Today, defined benefit (DB) pension schemes are seen by many as legacy products that are as antiquated as a “job for life”. The idea behind DB schemes is to give members a pension when they retire. The pay-out is based on pay and service combined. The benefit may have been an agreed amount paid weekly or a set amount allowed for every year of service in the company. Over the years, DB schemes have modified. By this, the modern version is a package steeped in ambiguity because it is expressed as a fraction or percentage of pay taken at or near retirement – a tall order for the company making the promise to plan for, when the final salary is unknown.
For the employer and employee, the DB offers two very different sets of perspective. Let’s concentrate on the former in this instance. It is difficult for an employer to guarantee a guaranteed pension scheme in times of economic uncertainty. For a plan with such a long shelf life (until the youngest member in the scheme passes away) and very little predictability or accurate forward cost estimates, the management of such a liability can prove an enormous headache for companies.
Management and good advice are key components when dealing with existing DB schemes. Employers will need to factor in the elements at play that can substantially alter progress. These can include changes to interest rates, risks in the financial markets and inflation. Employers want to know if DB schemes are sustainable and represent good value for them and their employees. It can cost companies a lot of money to keep these schemes in operation especially in the context that spending your working life with one company is highly unlikely.
Yet it remains that there is a feeling that DB schemes are good when compared with Defined Contribution (DC) pensions where your employee contribution and the contribution paid by your employer are usually fixed as a percentage of salary. Often the issue with DC Schemes is that the contribution rate is significantly lower than what is being paid into the DB Scheme – this will obviously lead to a poorer outcome – contribution levels are critical to the success of DC Schemes.
The Irish Auditing and Accounting Supervisory Authority (IAASA), published a report in August of this year which looked at 28 equity issuers. Of these, 17 have DB schemes.
The IAASA study gives good reading on the intricate nature of operating a DB scheme. This survey focused on the four assumptions that issuers most frequently address in pension accounting including: discount rate; rate of increase in salary; rate of increase of pensions in payment; and inflation. The report also noted that the total present value of the defined benefit obligation for all issuers included in the survey was €23.7bn while the fair value of the plan assets amounted to €20.7bn. This gives a total net pension deficit for all issuers included in this survey of €3bn, compared with €4.7bn in the previous financial year.
A question employers with DB schemes should ask is whether the scheme will come good if interest rates fall? The general opinion is that once interest rates normalise and return to 3% and above the schemes will be affordable again. But, accounting laws have changed over the last few years meaning company’s must now declare DB liabilities on their balance sheet. We only need to look to the UK to see how this declaration impacts a company’s ability to trade and balance sheet issues can pose big problems when there is a pension promise to employees, past and present.
A DB pension scheme is akin to an insurance business and needs to be managed as such (as pensions regulation is moving closer to that of an insurance company). A company cannot leave the management of schemes to volunteer trustees. Indeed, perhaps the most interesting barometer of DB durability is the fact that practically all financial institutions in Ireland have moved away from this pension scheme model and no longer offer a DB option to employees. The pensions industry no longer offer DB Schemes to their employees – a clear signal to the rest of the market.
Rebekah Brady is an Acuvest senior investment advisor, focusing on investment research and client management. Contact Rebekah at email@example.com
Acuvest is an independent pensions and advisory management business taking care of the futures of over 40,000 of our clients’ employees. For more market analysis and expertise follow Acuvest’s daily updates on Twitter @AcuvestIreland and LinkedIn and our fortnightly blogs.