Starting with a blank slate, the first characteristic of this new plan would be a liability-led approach to investment. Recent history has shown that over-reliance on equities can cause high volatility and pension funding shortfalls when markets perform badly. Ideally, a plan would be more closely matched to its liabilities, heavily invested in bonds right from the beginning. This would significantly reduce the mismatch of assets and liabilities that has caused UK financial directors difficulties in recent years, and mean that funding levels would be far less volatile. A far cry from the volatility we’re currently seeing – for example, in September the combined FTSE 100 pensions deficit was £58bn, having been £78bn the previous month.

However, this approach would also increase the likely cost of funding the plan, as it would benefit from potential equity upside. This is the reason that some reward-seeking assets might be included in the mix; a portfolio of purely government bonds, while a good match to the liabilities, may make the pension plan prohibitively expensive to fund.

The second trait of our perfect DB plan would be transparency. Sponsors would have a clear, frequently updated picture of what the pension would cost them. In the first instance, this transparency is aided by the more predictable, bond-heavy, asset allocation. Sponsors might also use a series of risk caps and controls to avoid any nasty surprises.

As the size of an individual’s DB benefit is typically linked to their salary, two salary caps might be put in place. First, there would be a cap on what speed of salary growth is taken into account for calculating the pension’s size. So instead of benefits linked to salary inflation, benefits would be limited to price inflation or a fixed cap, eg increases of 2% a year. Also, there could be an absolute cap on the highest salary level on which the pension would be based. These changes would help mitigate the impact of one of the most costly DB scenarios: the employee who joins at a young age and rapidly moves to a well-paid position. Such an individual’s salary growth and size would be capped, in pensions terms. At the same time, the caps wouldn’t usually impact lower earners so much, and so their benefits wouldn’t be affected significantly.

This is an important provision, as lower earners are more likely to need and value the security of a DB pension than their better-paid colleagues, who may more optimally be compensated through other items of the reward package. In other words, more pension protection will go to the employees who need it most. One challenge is to ensure the relevant employees understand and appreciate this benefit.

When most DB plans were established, employers had not anticipated the improvement in life expectancy we are now seeing. Increased longevity has been one of the causes of DB pain for sponsors, and our ideal plan would manage this from the start by establishing a life expectancy cap. This would link the date when a pension could be drawn with longevity; for example, if average life expectancy rose by several years, employees would have to wait additional years before claiming their pension. This would avoid DB pension costs being driven up by increased life expectancy for future pensioners.

A final cap would be a limit on pensions increases. A retiree’s pension payments conventionally rise with price inflation, capped at 5% a year. This creates extra volatility, and a lower pensions increase cap would give a lower limit for the inflation rate – 2.5% a year, for example.

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