allowing executives to continue to fund for retirement benefits without reference to the Lifetime Allowance or the Annual Allowance, with the executive meeting any additional tax charges as and when these arise.

For companies employing individuals impacted by pensions simplification, 91% are planning to implement a policy to provide alternative benefits, which may avoid these extra tax charges.

Only 12% of companies however have completed the development of their post A-Day policy. The balance of companies have indicated that they are still in the planning stage. However, time is now of the essence with only six months for plans to be finalised and communicated to the impacted population.

Key drivers

Respondents rated the importance of various drivers which we have used to calculate the index illustrated below.

For companies developing new policies, retaining key talent was rated most important followed by managing cost implications and maintaining current benefit levels.

Whether or not post A-Day policies are effective in retaining key talent may be a function of how a given company’s policy compares against its peer group. This information however, will only become available in the disclosures to post A-Day company accounts when we expect that some companies may look to revisit their policy to remain competitive in talent retention.

While pensions simplification presents an opportunity for organisations to develop a single robust executive pensions policy, the importance of retaining key talent creates pressure to maintain current benefit levels for existing executives in the new tax regime, while putting in place a different policy for new executives.

Companies will however, be sensitive to criticism from shareholders and their representatives, as well as the media, that they are continuing with generous pension policies for executives in an environment where general levels of employee pension provision are being cut back.

The Association of British Insurers (ABI) recently indicated that they believed pensions simplification provided an opportunity for companies to reassess their pension arrangements for executive directors and senior executives.

In particular, where individuals have already accrued pension entitlements in excess of the Lifetime Allowance, the ABI have stated that shareholders would expect a "convincing rationale" for the continuation of defined benefit type pension provision.

In a number of cases, the drivers and objectives of an A-Day strategy may be at odds with each other. For example, maintaining current levels of benefit may not be compatible with managing cost implications. How these potential conflicts are resolved to the satisfaction of all concerned will be a main determinant in the success of post A-Day executive pensions policy.

The true picture of post A-day strategy will only appear in post A-day accounts. Anecdotal evidence however, suggests that most companies are putting in place policies which will not result in any net increase in costs for the company. This indicates that overall levels of executive pension provision can be expected to fall as a result of pensions simplification.

Alternative options

We were keen to understand which options companies had looked at when developing their policy for post A-Day pension benefits for executives. As noted earlier, many companies responded to the introduction of the earnings cap in 1989 by putting in place Funded Unapproved Retirement Benefit Schemes (FURBS) or Unfunded Unapproved Retirement Benefit Schemes (UURBS) to provide for benefits based on salary in excess of the earnings cap.

The recent statement by the ABI, combined with a less favourable tax position for FURBS and UURBS than when they were first introduced, means that many employers are now favouring cash supplements.

Other less traditional options, such as employee benefit trusts and family benefit trusts are technically available for post A-Day pension compensation, but have not been popular.

Cash compensation has certain attractions for executives as they will have full flexibility as to how this is invested and when and how the benefit is taken. While cash compensation is a simple solution, it is not ideally suited for meeting the objectives of long term retirement provision and results in additional National Insurance costs, particularly for the company; this should be taken into account when determining the quantum.

Unsurprisingly, the relative attractiveness of cash will depend on how much is paid. Cash also normally lacks both the retention benefits of many pension promises as well as any link to performance. Care will be needed to ensure this is not simply regarded as another element of basic pay.

For those companies that have responded to pensions simplification by using UURBS or "defined benefit" FURBS to provide compensation, the response of their remuneration committee to the ABI statement on justifying the use of these arrangements may, in due course, require this decision to be revisited.

Whilst not specifically mentioned by respondents, we are aware of some companies making adjustements to existing defined benefit arrangements (via acceleration of accruals, ammendments to the definition of pensionable remuneration, adjustments to early retirement factors etc) to keep executives whole at no extra cost to the company. Where this is possible it can be very tax efficient, since it maximises benfits under the pre A-day regime.

Contributions Basis

We were interested to find out whether contributions to any alternative benefits would be calculated on a individual or group basis. The mixed response of our survey indicates that there is no prevailing common practice.

This is still an emerging area. From our own experience, many employers undertook individual calculations to assess a cost-neutral alternative solution, but have subsequently decided to offer somewhat less than the full funding cost and as such have less need to carry out accurate individual calculations.

It is typical practice for many companies to have a banded approach to compensation, compensating senior employees at a higher level than more junior ones.

Levels

Contributions to alternative benefits are generally less than the funding costs of typical defined benefits for executives. Where our respondents indicated the contribution rate to compensate employees these were all less than 35% of basic salary, whereas the value of executive defined benefit plans can be twice as much according to our own research earlier this year (The Missing Link: Executive Directors’ Pensions – Policy and Practice, February 2005).

The levels of contributions planned were no different across the alternative options or by different types of organisation. This suggests that there does not appear to be a premium for cash alternatives being paid in relation to defined benefits.

What is not clear is whether some of the funds which are currently spent on executive pensions will be re-allocated to other elements of the remuneration package, which may have a stronger link to either corporate or individual performance.

Communication

Communicating the agreed policy effectively is an important component of managing the impact of pensions simplification. Individuals will need a clear understanding of how the changes impact on their current pension expectation, what alternative provisions the company is putting in place and what decisions, if any, they will be required to make.

Communications will include projections of likely benefits, often using a range of financial assumptions. Bespoke software packages have been developed by leading market practitioners to carry out the necessary calculations and to present these in a meaningful and clear format.

There are different communication methods available and many respondents have indicated their communications strategy will use a mixture of these. In addition, companies may wish to commit different levels of resource to different groups; for example individuals with more complex circumstances or choices to make may be offered tailored individual advice whereas individuals with more straightforward circumstances may only be invited to a group presentation. We would expect that these sorts of decisions would be clarified at the strategy planning stage.

Footnotes

1 The Missing Link: Executive Directors’ Pensions – Policy and Practice February 2005.

2 "Other" includes other FTSE and AIM listed companies, large multinationals with operations in the UK, partnerships and other sizeable privately owned companies.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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