BT's radical redesign tackles its volatile defined-benefit costs
Although closed to new entrants in 2001, the costs of BT's final-salary pension scheme have still been escalating. To address the problem, the company has undertaken a major redesign of the plan that incorporates a move to a career-average basis, ceasing to contract out and an increase in retirement age. We examine the changes.
On this page:
Rising deficit
Review and consultation process
Major redesign
Increasing the normal pension age
Changing the accrual rate for section C members
Introducing a CARE basis
New contribution rates
Contracting back into S2P
Flexible benefit options
Moving on
Table 1: BT pension scheme benefits for service up to 6 April 2009
Table 2: Revised contribution rates for section B and section C members
Box 1: BT pension scheme profile
Our research.
Key points
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With nearly 350,000 members, more than 65,000 of whom are current employees, and a fund with a market value at the end of March 2009 of nearly £29.3 billion, the BT Pension Scheme is the largest private sector scheme in the country. Faced with continually spiralling costs and wanting to "develop a sustainable, competitive and flexible scheme", the company decided that it needed to redesign this final-salary plan. The transformation includes raising the pension age, switching to a career-average revalued-earnings basis, contracting into the state second pension (S2P), increasing member contributions, reducing accrual rates and offering members more flexibility.
As well as remodelling the defined-benefit (DB) scheme, BT has also made major changes to its two defined-contribution (DC) schemes, which we shall be considering in next month's issue.
Rising deficit
In an earlier move to combat rising costs and meet the needs of a changing workforce, the final-salary scheme was closed to new entrants in 2001 and replaced by a DC plan (see BT battles to gain members' interest in new DC scheme). Despite this move, improved mortality, lower expected investment returns and increased regulation have all had a major impact on the DB scheme's funding in recent years. BT's fourth quarter results for 2008/09 reveal that the DB scheme had a net deficit of £2.9 billion on the basis of International Accounting Standard 19, and the company has to agree to pay an annual contribution of £525 million for the next three years to improve the funding position.
BT's liabilities under its DB arrangement are now three times the market capitalisation of the company. In an increasingly competitive telecommunications market, the company wanted to find a way of obtaining more control over its pension costs. In the spring of 2008, the firm decided that it was time to undertake a fundamental review of the DB scheme to see if risk reductions and cost savings could be identified while maintaining a sustainable and competitive arrangement. In fact, since privatisation in 1984, BT had not made any significant changes to the plan and it still retained many features of a public sector scheme.
Amazingly, in less than a year, BT has been able to reshape its final-salary scheme, complete the consultation and legal processes and introduce the changes. We examine the revised scheme structure below.
Review and consultation process
The main people involved in the review were Kevin O'Boyle, BT's head of pensions, industrial relations and finance managers, and representatives from the two main unions at BT - the Communication Workers Union (CWU) and Connect. The need for a review was discussed with the board of the trustee company, which decided to maintain a neutral stance as far as any redesign was concerned awaiting the outcome of consultations. However, it was kept informed of progress.
Apart from achieving cost control, the main objectives of the review were to increase flexibility for members and ensure the scheme remained fair but competitive. With these aims in mind, O'Boyle says that they started the review process with a more or less blank sheet of paper. A matrix was drawn up showing the full range of possible options, from leaving the scheme unchanged at one extreme to total closure at the other. With the aid of the consultancy KPMG, which was brought in to provide the team with independent technical support, the impact on cost and risk reduction of each of the options was investigated.
The review was more complex because the DB scheme has three sections, each with different provisions. Table 1 gives details of the eligibility, contributions and main retirement benefits under each section (A, B and C) before the redesign.
Eventually the options for change were whittled down until a design was found upon which the company and the unions could agree. To meet the legal consultation requirements every member of both the DB and DC schemes was sent a detailed consultation pack setting out the proposed changes. A website was developed to contain all the documentation plus short videos, questions and answers, and modellers to help members understand the impact of the changes on their benefits. A dedicated telephone helpline was established that dealt solely with the proposed scheme changes.
The consultation booklet tried to quantify the impact of the changes on individual members by showing their effect on typical members. Six illustrative profiles were developed - three each for sections B and C. BT has many long-service members and the profiles reflect this, with examples given for service ranging from eight to 31 years in respect of each of the major changes.
