UK: Employee Benefits Review - Insure The Future

Last Updated: 20 February 2009
Article by Peter Maher

ECONOMIC OPINION - A DIRE OUTLOOK

What started as a credit crunch and financial downturn in 2007/08 has developed into a G7 economic recession. The feedback loops between the financial system and real economy have proved far more powerful and 'contractionary' than most forecasters predicted.

The UK's recession has been deepened by the high level of consumer and corporate debt in the economy, and the fall in house prices. Government sponsored support and re-capitalisation schemes for the financial system, which were first announced in 2008, have proved inadequate as the scale of bank balance sheet impairment has dwarfed the early schemes and banks have been left with toxic assets on their balance sheets.

The uncertain scale of the losses on toxic assets, many of which are tied in value to the US housing market, has meant that UK banks have been hoarding cash, both because they have been reluctant to lend to other banks, and in order to meet capital ratios. This cash stockpiling, alongside reduced lending to households and corporates, has increased corporate defaults and housing repossessions, causing further deterioration in bank balance sheets.

To date, UK Government schemes and record low base rates (1%) have not broken the vicious spiral downwards in activity and lending. In the US, Treasury-led bank support schemes and a reduction in short interest rates to zero have not succeeded either in preventing a deepening recession. Both the UK and US economies recently reported annualised contraction of about 5% in the fourth quarter.

Key to this year, for the UK, is the financial system's state of health. If it remains dysfunctional, it is hard to see the economy recovering significantly in 2009, since higher unemployment and lower house prices are likely. However, some stabilisation in the financial system and associated improvement in confidence may restrict the decline in consumer spending.

Unfortunately, even in an optimistic scenario, the recession looks likely to be at least as long as the 1990-1992 version of six to eight quarters (the economy has now been contracting for four quarters).

INSURANCE-BASED INCOME PROTECTION - INSURE YOUR EMPLOYEES' WELL BEING

There are currently 3.1m people in the UK who have been on benefits for over a year. The Government's Welfare Reform Act (the Act), which came into effect on 27 October 2008, aims to reduce the number of people claiming state benefits and also increase employment levels, by helping sick and disabled employees back to work.

The Government has accepted that its current spending on long-term sickness benefits is unsustainable. Consequently, it is calling upon employers to invest in the health and wellbeing of their employees and to adopt procedures to rehabilitate sick or disabled employees.

To assist in meeting these aims, a new Employment and Support Allowance will replace the current Incapacity Benefit. The amount of benefit paid will vary depending on how the claimant is assessed, with the emphasis being more on capability rather than actual disability – as is currently the case.

However, as a result of the Act, benefits will be harder to claim and, in many instances, be lower in value.

So how does an employer make sure that it honours its responsibilities, bearing in mind that the Act seems to shift the cost of an employee's prolonged absence from the state to the employer?

Traditionally, many employers have underwritten their liability for funding long-term sick pay with an insurance-based group income protection arrangement.

These arrangements are designed to provide a replacement income if illness or injury prevent employees from working for a long period of time.

The insurance benefit becomes payable when the member has been ill for a while. Benefits become payable after the end of that waiting period, i.e. the deferred period. Typically, this will be about six months, but longer or shorter periods are available.

The insurance-based element of these schemes is of great benefit to the employer as it provides a known premium cost, compared to the unknown cost of self funding long-term sick pay. Furthermore, the schemes offer additional and valuable support.

Insurers will offer rehabilitation services including occupational therapy, psychology, nursing, counselling and disability management. The medical professionals would typically meet with the employer and the claimant in order to formulate a 'return to work' programme. If necessary, they can assist with preparing the workplace for a return to work and provide information on any necessary adjustments.

Many schemes also offer employee assistance plans at no extra cost which provide telephone and, in some instances, face-to-face counselling for employees with stress, legal, medical or financial issues.

The Welfare Reform Act should be seen as an opportunity for employers to review their strategy in dealing with staff absence, health and wellbeing; our team of employee benefits specialists are able to advise and assist with the process.

STRUCTURED PRODUCTS - PUT A LITTLE STRUCTURE INTO YOUR PORTFOLIO

Given the turbulent state of the financial markets, it is easy to think that you should only put money into cash. However, with interest rates at record lows, this is hardly an attractive proposition for investors seeking to maximise returns or produce the same level of return that their pension projections have been based upon. Luckily, there are some alternatives, including a vehicle that pays out a generous bonus and promises to back your original investment.

