Pensionable pay cap provides a solution for ailing defined-benefit schemes
Employers are increasingly introducing pensionable pay caps for members in final-salary schemes in order to reduce pension liabilities. We explore the trend, looking at actions taken by 17 companies, and assess the advantages and drawbacks of taking this route.
On this page:
Controlling costs and risk
Other benefits of capping
Impact on members
Setting a ceiling
Concessions
Reducing the adverse effects
Limiting cap to future accrual
Limitations
Table 1: Defined-benefit schemes with pensionable pay caps
Table 2: Additional features associated with pensionable pay cap.
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Key points
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Whereas many employers with final-salary schemes seek to control their pension costs by closing the scheme to future accrual or by switching to career-average, an increasing number are opting to cap pensionable pay growth. In this survey, we assess moves made by 17 employers - all with schemes that are closed to new members - to reduce pension liabilities in this way, and outline the pros and cons of doing so.
Limiting the amount of members' pay that is pensionable in any one year - particularly if it is done at a below-inflation rate - can be an effective way to reduce pension liabilities and can result in significant savings. According to James Patten, benefit design specialist at consultancy Aon Hewitt, capping pensionable pay growth at 1% per annum, for instance, can lead to deficit savings that are more than 80% higher than those gained from closing a defined-benefit (DB) scheme to future accrual, on an ongoing funding basis.
When the Royal Bank of Scotland (RBS) capped the amount of future salary increases that will count for pension purposes to the lower of 2% or inflation (see table 1), it recognised a curtailment gain of £2,148 million in its 2009 accounts. Similarly, Lloyds Banking Group, which capped pensionable pay at 2% (or inflation, if lower), recorded a £910 million net curtailment gain - a result of the cap, coupled with a further change made to commutation terms.
Controlling costs and risk
Applying a pensionable pay cap in a final-salary scheme can control costs relating to pensionable service built up in the past, as well as future-service pension costs. "One of the key advantages from an employer standpoint of capping pensionable pay growth is that you can apply the cap to the whole period of service and therefore reduce your deficit," says Patten. "If you set the cap at levels below price inflation, you are potentially able to reduce the deficit to a greater extent immediately than if you were just to close the scheme to future accrual. This is because if the scheme were closed, past-service benefits for deferred members would typically increase in line with price inflation."
Patten adds that capping pensionable pay growth can also work well for employers with concerns about the management of risk. "Instead of reducing contributions into the scheme in response to the reduced deficit," he said, "employers can maintain contribution rates at the same level as before in order to finance a reduction in the amount of investment risk they need to carry to provide the benefits due to members."
Other benefits of capping
Clive Fortes, head of corporate consulting at Hymans Robertson, agrees that the capping of pensionable pay is now an increasingly popular option for employers. A key benefit of using this method to reduce liabilities is that it can be implemented outside the scheme rules. "It is just an agreement between a company and an employee. They reach an agreement about how much of their pay is pensionable. It is pretty straightforward," he says. Employers are, however, required to consult with employees if they change what elements of pay constitute pensionable earnings, or change the proportion of, or limit the amount of any element of pay that forms part of pensionable earnings.
Fortes adds that it would be very difficult to achieve this type of change within the scheme rules. "You may be able to satisfy s.67 requirements [that prevent accrued rights being modified adversely], as that is quite a narrow test of accrued rights, but trustees would be very reluctant to agree a sub-inflation pensionable pay cap. However, there would be no need to achieve this if the change can be achieved outside the pension scheme through contracts of employment."
Another advantage of this method of reducing liabilities for employers is that they can still offer employees continued membership of a DB scheme, helping maintain good employee/employer relations. According to Fortes, even where the ceiling is set below inflation, schemes rarely see a material opt-out of members to alternative defined-contribution (DC) schemes, largely because people prefer the comfort of knowing their pension will be guaranteed by their employer. "In addition, a lot of people have been seeing below-inflation pay growth anyway in recent years," he says.
Impact on members
As with any method of achieving significant savings in DB schemes, the move can have a major impact on the level of pension that members can expect when they retire, and it is therefore likely to prompt opposition. Limiting future pensionable salary increases will reduce the value of members' future pensions and their pensions that have already built up, and is especially likely to have a severe effect on the pensions of younger members.