The formal consultation ran from 13 November 2008 to 13 January 2009. The CWU and Connect executives supported the changes but balloted their members to obtain their approval of the new measures. To assist members, the unions dedicated sections of their websites to the BT scheme and held meetings around the country to explain the proposals face to face with BT employees. There was overwhelming support from Connect members, who are generally professional and managerial staff, with 85% voting in favour of change. The CWU members were less keen, with 65% in favour of the revised scheme, still a very high percentage considering the impact the overall changes would have on member benefits.
Major redesign
The main changes made to the BT Pension Scheme for pensionable service from 1 April 2009 are:
- the normal pension age has been increased from 60 to 65;
- the benefit structure for section C members has been changed from an accrual rate of 1/60th to a rate of 1/80th plus an automatic tax-free lump sum of three times the annual pension;
- the basis on which pension for future service is calculated has switched from final salary to career-average revalued earnings (CARE);
- the contribution rate for section B members and higher-earners in section C has been increased;
- the scheme has ceased to contract out of S2P; and
- new options have been introduced to increase the flexibility of the scheme for members.
The consultation feedback report reveals that the change that generated the most questions was the raising of the normal pension age, with the increased contribution rate coming second. However, no changes have been made to the proposed scheme design as a result of the consultation.
The profile sets out the scheme's benefits and other provisions in more detail.
Increasing the normal pension age
The normal pension age has been increased for service on and after 1 April 2009. This means that if a member retires before age 65, only pension in respect of post-April service will be actuarially reduced for early payment between age 60 and 65. Members cannot take their pre-April accrual and post-April accrual pension in two tranches to avoid this reduction as, for ease of administration, they have to take all their pension at the same time.
BT has introduced an easement to try and meet concerns about the change, particularly for those members near to retirement. Under this, any members who retire from age 50 before April 2012 and take immediate payment of their pension will not see a reduction on the post-April accruals, ie the pension built up with a retirement age of 65 will be paid unreduced as if taken from age 60. In the consultation feedback the company also makes the case that, because the change only applies to future service, it means that current members will not have to work for an extra five years in order to retire with the same level of benefit as they would have had to do before the change. Members currently aged 30 will have to work an extra 3.17 years; those presently aged 55 only have to complete an additional 1.17 years of service to be in the same position.
Changing the accrual rate for section C members
In a move that is counter to the prevailing trend, the future accrual rate for section C members has been changed from 1/60th with an option to commute part of their pension for a tax-free lump sum to 1/80th with an automatic lump sum of 3/80ths for each year of pensionable service. This used to be the normal benefit structure under public sector schemes, but in recent years the main public schemes have moved away from compulsory lump sums.
However, according to O'Boyle, there are sound reasons for changing to this accrual rate. One is that most members take their maximum cash in any event so the change will have little impact on many members' benefits. In addition, it means that all three sections of the DB plan have the same accrual rate, which will make it simpler for section B members to move to section C, which they may choose to do under one of the new flexible options to take advantage of the lower contribution rates under that section. Finally, it has an advantageous cost and risk impact on the fund.
Introducing a CARE basis
The change from a final-salary to a CARE basis for future service did not elicit a large number of comments during the consultation period, yet for some members it could result in a significant difference in their benefits. Pension and lump sum for each year of service from 1 April 2009 will be based on pensionable pay in the particular year increased in line with the lower of the increase in the member's salary during each year or the increase in the retail prices index (RPI) (although accrued rights cannot be reduced if the RPI goes down). Most CARE schemes do not cap their revaluation in this manner and BT expects the introduction of the CARE approach to have a significant impact on costs over time.
O'Boyle argues that this structure is fairer for more employees than final-salary accrual. BT has a large number of long-service employees who are at or near the top of their pay grades and who therefore are unlikely to experience big pay rises in the future. A final-salary basis tends to favour those members who experience rapid pay growth. BT also has a significant proportion of the workforce who work part time or take career breaks. O'Boyle believes that, in practice, many members, particularly those closer to retirement, will not see a huge change in the amount of their retirement benefits as a result of the move to CARE but the new structure will significantly reduce BT's exposure to risk. The extract above from the consultation report illustrates the combined impact of these three changes on the benefits of a typical member of both section B and section C.