The product

This type of investment vehicle is known as a 'structured product' and is from a product group that is used internationally by banks, insurance companies and fund managers to create returns that have something different from traditionally managed investment funds. Quite simply, the creators of these products package different components together to make something that has an element of certainty quite unlike anything that a managed fund can provide.

There are a number of structured investment products on the market offering security of capital, provided that the money remains invested for a fixed period of time. At least that protects you from losing more money, but what about the investment returns?

As with all structured products, the risk lies with the financial strength of the company giving the underlying guarantees and the way in which it arranges the delivery of the returns to investors.

This vehicle's investment strategy uses derivatives combined with products providing certain returns to allow the fund managers to decide what they can promise. Some will offer a given return dependant upon certain indices or instruments performing as expected, while others will make a payout if the price of a certain commodity remains within a given range of parameters. Whatever their rationale or strategy, structured products can provide some element of certainty within a portfolio, which 'straight' equity, bonds or property investments cannot.

Who can benefit?

The scheme's most important advantage is certainty of capital. This is often a requirement for personal or corporate pension fund investors, charities and endowment funds, where security of capital is important. Many people are risk-averse and cannot take the chance that their capital will be lost or eroded. Similarly, for a proportion of their portfolio anyway, they cannot take the chance that the returns they receive are too small to make their money compete with inflation or other rising costs.

Structured products are becoming much more popular within both retail and institutional markets as issuers generate new ways of creating good returns while managing risk. They are increasingly being considered by portfolio managers and their clients as they seek to achieve good results in a constantly changing investment landscape. If you think this investment vehicle might suit your needs, give us a call and we will help assess the situation.

DEFINED BENEFIT SCHEMES - LIVING LONGER?

As life expectancy increases, so too does the cost of securing an annuity. For a defined benefit scheme looking to wind-up, changes in mortality can have serious implications on an already fragile asset/liability balance. To put things into perspective: in 1911 only 100 people lived to the age of 100, in 2007 this number had increased to 9,300 (Source: Office for National Statistics).

So what is the solution? An immediate buy-out of all members' benefits through individual insurance policies would be the natural way to remove all the risk, but, in today's world, most schemes cannot afford the large premiums often associated with a sudden wind-up.

The industry has recognised the problem and has developed a number of solutions to hedge against the financial impact of people living longer. As you would expect, there is diversity among the products available and the exact level and duration of cover can vary. Two of the most recently introduced products are longevity insurance policies and asset/liability matching insurance policies.

Longevity insurance policies

A longevity insurance policy will reimburse the pension fund for the cost of any future pension payments which arise from pensioners living longer than expected. Generally speaking, they provide comprehensive cover as the policy remains in force until the death of the last remaining pensioner or dependant.

As the policies have no expiry date (providing of course premiums are maintained), this may suit schemes that have no immediate plans to wind-up.

Asset/liability matching insurance policies

An asset/liability matching insurance policy employs a sophisticated 'liability driven investment' strategy that can be used to guarantee that scheme assets do not fall below the value of the liabilities, regardless of market movements or changes in longevity.

The policy usually has a fixed, agreed term and may be best suited to schemes looking to wind-up over a period of ten years.

A policy to suit your liability

However, the bulk of these new products are aimed at large FTSE 100 and FTSE 250 companies with defined benefit liabilities in excess of £100m. With schemes of that size making up only a small percentage of defined benefit schemes in the UK, the trend may be about to change.

There are now longevity insurance products specifically aimed at schemes falling into the £10m-£100m liabilities bracket. Such plans allow trustees to guarantee the future actuarial basis that will be used to calculate the price for buying out the scheme's liabilities, for a fixed agreed term. These schemes allow trustees to remove one of the 'known unknowns' from the scheme's exit strategy.

PERSONAL ACCOUNTS - PERSONALISE YOUR PENSION SCHEMES

On 26 November 2008, the Pensions Bill became law as the Pensions Act 2008. Most of the act's measures come into force in 2012, including personal accounts - the government's reforms to private pension provision. The Government hopes that this scheme will encourage greater private saving as personal accounts will introduce a low-cost investment vehicle.

The reforms take effect on 6 April 2012; however, businesses need to implement many of the necessary changes well before then if they are to have the right impact.

