Clause 17 - Indexation requirements for cash balance benefits

Part of Pensions Bill [Lords] – in a Public Bill Committee at 2:45 pm on 14 July 2011.

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Photo of Steve Webb Steve Webb The Minister of State, Department for Work and Pensions 2:45, 14 July 2011

The clause deals with a category of pensions known as cash balance schemes. I must explain what clause 17 does before I explain why we want to change it, so I hope that will obviate the Committee’s need for a separate clause stand part debate.

A cash balance scheme is rather unusual. Traditionally, one assumes that a pension scheme either provides a percentage of salary or is a pot of money invested in the stock market. With a cash balance scheme, however,  someone will get a certain amount of cash and the amount of pension it converts into depends on such things as annuity rates at the time, so it provides a measure of pension guarantee but not complete certainty, somewhere between DB and DC in the spectrum of risk. Historically, with cash balance schemes, when the pension pot is converted into an annuity there has been an obligation to buy an indexed annuity. In fact, however, some such schemes could be regarded as having the character more of a DC scheme than a DB scheme. The clause is about whether cash balance schemes require mandatory indexation.

To give the Committee a feel for the scale of the situation, there are currently about 80,000 members of cash balance schemes in the UK and—compared with about 53,000 DC schemes and about 6,000 DB schemes—there are about 2,000 hybrid schemes, in which older cash benefit schemes are generally included. The number of such schemes is likely to grow in the coming years as schemes are opened to new members and there is accrual.

The change included in the clause is not intended to affect the overall value of an individual’s accrued pension. What will happen is that the member, not the scheme, will pay for the indexation benefit through a lowering of the starting annuity rate. As when buying a normal annuity, an individual can choose a level annuity or an indexed annuity that starts at a lower level, but gets higher depending on the inflation rate. In that scenario, if a member chooses to take an annuity without indexation, the pension would at first be paid at a higher flat rate, but its relative value would decline over time.

Section 51 of the Pensions Act 1995 sets out the indexation requirements for occupational pension schemes. The clause amends that section so that, for schemes that can take advantage of the relaxed requirements, an annuity or pension paid from the scheme no longer has to include limited price indexation, which will give scheme members greater choice.

I can feel an intervention coming on, with someone asking about schemes with a guaranteed conversion rate, but I will pre-empt that intervention. The Committee will be reassured to know that, under the clause, cash balance schemes that offer a guaranteed rate of conversion or a guarantee to calculate the pension as a proportion of the accrued sum are excluded from the relaxation of the indexation requirement, because such schemes promise a particular rate to their members and that needs to be funded. For the record, cash balance schemes which are or have been contracted out on a defined-benefit basis will not be affected by the clause unless the only period of such contracting out was before April 1997.

The group of Government amendments will make minor and technical changes to clarify the operation of the clause in relation to cash balance schemes that include periods before 6 April 1997, where the scheme has contracted out of the state additional pension system in relation to an earner’s employment. The amendments will ensure that the indexation requirement continues to apply to schemes that were or are contracted out on a defined-benefit basis after 6 April 1997. As my note states, that “limits potential for confusion”, which might otherwise have arisen. If the amendments are not made, schemes might be prevented from taking advantage of the relaxed indexation requirements if they had been contracted out before 6 April 1997 on a defined-benefit basis. The amendments deal with that potential policy  confusion and will restore the policy intent of the clause, which, as it gives scheme members new choices, will be generally welcomed and I commend them to the Committee.