Members' accrued final-salary benefits will be based on their final pensionable salary, ie at actual retirement or on leaving BT, and not on their salary as at 1 April 2009, an approach adopted by some schemes changing from a final-salary to CARE basis.
New contribution rates
To recognise increasing costs, increases to member contributions were introduced. Reflecting the higher value of benefits payable to section B than to section C members, for example uncapped increases on pensions in payment, their contribution rate is being increased over two years to 7% of pensionable pay. In addition, the contributions payable by higher earners under both sections B and C are being raised.
BT calls the level of pay above which higher contributions are paid the "contribution earnings threshold" (CET), which is defined as "109.3% of the 40% higher-rate threshold for tax". For the 2009/10 tax year the CET is £44,633. This figure has been chosen to achieve equality between higher- and lower-rate taxpayers so that once tax relief is taken into account, higher-rate taxpayers pay broadly the same proportion of their earnings into the scheme as lower-rate taxpayers.
Table 2 sets out details of the new rates.
Contracting back into S2P
The most technically challenging of all the changes, but one that received only 71 comments during the consultation, has been to contract the scheme back into S2P for service from 1 April 2009. According to O'Boyle, this was breaking new ground as no previous examples could be found where a large ongoing DB scheme has done such a thing. Counsel's opinion had to be sought to see how it could be achieved.
At first glimpse it may seem a strange cost-reduction measure as not only will the company's national insurance (NI) contributions go up, but the company is adjusting employees' pay to cover their higher NI payments. However, members' S2P benefits will in the future be offset against their scheme benefits. This, in effect, reduces future accruals and will result in a reduction in funding costs that is expected to broadly balance out the increased NI payments.
In addition, over the long term, the company expects the move to result in a reduction in the risks faced by the scheme. This is because the future mortality and investment risks relating to the S2P benefits are being passed back to the government. O'Boyle believes that now BT has blazed the trail, other schemes will follow suit as, once the complexities have been thought through, implementation is surprisingly easy.
Flexible benefit options
Section A members, all of whom are close to retirement (they had to have joined BT before November 1971), were not automatically included in these changes. However, a section A member could elect to switch to the new terms on an individual basis by paying increased contributions. In certain situations, the new design makes sense for such members.
However, one of the aims of the pension review is to increase flexibility for members of all sections so a number of further options have been introduced.
- Section B members moving to section C terms: section B members who do not wish to pay the new higher-contribution rate have been given an option to transfer to section C terms and pay a lower-contribution rate. There will be an opportunity for section B members to exercise this option annually but once they have made the decision it cannot be reversed. Very few section B members took advantage of this option on the first exercise date, which was 1 April 2009.
- Reduced accrual rate: all section B members also have the option of remaining in section B, reducing their contribution rate to 6% (or 7% if they earn above the level of the CET) and accruing pension at the rate of 1/90th and a lump sum at the rate of 3/90ths for each year of future pensionable service. This option is also available to section C members. Again, there is one opportunity a year for members to change their accrual rate and those who exercise this option may not reverse their decision subsequently. Initially, only 300 members have chosen this course of action.
- Pension increase conversion: Members will have the option on retirement of converting future pension increases on part of their pension to a higher flat-rate pension. However, this option is restricted to pension accrued in respect of service before 6 April 1997, as increases are obligatory for all DB schemes on subsequent service. The example in the consultation feedback report shows the impact of taking up this option on a member with a starting pension of £10,000 a year, £6,000 of which relates to pre-April 1997 service. If the member chooses this option, £4,000 of the pension would continue to increase in line with scheme rules and the £6,000 pension would increase to £8,040 a year but would not go up subsequently.
At the same time as introducing these options, the company has withdrawn the option of transferring in benefits from previous employers' schemes.
Moving on
Despite the radical nature of the scheme changes, BT received little negative feedback from employees. Part of this was because the redesign was supported by the unions. In addition, other similar schemes such as the Principal Civil Service Pension Scheme and NHS scheme have also undergone extensive reviews recently. The members seem to have accepted the need for change, as one member is quoted in the consultation report as saying "we would prefer for there to have been no reduction in benefits for anyone, but given that changes have to be made, we are relieved that these have not been as severe as we feared." The biggest problem area for the scheme involved changing the administration systems to deal with such a complex range of amendments in a short period of time. The employee consultation results were published on 6 February and all the changes were implemented from 1 April as planned.
