The closure of the Independent News and Media DB scheme that was announced in November 2016 is just one in a growing number of defined benefit (“DB”) pension schemes being wound up over recent years. These wind-ups can result in some members receiving less than the benefits that they had originally expected, and significantly so in some cases. Even for those who don’t work in the area of pensions and investments, it is impossible to have missed the increased level of media focus on the problems that have been and continue to be facing DB schemes, their trustees, sponsoring employers and ultimately their members.
It goes without saying that any events that lead to members of a retirement savings scheme receiving a lower level of benefits than they had expected is regrettable, and is likely to inevitably lead to severe disappointment and difficulties for those affected. Any such events should definitely be looked into, and hopefully addressed to reduce the chances of reoccurrence, but the simple fact is that trying to provide a predictable income for people in retirement, in the absence of being able to predict how long they will live, interest rates, inflation rates and investment returns, is a complex matter. In an effort to smooth the cost of providing these benefits over the working lives of the members of a DB scheme, the actuary makes a series of assumptions that include the investment returns that will be earned each year (often for more than 60 years), the interest rates that will prevail when members come to retirement (sometimes more than 40 years into the future), and how long the members will live and draw down benefits in retirement.
As a means of providing retirement benefits for people, DB schemes offer some distinct advantages over other vehicles, such as defined contribution (“DC”) schemes. For one thing, large DB schemes have the ability to provide for paying benefits based on the average life-expectancy of its members. This compares with an individual DC member who probably has to have significantly more in contingency because they might live for 10 or 15 longer than the average member and need to avoid running out of assets while they still have spending needs (often referred to as bomb-out). As the assets in DB schemes are also invested in a pooled manner and there is a degree of visibility of their future cashflows, DB schemes have more freedom to invest in less liquid assets. DC Schemes still widely require very liquid or daily-dealt investments which restricts their investment universe.
DB schemes by their nature offer members a fixed level of income that they can expect to receive in their retirement, for as long as that might be. This “defined benefit” is conceptually appealing to many people, as it offers a degree of visibility that allows people plan for their financial future. DB members assume they are provided for in retirement and they don’t tend to think about the difficult variables that DC members need to consider, like making investment choices, achieving sufficient investment returns, deciding on an appropriate level of contributions (or savings), thinking about future interest rates, or even setting an objective for themselves on what they want to achieve from their retirement savings. DB schemes do not allow people vary the level of benefit they will get, or the manner in which they can take their benefits, and as such, all of the decisions are taken by the company and scheme trustees, which is a great relief to most scheme members.
Unfortunately, a combination of low interest rates, investment returns below previous expectations, and improvements in people’s longevity expectations means that the cost of providing the benefits that were promised to members of DB schemes is now very high, which has led to many DB schemes facing funding challenges. For this reason, many schemes have been forced to reduce the level of benefits that they can offer to members, and many employers have decided that traditional DB benefits are no longer affordable. Accordingly, at this stage many, if not most, DB schemes in the private sector have been closed to new entrants, and increasing numbers of DB schemes have now closed to future accrual.
The new risk to members of DB schemes is that employers are increasingly placing a limit on the level of cost that they are able to, or in some cases prepared to, allocate to providing retirement benefits for past and present employees. The legislative protection that is provided to pensioner members of DB schemes and the absence of new members means that younger members (who are at the end of the queue to collect benefits) are bearing an increasing level of risk that the assets will not ultimately be sufficient to pay their expected benefits. It is clear from our work with companies, trustees and scheme members, that many members are not aware of this risk. In some cases, despite the fact that the scheme may not be in a position to pay the benefits it has already promised to members, the existing employees are continuing to make contributions in the expectation that a way will surely be found to pay future as well as past benefits.
While we welcome well intentioned initiatives such as the recent pensions bill to place a legal obligation on solvent employers to fund DB schemes up to the minimum funding level before winding them up, and the recent ICTU paper advocating that DB schemes should be protected and preserved where possible, it is our contention that when grappling with difficult pensions issues, companies and their advisers need to remember to focus on how to allocate the available assets in a manner that is fairest to all members (pensioner, past and present). It is very easy to be distracted by the complexity of DB schemes and the various assumptions associated with retirement savings and to end up focussing on trying to “fix the DB scheme” or “make things right”. However, if there is any doubt over the strength of the employer covenant to ultimately pay all benefits and to provide sufficient funding to satisfy regulatory requirements, then there is a case for allowing younger members to choose to move their share of the assets and the future contributions into a different retirement savings arrangement, such as a DC scheme.
While saving for retirement through a DC scheme involves the investment risk shifting from the trustees to the individual member, this can be somewhat offset by the increased certainty that the contributions and accumulated assets within a DC scheme cannot be reduced by subsequent trustee or employer actions, “what’s mine is mine”.
Ultimately, whether pension benefits are provided through a DB or DC scheme, the level of benefits to be provided must be funded through a combination of contributions (employer and employee) and investment returns. If the equivalent level of contributions is put into DC scheme than would have been put into the DB scheme and the scheme is well managed, there is no reason why a DB Scheme should provide better benefits than a DC Scheme.
Damian Cooper is the COO of Acuvest, independent pensions advisory specialists.
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.