Employers face tough questions over pension contributions. If too little is paid in, the scheme funding level will go down and the employer will need to make significant injections of cash. If, on the other hand, too much is paid in, it may be hard to recover any scheme surplus.
Most employers turn to actuaries to get an estimate of the expected cost of their pension scheme. That estimate depends on the assumptions made, such as when members will retire, how long they will survive in retirement and how pensions will increase. Using these estimates, an actuary can then predict the timing and size of the pension payments.
Perhaps the most important assumption is that of the expected returns on the contributions invested. This determines what proportion of the final scheme cost should come from contributions made by the employer and employee – and how much should come from investment returns. In other words, the higher the expected investment return, the lower the employer contributions required. If actual investment returns fall short of expectations, the employer would then need to top up the pension fund with additional contributions.
The actuary’s calculation of the expected investment return rests on two things: what they believe the various asset classes will achieve over the period of investment and the actual portfolio of assets selected for investment.
Differences in expected returns lead to different contribution rates – even in situations where the benefit provided and other assumptions are broadly similar.
Take, for example, the situation in two of the main pension schemes in which housing associations participate. An average Local Government Pension Scheme (LGPS) looking to fund £1 a year of pension (in today’s money) at retirement age for a member currently aged 45 would now need to set aside around £11. (This is an average: the actual contribution varies greatly across the different LGPS funds.) For the same member in the Social Housing Pension Scheme (SHPS), the equivalent amount is £16.
While both schemes have similar investment strategies, the LGPS relies more on future investment returns. And while some employers express concern about SHPS underfunding, arguably LGPS schemes are at greater risk of this.
Many employers now consider the risks associated with defined benefit schemes to be too high. They are therefore looking at alternatives, in the form of defined contribution (DC) arrangements. These provide much greater flexibility, but also come at a cost: in DC schemes, it is the employee who shoulders most of the responsibility for ensuring sufficient money is set aside to fund their retirement pension, with the employers not sharing in that risk.
The pensions market is constantly evolving and the position may yet shift again. Indeed, with current proposals to place LGPS fund assets into much bigger pools and with the next actuarial valuation of SHPS due at 30 September 2017, housing association pension schemes could look very different a year or two from now.
If you are concerned about the level of risk involved in your pension scheme, speak to your actuarial adviser about the types of mitigating actions being taken by other housing associations.