The National Union of Journalists, for instance, estimates that a BBC employee aged 25, on a salary of £25,000 per year, who joined the corporation five years before the introduction of a 1% pensionable pay cap, would have looked forward to a pension worth £31,266 per year on retirement at the age of 60, if they received annual pay rises of 4.7%. With the introduction of the pay cap, it says, the pension of someone who remained in the capped DB scheme would amount to just £9,200 per year.
Responding to the 2% cap imposed by Lloyds Banking Group, the Lloyds TSB Group Union described the move as "cynical", "opportunistic", and "dubious". Unite, the union representing workers at the Royal Bank of Scotland, described the bank's intention to impose a 2% cap as a "body blow" to members.
Setting a ceiling
As can be seen from table 1, the level at which the pensionable pay cap is set can vary from a complete freeze on pensionable pay rises from a certain date (eg magazine and newspaper publisher Archant, and pharmaceutical company AstraZeneca) to a less restrictive 3% (at RS Components), or inflation plus 1% (at the Railways Pension Scheme).
The BBC, Marks & Spencer and ITV set their limit at 1%, while pub and restaurant group Mitchells & Butlers set theirs at 2% (the Mitchells & Butlers DB scheme has, however, subsequently been closed to future accrual). Lloyds Banking Group and RBS take inflation into account - Lloyds setting its limit at 2% or the retail prices index (RPI), whichever is lower in any one year - and RBS at 2% or the consumer prices index (CPI).
Companies setting their pensionable pay ceiling at 2.5% are the motoring group AA, industrial gas company BOC, insurance group Legal & General, and TUI Travel. Construction firm Redrow has set its limit at the lower of 2.5% or RPI. AXA, the insurance group, and United Utilities ensure that members' pensionable pay growth keeps up with inflation by setting the ceiling at RPI.
Concessions
Several of the employers covered by this survey have not experienced straightforward negotiations with members when implementing the pensionable pay cap. The AA, for instance, originally proposed a 1% cap but this was changed following consultation to 2.5%. United Utilities proposed two different cap levels for different sections (5% or RPI in one, and 2.5% or RPI in another), but the final result was a cap set at RPI for all members, across the board.
The Railways Pension Scheme had planned to freeze pensionable pay and transfer out some of the members, before its negotiations (as referred to previously, an RPI plus 1% cap was eventually agreed). Some organisations, such as the BBC and AstraZeneca, suffered strike action as a result of pensionable pay cap proposals. The BBC resolved its dispute by agreeing to the establishment of an alternative career-average scheme with an annual revaluation rate of 4%, or CPI if lower.
Reducing the adverse effects
Employers that introduce a cap on pensionable pay growth can soften the blow to members in various ways (see table 2). For instance, an option to transfer to a career-average scheme can be introduced (as at the BBC and the AA). Some companies provided assistance to help members decide the best option for them. The AA, for instance, set up an online calculator and held face-to-face briefings.
At Archant, RS Components and TUI Travel, the balance of pay awards above the cap counts towards benefits through a DC plan. At TUI Travel, the cap also only relates to staff earning more than £30,000.
AstraZeneca provides incentives to members of their DB scheme who opt to move to a DC alternative. The company offers 14% to 18% of "base" salary, either to be paid into the company's group self-invested personal pension, or (for eligible employees) as cash, to spend as they wish within the company's flexible benefit arrangements.
BOC takes a long-term view of pensionable pay increases, averaging pay out over rolling five-year periods. This means that in years when an individual's increase in pensionable earnings is less than 2.5%, they earn a credit equal to the difference between the increase and the cap. This can be applied to offset the effect of the ceiling in years when the increase in pensionable earnings is more than 2.5%. AXA uses a similar methodology.
Another way to make the move more palatable to members is to promise a regular review of the cap. The Railways Pension Scheme cap will be reviewed every three years by the company and unions.
Limiting cap to future accrual
Unlike many others affected by a pensionable pay cap, members in the AA and Legal & General DB schemes have some protection for their accrued benefits. In both cases, accrued pension, in respect of service up to the cut-off date, will be treated as a deferred pension. Only service after the cut-off date is affected by the pensionable pay cap. At the AA the accrued pension will increase in line with the RPI up to a maximum of 5%. At Legal & General, accrued pension will increase in line with the CPI to the same maximum, but with a comparator to average earnings being applied for some service.
