PensionsSchemes that mix aspects of defined benefit and defined contribution have been a surprise hit in 2006, with cost a major factor, writes Michael Madden

In the pensions world, the big talking point in 2006 has been the unexpected emergence of hybrid pension schemes. Major players in the financial services industry such as Allianz, the EBS Building Society and Irish Life & Permanent have all introduced them. Bank of Ireland's well-publicised proposals to alter its pension arrangements for new employees radically also involve a hybrid arrangement.

What exactly are hybrids, and why are companies introducing them now instead of following the well-developed trend towards defined-contribution (DC) pension schemes?

To understand the issue, we must firstly look at where we've come from. Up to now, companies with defined-benefit (DB) pension schemes faced three main risks: the risk of poor investment returns on the assets of their pension fund; the risk that salary or price inflation would cause payouts from the fund to be higher than expected; and the risk that pensioners would live longer than expected.

All three risks, if they go sour, cause companies to have to inject more cash into the fund. A fourth issue has emerged more recently: the requirement under accounting standards (eg, FRS17) and solvency standards to measure liabilities by reference to bond yields, which means that any movement in bond yields can result in a sudden rise or fall in liabilities. A sudden rise is of course bad news for companies to the extent that they don't see a corresponding asset gain, especially now that they have to show pension liabilities on their corporate balance sheets.

To help avoid the bad news, companies for some time now have been closing DB pension schemes and replacing them with DC schemes for new employees. The great thing about DC schemes, from a company perspective, is that they transfer all the risks to the employee.

If the investment performance is poor, or if greater longevity results in lower annuity rates, it's the employee that suffers, not the company.

Similarly, if employees get large salary increases, the company doesn't have to put extra money into their existing DC fund to ensure that they can buy the same pension relative to their new salary, which is effectively what happens in a final salary DB scheme. And accounting and solvency standards don't even apply to DC schemes, once the employer puts the promised contributions in. No wonder that DC has been seen by employers as the obvious solution to the pensions headache.

Why, then, have some companies plumped for some kind of hybrid between DB and DC in the face of such overwhelming logic for DC?

Believe it or not, one of the major considerations can be cost - DB can sometimes be cheaper than DC. In a white-collar industry such as financial services, it would be hard for a prominent player to get away with paying a DC contribution rate of much less than, say, 10 per cent of salary. While DB schemes seem to cost more than this, the reality may be different. Although the company contribution rate to the DB scheme may be up to 20 per cent, or even higher, if you look at it more closely you will find that part of this may be to fund a deficit, part of it will be to pay for death benefits, there will be an offset to allow for the State pension, etc. When you strip these factors out, the true underlying cost may be closer to a reasonable DC contribution rate.

But the real clincher in favour of DB is that the early leaver gets much lower benefits on leaving than he or she would get under a good DC scheme. For example, a leaver after five years under a typical DB scheme would get a deferred pension that might cost perhaps only 3-5 per cent of his or salary over that period. And when you have high staff turnover, as is often the case with financial services companies in this full-employment economy of ours, you may find that the overall cost of your DB scheme is lower than a replacement DC scheme of any reasonable quality. So not only does DB cost less for such employees, it fits in with most companies' preference to allocate more pension resources to those who stay with the company rather than those who leave.

When you add in the fact that trade unions generally prefer DB over DC, and staff may prefer it too, it can be much easier to stick with DB rather than introduce DC.

So, if DB is maybe not so bad after all, how can we control the risks? This is where the hybrid comes in.

There is a variety of things that can be done. The most common idea in the case of the institutions mentioned earlier is to put a cap on salary for pension purposes in the DB scheme. Once an employee exceeds the cap, they go into a DC scheme for the excess. The result is that, if the employee receives a large salary increase on promotion to a senior level, there is a limit on the salary that qualifies for pension purposes and hence the company doesn't suffer the same past-service liability "hit" that would arise in a pure DB scheme.

Another idea, which one company has implemented, is to increase the cash and reduce the pension that an employee takes at retirement. This reduces the longevity risk to the employer. In the UK, British Aerospace has agreed a retirement age with its workforce that will vary in future depending on longevity experience, which is another innovative way of controlling longevity risk.

Also in the UK, Tesco has changed its DB scheme to link the final pension to career average salary (with index-linking of salary up to retirement age) rather than to salary just before retirement, which controls the salary inflation risk.

The common ground among all these employers is that they have held on to the DB idea in some shape or form rather than ditching it completely for DC. In fairness to such employers, while cost may have been a contributory factor, in some cases there has undoubtedly been a desire to maintain a culture of caring for employees, and to protect them from some of the risks associated with pure DC.

And, given that DC schemes don't need actuarial valuations but hybrid schemes usually do, there may be a future for actuaries in pensions after all. Now there's a happy thought for 2007!

Michael Madden is a consulting actuary with Mercer