The new regulations

Jobholders (anyone aged between 16 and 75) who are at least 22, and less than the state pension age, must be enrolled into the Government's centralised onesize- fits-all personal accounts scheme unless they are active members of a qualifying scheme. Employees under 22 and over 75 years of age can choose to opt in. Employers will be responsible for enrolling their employees and will be required to contribute at least 3% to the pension. Employees will have a minimum 4% contribution limit; the scheme has a maximum contribution level of £3,600 per annum.

Qualifying earnings are between £5,035 and £33,540 per annum (based on the 2006/07 year) and include salary, wages, commission, bonus, overtime and maternity, paternity or adoption pay.

Employees can opt out and receive a refund within 30 days but will not be permitted to opt out in advance, something that would have made the administration easier for all. Automatic reenrolment will occur every three years.

Qualifying schemes (occupational or personal pension) which fulfil specified 'quality requirements' will be exempt. The requirements include minimum earning limits, satisfying standard scheme tests and auto-enrolment.

Auto-enrolment

From 2012, employers will be legally required to auto-enrol employees into either personal accounts or a qualifying pension scheme. This obviously has an immediate impact on costs in terms of qualifying salary roll.

Not only will costs increase for those companies that will be introducing a pension for the first time, but because it is an auto-enrolment scheme, there will be higher take-up rates for those who currently run voluntary ones. In fact, this is what the government's premise is based on, and means that most companies running pension arrangements will see their costs increase.

However, on another level, companies contribute to pension arrangements, in part, to aid recruitment and staff retention – what kudos will a company get by doing what it is required by law to do?

The devil is in the detail

Earnings that qualify for personal accounts include commission, bonuses and overtime, all of which are often excluded from the definition of salary for company sponsored pension arrangements.

Businesses will need to ensure that contributions to qualifying schemes meet the minimum criteria. Let's hope that this is on an annual basis rather than monthly, otherwise it might be too unwieldy to work. However, if it is an annual check, how will the top-up amounts due from both the employer and employee be fulfilled? How will employees feel about having a large sum being deducted from their pay? Perhaps the business will be able to spread this catch-up payment, but that only increases the administration problem.

A personal solution?

Employers might level down benefits in an effort to control costs. Another option would be to close schemes with higher contributions – either completely, to new entrants or to particular staff. Of course, it is hard to put a positive spin on the removal of a pension arrangement, so businesses should either embrace personal accounts or raise their current offering.

The principal benefit to adopting the personal accounts scheme is the simplicity it affords employers. However, as the pension is aimed at low to median workers, the company will still need to arrange pension provision for its senior employee, such as a group Self-Invested Personal Pension (SIPP). Furthermore, your employees might feel 'abandoned' if you choose to opt for the simpler, less 'personal' personal accounts scheme.

If the company chooses to raise its current offering, there are a few points to bear in mind. As we've already mentioned, all UK companies will have access to a pension scheme, so providing one will no longer be a competitive advantage in the job market. And the profile of pensions will be raised generally. Furthermore, £1 in a basic rate tax-payer's pocket costs £1.63 (2008/09), whereas £1 in pensions costs £1.

Overall, Smith & Williamson supports the personal accounts initiative. Using the inertia usually inherent within people to ensure that they remain members of a pension arrangement rather than remaining non-members will lead to more people funding for their retirement in the longer run. We'd feel happier if this was fully rewarded by the benefits coming from the state, but let's save that for another day. Our main concern is the impact this regime will have on employers, both large and small, in terms of the administration burden and costs. However, there is time to address this, but 2012 is not as far off as you might think.

PENSIONS CAN HELP BUSINESSES BOOST LIQUIDITY

Businesses can now look to their pension scheme to create a loan to the firm which is worth up to 50% of the fund's value.

In today's cash-strapped environment, a loan from the pension scheme can represent a valuable means to fund capital expenditure and prove highly tax efficient. While interest payments must be paid at a commercial rate, this has the benefit of increasing the value of the fund; they can also be offset against corporation tax which can be a further boost to liquidity. It's also worth bearing in mind that loan interest repayments become a tax deductible means of moving funds away from the company and into the pension plan making.

These arrangements are most suitable for smaller and medium-sized businesses or family owned firms. However, it is important that the trustees of the pension fund are satisfied that any such investments are a suitable way of investing pension scheme assets. It may also be necessary to restructure an existing scheme to enable the loan back facility.

While this is a valuable opportunity and particularly relevant in the current economic climate, professional advice should be taken.

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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