Gary Smith, senior consultant at Watson Wyatt looks at whether defined contribution schemes provide the get-out clause to final salary schemes.

So, you’ve closed your final salary pension scheme to new employees and perhaps set up a defined contribution (DC) plan for new joiners. At least that is the employer’s pension headache covered in the long-term. Well, maybe not.

Unless appropriate action is taken, employers could wake up to an HR nightmare not too far down the road as and when these new joiners come to retire or start to realise that their dreams of a comfortable retirement will not be realised.

DC plans transfer all the investment risk to employees and empower them to take control of their retirement savings. This employee empowerment could indeed be part of a wider cultural shift within an organisation to give greater flexibility, control and personal responsibility to individual employees.

However, while employees are demanding more flexibility and choice, employers should not be fooled into thinking that this is entirely the right thing to deliver. Empowerment is great if you have the ability and know-how to deal with it, but unfortunately most employees do not.

They need all the help they can get to deal adequately with it. Given full empowerment, particularly in relation to retirement savings, the majority of employees will not cope and, quite frankly, most will not even know where to start. We are already seeing this where DC provision is in place.

Far too often the level of retirement savings being made by these employees, if any is being made at all, is woefully inadequate to ever have any chance of providing a sustainable level of retirement living.

If this is allowed to continue, then employers will soon begin to experience the effects of a workforce which cannot actually afford to retire. So what would happen if the workforce could not afford to retire in the future?

In this situation, employees are likely to turn to their employers for support, either by allowing them to continue to work or by blaming their employer for letting them under-provide and not giving them enough help and assistance to support them in the choices and decisions they had to make.

The problem will be a particular concern for employers where there is a strong union presence. A union backlash when these employees simply cannot afford to retire is a certainty.

The three major areas of concern in relation to DC pension provision are low take up rates, contribution rates that are too low and the DC ‘pensions lottery’, whereby income in retirement is affected by investment markets and annuity prices, both of which change over time and over which employer and employee have little or no control. There are a number of solutions to these problems, including:

• Automatic enrolment.
• To increase (or restructure) employer contributions.
• Review investment strategy.
• Review the benefit design.

In practice, however, no one single solution will deal with all the problems. Whatever is the right way forward for employers though, the critical point is for employers to recognise the need to act now to avoid the next pension’s crisis and stop the DC time bomb from blowing up in their faces.

Why a general lack of governance around DC plans is causing problems.