Pensions and innovation are not usually two words you would put together, as the first generally makes people yawn while the second makes people think of whizz-bang gadgets like iPads. But in response to the growing pensions crisis and ageing population in the UK (and other developed countries), the stodgy world of pensions is looking for new solutions. The long-term trend of a shift from defined benefit (DB) pensions - where the employer agrees to pay employees a set percentage of their final salaries as long as they live - to defined contribution (DC) - where the employer pays a set contribution to employees’ pension funds but the ultimate amount the employees receive is down to investment performance - could be halted as two different approaches are gaining popularity. The first, hybrid plans – also known as cash balance plans – share the investment risk between employer and employee, rather than putting it entirely on the employer (in the case of DB) or on the employee (with DC). Like DB, the employer manages investment collectively for all employees and gives them a guarantee. However, unlike DB, that guarantee is a set cash value at retirement, rather than a set income throughout retirement. The employee is responsible for turning that pot of cash into an income at retirement, usually through an annuity, as with a DC scheme. With the other option, known as collective defined contribution (CDC), employers make set contributions and are not responsible for any risk (as in a DC scheme). But instead of individual employees shouldering their own investment and longevity risk, this is shared amongst them. Employees contribute into a collective fund rather than individual savings accounts. When fluctuations in investment returns result in the collective pension pot being worth more or less than previously anticipated, projected pensions can be adjusted to balance the books. This can be done in different ways but the main approach is to allow those approaching retirement to be less heavily impacted by low returns than younger members, as the value of the collective pot should increase over time, making up the losses. However, because the younger members of the scheme are in effect subsidising the older members, critics of CDC have called it a Ponzi scheme. Neither approach is perfect but neither are DB and DC schemes. Working to find a balanced approach where risk is better shared is a major step in the right direction. Of course even a perfect system relies on both employers and employees contributing enough to ensure that the end result is a sufficient pension!
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