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Pensions
that fit There are not too many negatives with being paid a lot but there is one – the UK government’s pensions earnings cap. Introduced in 1989, pensionable earnings above £95,400 a year (cap for 2001/2) are excluded from tax relief. The loss in pensionable income forces companies to look at ways of making up for it. This maintains the value of the financial package which helps retain and recruit top executives. Unapproved retirement benefit schemes (URBS) still get the most attention while share schemes and incentive packages are poking their heads around the corner. With a cap now set in line with inflation at £95,400 the final year two-thirds salary rule for determining the pension, the maximum pension executives could receive with tax relief is £63,600. An average director’s earnings are rising faster than the RPI (retail price index) and the average salary is well above the cap. For example the median salary of a FTSE company director is £600,000 says Sue Bartlett, a partner in the Human Capital Group at Watson Wyatt, the financial services consultancy. Towers Perrin, the financial consultant reveal in a survey conducted in 2000 that 92 per cent of the 200 companies they interviewed had ‘capped executives’. Of these companies, 22 per cent had more than 20 capped salaries. It follows that the cap is a very important issue during recruitment interviews with high level executives. William M. Mercer, the financial consultants, conducted a similar survey on the Pensions Earnings Cap last year. 62 per cent of a sample group of 200 companies said the cap was raised as an issue at recruitment interviews. At 83 per cent of the companies surveyed, the issue was raised when recruiting board directors. In practice “what normally happens is that any pension provision [above the cap] is paid by the employer,” says Rob Wild, European principle, at WM. Mercer. The company does so usually through URBS. Before any URBS are arranged however, the first step that might be taken could be to maximise the pension accrual rate, the rate at which your pension benefits build up. The rate is usually set at 1/60th of salary per year for each year you are employed at the company. Thereafter, an unapproved scheme would be the next likely step. URBS fall into two categories: the funded and the unfunded. Unfunded unapproved retirement benefit schemes (UURBS) are paid when retirement age is reached. With funded unapproved retirement benefit schemes (FURBS), money is built up in a fund. At retirement age there is a pot of money to pay some sort of benefit in annuities or a lump sum. After the introduction of the cap, UURBS were the most popular choice. They were the easiest solution to employ. In very simple terms, the amount of the unfunded promise could be the amount of pension that would’ve been foregone by the employee, given the cap. Tilly Ross, a consultant at Towers Perrin, says: “When the earnings cap first came in, most companies were providing final salary pensions. With pressure rising for a quick and easy solution they looked at providing something similar to final salary, but with an unfunded scheme.” Evidently, from an individual’s point of view an unfunded scheme is risky as it depends on the company being around at retirement age to pay your benefits. Says Peter Brook, senior consultant in executive benefits, at Aon Consulting Group, “UURBS are only as good as the company itself. If the company goes bankrupt, there is no security.” FURBS, on the other hand, are independent to the company’s livelihood. From the company’s point of view there is another deterrent to issuing UURBS. If the executive leaves the company before retirement age, the company is still liable to the executive up until his/her retirement age, when the UURBS is paid. The company may want to relinquish any ties to the executive straight after his departure. Rob Wild, European principle, at WM. Mercer, says: “The individual’s footprint is there even after they have left. They may not retire for many decades and it is especially bad if the executive has left without exactly covering themselves in glory.” Another reason UURBS may prove unpopular is when the company is not too keen on having the liability on their balance sheet. The number of UURBS may accumulate, creating quite a sizeable liability after a while. While UURBS have their many disadvantages, FURBS also have theirs. Most importantly, FURBS are subject to tax on the contributions paid in. These are payable by the employee. In addition, the assets in the scheme are subject to income tax and capital gains tax (34 per cent). In effect you are paying tax on benefits you won’t receive until much later. On top of the taxes, national income contributions were added to FURBS in 1998. But its popularity still didn’t waver. Of the companies surveyed by WM. Mercer, 34 per cent used the scheme. Looking ahead, 42 per cent cited FURBS as the instrument for compensating the earnings cap. Conversely, UURBS have fallen in favour to 24 per cent from 30 per cent in 1998. The arguments against UURBS are substantial now. But there will always be a market for them. Says Ross, “ Some organisations are now reviewing what’s right for them. Some organisations believe they are the right fit, for example some types of large organisations.” Larger organisations may have the reputation and financial stability to stick around. Indeed, recognising the need for security against an unfunded promise, companies are now offering SUURBS, or secured UURBS. A third party would often hold assets that would be cashed if the UURBS defaulted. Bartlett says: “If the UURBS defaulted, the independent trustee can cash in the charge they hold, cash assets like gilts.” Aside from URBS, employers may use extra cash and incentive schemes as a way for compensating pensionable pay. 28 per cent of respondents in the WM. Mercer survey said they are now offering extra cash as the solution to the earnings cap. This compares to 20 per cent two years ago. The cash solution offers individuals a cash supplement outside of their pay that would compensate the loss in pensionable income. While this is quick and easy it suits some and not others. Says Aon’s Brook, “if you pay cash and there is no [compensating] pension, they may feel that they let the employee down.” Although the reason is more emotive than financial, some employees may feel a pension is a necessary part of the remuneration package, even if it comes in the form of UURBS. Bartlett confesses to being surprised by the slow uptake in cash solutions: “I am a bit surprised that cash is not growing in use. It’s not as widespread as I would’ve thought.” The popularity of FURBS over cash could be that the longer-term nature of FURBS is desirable: “Some companies can build in a golden handcuff effect. FURBS cannot take benefit until retirement while cash is instant.” In terms of incentive schemes such as share options and performance-related pay, 17 per cent of respondents in the Mercer survey felt long-term incentive plans were more of a probable solution than UURBS benefits. Says Ross, “a new generation of companies say we will give you the pension up to the cap, and none over it. We’ll give a performance-related pay package instead.” The popularity of share schemes is driven by the presence of dot com companies, which tend to have a work culture relating pay to performance. The disadvantage of performance related remuneration is that the pension is now related to the performance of the company. Moreover the performance of the company is not necessarily under the control of that individual so it may seem unjust. Overall, FURBS are still the prevalent solution to the problems the pensions earnings cap poses, albeit an ad hoc policy is the most logical one to adopt. Companies are tailoring their remuneration packages according to various factors to create a mix and match end product for their top executives. Says Bartlett, “There is no panacea, you need to look at the company, then find the best way ahead.” Ross agrees, “One must think about what organisation it is. It [pension provision] depends on what the sector or industry the company is in, as well as the culture it has. There is quite a lot of change going on in the market presently.” Incentive
schemes loom large on the horizon. Bartlett thinks the market is
now talking more and more about the share schemes as an alternative.
“With an emphasis on corporate governance, there is nothing wrong
with pay linked to performance. Executives should not be feather-bedded
too much. There is a point where the icing on the cake [pensionable
pay above the cap] should be performance related even if the jam
in the cake isn’t [sub-cap pension].” BACK
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