It has become generally accepted that defined benefit (DB) pensions are a dying breed, at least in the private sector, but what is the evidence for this?
Species die out in a number of ways. They could be hunted to extinction like the dodo, suffer a major environmental catastrophe like the dinosaurs, or they could fail to reproduce in sufficient numbers as the pandas seem likely to do.
The recent publication of the Pension Protection Fund’s Purple Book assesses the current state of play for defined benefit pension schemes and shows us an entity that has been subjected to all these scenarios and survived, but in considerably reduced numbers.
It seemed like a good idea at the time…
First of all, they were attacked by a wave of legislative changes, these were well-intentioned but fatal for many.
In order to protect members’ rights a succession of Parliamentary Acts increased the depth and scope of guarantees that employers were obliged to underwrite. The right to preserved benefits on leaving employment was introduced in 1975, swiftly followed by the requirement to revalue these deferred benefits and provide indexation of pensions in payment.
Then came the statutory funding requirement and the introduction of recovery plans for schemes which failed to meet it. This has developed into full-blown funding principles, investment strategy and governance, all of which increase employer obligations and potential costs.
In the midst of all this, DB schemes were hit with a second challenge – the massive environmental impact of the market crash in 2008 and the resulting fallout.
Investment returns in the 1990s had been extremely positive and many final salary schemes had come to rely on them, to the extent that temporary contribution holidays were seen as reasonable. When the market downturn began solvency ratios plunged dramatically as schemes not only had to absorb the impact of lower investment returns but also much lower interest and annuity rates which further increased the cost of their liabilities.
As a result of all these pressures, many DB schemes closed, at first to new entrants, and then increasingly to future accrual. Currently, only 12% of private DB schemes are open to new members and, of these, only 47% are open to new benefit accrual. And there are no new schemes to replace them.
DC is the future
The net result of all of this is that defined contribution (DC) savings are undoubtedly the future of private pension saving, on top of a decreasing state pension. Recent figures from the OECD show that the lifetime value of state pensions is declining all across the developed world. And although some are still very generous, the replacement rate in the UK for an average lifetime wage earner is only 29% – the lowest of all the OECD countries.
Defined contribution is not necessarily a bad thing, providing enough money is paid in and the fund achieves the desired investment growth. ONS figures show that the average contribution rate in private DC occupational schemes is only 5.8% of pensionable earnings and 7% for group personal pensions, in comparison with the average of 22.5% paid into DB schemes.
So long as this continues we cannot begin to expect that DC scheme members will achieve the same level of benefits as DB scheme members can expect to receive. Should the mooted defined ambition model become available it will not so much solve this issue as highlight it.
People with DC pensions are also likely to need more support. Under DB all the investment decisions and the impact of poor returns, high charges and poor annuity rates are managed by the scheme.
Furthermore, the retirement income is defined – members will know what income they will receive. Under DC all of these risks and uncertainties are carried by the employee and it is likely that employers will come under pressure to assist, by offering increased guidance and/or access to regulated advice.
In summary, current DC pension schemes may be seen as not having come far beyond the small brown rodent stage that eventually evolved into a dominant mammalian species, while DB schemes are looking increasingly like dodos.
This wide void needs to close and quickly if we are to see retirees achieve and maintain a good standard of living in retirement.
Fiona Tait is technical director at Intelligent Pensions