Limiting the cap to future service only significantly reduces the amount of savings that can be made, which is why most employers instigating a cap do not ring-fence past service. "The main purpose of doing this type of change in a final-salary scheme is usually to reduce accrued liabilities," says Fortes. "If all you are trying to do is to cap the rate of growth in future, the most logical change that you can do is move to a career-average scheme. It would have broadly the same financial impact." He adds that ring-fencing past service in this way is an administratively complex task.
Limitations
It is likely that the trend towards pensionable pay caps will continue as schemes and employers increasingly look for ways to manage pension costs. However, there are some issues employers need to consider. Hymans Robertson points out that if the DB scheme is contracted out of the state second pension, there can be a risk in the future of breaching the contracting-out requirements, as the reference scheme statutory minimum is linked to gross earnings rather than pensionable earnings. In addition, if benefit accrual in the DB scheme is at a low level, there could be a risk of it not meeting the standard for a qualifying scheme for automatic enrolment, as, again, the quality requirement is linked to gross earnings rather than pensionable earnings.
Summing up on the motivation behind a cap on pensionable pay growth, Fortes says: "It is a perfectly reasonable and rational approach from an employer perspective because it does generally cost more to employ somebody in a final-salary pension scheme compared with those in DC pension arrangements. If you have two people working alongside each other in exactly the same jobs, you can equalise the cost of employment in one of two ways - by closing the final-salary plan and moving all employees to the same DC plan, or by capping pensionable pay growth for DB plan members."
The research for this survey is based on information provided by the companies, company annual reports and press statements, as well as from unions and press reports. We have also benefited from a newsletter produced by Hymans Robertson, and from interviews with Clive Fortes, head of corporate consulting at Hymans Robertson, and James Patten, a benefit design specialist from Aon Hewitt. Occupational Pensions gave all of the organisations named in this survey the opportunity to comment on the accuracy of the article prior to publication.
Table 1: Defined-benefit schemes with pensionable pay caps |
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Company/Scheme |
Cap on annual increase to pensionable earnings |
Date introduced |
AA |
2.5% |
July 2010 |
Archant |
Frozen - no pay rises recognised after cut-off date |
December 2009 |
AstraZeneca |
Frozen - no pay rises recognised after cut-off date |
July 2010 |
AXA UK Group Pension Scheme |
RPI |
June 2009 |
BBC |
1% |
April 2011 |
BOC |
2.5% |
April 2011 |
ITV |
1% |
January 2010 |
Legal & General |
2.5% |
January 2009 |
Lloyds Banking Group |
2% or RPI if lower |
April 2010 |
Marks & Spencer |
1% |
October 2009 |
Mitchells & Butlers |
2% |
October 2009 |
Railways Pension Scheme |
RPI plus 1% |
December 2010 |
Redrow |
2.5% or RPI if lower |
July 2009 |
Royal Bank of Scotland |
2% or CPI if lower |
April 2010 |
RS Components |
3% |
June 2008 |
TUI Travel |
2.5% for staff earning more than £30,000 |
April 2011 |
United Utilities |
RPI |
April 2010 |
Table 2: Additional features associated with pensionable pay cap |
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Company/Scheme |
Additional features |
AA |
At cut-off date, accrued benefits are treated as a deferred pension, increasing in line with RPI to a maximum 5% per annum for service up to the cut-off date (up to 2.5% for service since then). Option to move to a career-average revalued-earnings section as an alternative to final-salary. |
Archant |
Balance of pay awards above cap paid into DC plan, which has matched employer contributions. |
AstraZeneca |
New group self-invested personal pension plan replaced DB scheme; members get 14% to 18% of salary as funding in respect of pension or other flexible benefits when they transfer over. |
AXA UK Group Pension Scheme |
Pensionable salary may increase by more than RPI in one year to balance out lower-than-RPI salary increases in previous years. |
BBC |
Members of DB scheme can transfer to new career-average or DC scheme. |
BOC |
The cap is averaged out over a rolling five-year period. A special variable pensionable earnings cap provides protection for members whose pay fluctuates. |
Legal & General |
The value of benefits accrued up to 31 December 2008 are underpinned using a specified formula. |
Mitchells & Butlers |
Balance of pay awards above cap paid into DC section. DB scheme subsequently closed to future accrual. |
Railways Pension Scheme |
Cap to be reviewed every three years by company and unions. |
RS Components |
Balance of pay awards above cap paid into DC plan. |
TUI Travel |
Balance of pay awards above cap paid into DC plan. |