In spite of these DB changes, BT's pension problems are not over. After the changes were introduced, the company announced that its latest triennial valuation, which has an effective date of 31 December 2008, is the subject of discussions with the Pensions Regulator concerning the assumptions used and the basis of the valuation. The deficit contributions of £525 million per annum are unaffected by these discussions.
One thing is certain: this will not be the end of change. Two significant messages emerged from the employee communications. Members asked whether they could opt out of the DB scheme and join the new, innovative DC scheme. At present DB members are not able to switch to the DC arrangement, which has lower member contribution rates, a high level of employer matching and offers significant flexibility. This is at the request of the unions, effectively to "protect people from themselves". However, removing the prohibition on switching is now under review. The company is also considering whether to allow members to contribute to its new self-invested personal pension arrangement in order to top up their DB benefits.
Next month we shall be examining the changes to BT's DC arrangements.
Table 1: BT pension scheme benefits for service up to 6 April 2009 |
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Section A* |
Section B |
Section C |
Eligibility |
Members who were employed by the Post Office before 1 December 1971 |
Members who joined the scheme between 1 December 1971 and 31 March 1986 |
Members who joined the scheme between 1 April 1986 and 31 March 2001, when it was closed to new entrants |
Member contributions |
6% x 0.94% of pensionable pay |
6% of pensionable pay |
6% of pensionable pay |
Normal pension age |
60 |
60 |
60 |
Normal retirement benefits |
Pension of 1/80th of 0.94% x final pensionable pay for each year of pensionable service, plus lump sum of 3/80ths on same basis |
Pension of 1/80th of final pensionable pay for each year of pensionable service plus lump sum of 3/80ths on same basis |
Pension of 1/60th of final pensionable pay for each year of pensionable service with option to commute part for a lump sum |
Pension increases |
In line with RPI |
In line with RPI |
Lower of RPI or 5% a year |
* Section A members have the option of switching to section B benefits within six months of leaving or retiring subject to payment of an additional contribution. |
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Table 2: Revised contribution rates for section B and section C members |
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Level of pensionable earnings |
Section B |
Section C |
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From 2009 pay review date |
From 2010 pay review date |
From 2009 pay review date |
From 2010 pay review date |
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Below CET |
6.5% |
7.0% |
6.0% |
6.0% |
Above CET |
7.0% |
8.5% |
7.0% |
7.0% |
Note: CET = 109.3% of the 40% higher-rate threshold for tax (£44,633 in 2009/10 tax year). |
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Box 1: BT pension scheme profile The BT Pension Scheme commenced after British Telecom was split off from the Post Office in 1971. In 1986, BT was privatised and the scheme benefits were amended at the same time. It was closed to new entrants in 2001 when a defined-contribution arrangement was introduced. Full scheme name: BT Pension Scheme. Type of scheme: Section A: final-salary, contracted-out; Sections B and C: final-salary, contracted-out for pensionable service to 1 April 2009, career-average revalued earnings, contracted-in for service thereafter. Pensionable salary: Basic pay plus London weighting and certain other allowances. Final pensionable salary: Sections A and B: the greater of either the highest pensionable salary in any year in the last three years of pensionable service or the best average pensionable salary in any three consecutive tax years in the last 10 years of pensionable service. Section C: highest pensionable salary in any continuous 12 calendar months in the last 36 months of pensionable service. Members' contributions: Section A: 6% of pensionable pay; Section B: 6.5% if pensionable salary is below the contribution earnings threshold (CET), which is 109.3% of the 40% higher-rate threshold for tax, and 7% if pensionable salary is above the CET, rising to 7% and 8.5% respectively in 2010; Section C: 6% if pensionable salary is below the CET and 7% if pensionable salary is above the CET. Section B and C contributions are reduced by the additional amount of national insurance contributions paid as a result of contracting in. Pension accrual rate: Section A: 1/80th of 94% x final pensionable salary for each year of pensionable service. Section B: 1/80th of final pensionable salary for each year of pensionable service up to 1 April 2009 plus 1/80th of pensionable salary for each year thereafter revalued up to retirement in line with the lower of the RPI or the member's pensionable salary. Section C: 1/60th of final pensionable salary for each year of pensionable service up to 1 April 2009 plus 1/80th of pensionable salary for each year thereafter revalued up to retirement as for section B. There is a state pension offset in respect of pension earned for service from 1 April 2009 for section B and C members, which is broadly equal to the state second pension built up during that service. Retirement lump sum: Sections A and B: three times scheme pension with the option to convert some into pension. Section C: by commutation for service up to 31 March 2009, three times pension for service thereafter. Eligibility: Section A: employees transferred from the Post Office on 1 December 1971. Section B: permanent employees between the ages of 18 and 55 who commenced employment between 1 December 1971 and 1 April 1986. Section C: permanent employees between the ages of 18 and 55 who commenced employment on or after 1 April 1986 and before 1 April 2001. Normal pension age: Section A: 60. Sections B and C: 60 for pensionable service up to 1 April 2009, 65 for pensionable service thereafter. Early retirement: Enhanced early retirement pensions available on redundancy from age 50; otherwise actuarially reduced by about 5% per annum for each year prior to normal pension age for early payment. Ill-health early retirement: Sections A and B: higher of pension earned up to the date of retirement plus the pension based on an additional 6 and 2/3rds years of pensionable service or service to age 65, if less; and pension earned up to the date of early retirement plus 75% of the potential future pension based on service to age 65 and pensionable earnings at the date of retirement. Section C: pension earned up to the date of early retirement plus 75% of the potential future pension based on service to age 65 and pensionable earnings at the date of retirement. Pension increases: Sections A and B: in line with RPI. Section C: in line with RPI subject to a maximum of 5% a year. Additional voluntary contributions: Sections A and B: may continue with added years contracts in place before 1 April 2009. All sections: in-house money-purchase arrangements. Death-in-service lump sum: Three times pensionable salary at death. Death-in-service pension: Pension paid to qualifying surviving partner of 50% of the pension that would have been paid if the member had retired on account of ill health plus a pension of 25% of the same pension for each child, subject to a maximum of two children; if no partner's pension is payable, children's pension increased to 33% under Section B and 50% under Section C. Lump-sum benefit on death after leaving but before retirement: Sections A and B: a lump sum is payable on death after leaving but before retirement equal to the greater of: (a) 1.25 x final pensionable salary; (b) 3/80ths of final pensionable salary for each year of pensionable service enhanced as for ill-health early retirement; (c) five times deferred pension at the date of death; and (d) a refund of the member's contributions. Death-in-retirement pension: On death within first five years of commencement of pension: Sections A and B: lump sum payable equal to the total amount of pension payable for the remainder of the five years plus a pension to a surviving qualifying partner of 50% of the member's pension; Section C: surviving qualifying partner receives a pension equal to the member's pension for the remainder of the five years, and 50% of the member's pension (before any commutation for cash) thereafter. On death five or more years after retirement: surviving qualifying partner receives the member's pension for 91 days, then 50% of the member's pension. Late retirement pension: Members can continue to contribute and accrue pension and lump sum if they remain in service after normal pension age. Transfers-in: Not accepted on or after 1 April 2009. Pension payment: Pensions are paid monthly in arrears by the employer. Early leavers: All leavers are entitled to a deferred benefit regardless of length of service and may transfer out to a qualifying pension arrangement at any time up to one year before normal pension age. Preserved benefits: Deferred pension revalued during deferment as follows: Sections A and B - in line with RPI; Section C - in line with RPI subject to a maximum of 5% a year. Governance: Scheme managed and administered by BT Pension Scheme Trustees Ltd, which has nine trustee directors - an independent chair, four BT representatives and four member representatives. Scheme's professional advisers: Actuaries: Watson Wyatt; lawyers: Lovells; administrators: Accenture HR Services. This "scheme profile" was produced using information available on BT's website and other material provided by the company. We are grateful to Kevin O'Boyle, BT's head of pensions, for his comments on a draft of this profile. |
Our research
This feature is based on a face-to-face interview with BT's head of pensions Kevin O'Boyle and we are grateful to him for comments on a draft of this case study. It also draws extensively on scheme literature given to members during and after the consultation.
