Defined benefits in retreat but lets keep targeted pensions

Where did it all go wrong? The UK defined benefits (DB) pensions industry was the envy of Europe in the 1960’s. At their peak in 1967, 8.1m employees were active members of private sector schemes. By 2006, numbers had slumped to 3.4m (source: ONS–Occupational Pension Scheme Survey 2006).

DB schemes were and remain popular amongst workers. And why not, few would argue against a predictable income at retirement, based on company service and earnings close to retirement. The decline in DB schemes has gained momentum over the past five years. Around two-thirds of schemes are no longer open to new joiners.

This situation is attributed to many issues. Legislation
by successive governments has heaped costs and complexity on employers. The fact that such schemes are set-up voluntarily by employers appears lost on the legislators. The cost of DB schemes has always been open ended, but in their heyday, life was a lot simpler with relatively simple benefit features.

Then change began in the 1970’s with statutory preservation of benefits for early leavers. Followed by, SERPs, contracting-out and Guaranteed Minimum Pensions. Then statutory evaluation of early leaver benefits and pension increases in retirement added to costs.

SERPs were modified in 1988, being deemed unaffordable. Contracting-out rebates were reduced in real terms; more cost and complexity. Legislation required surplus assets, yes surpluses to be reduced. Schemes either took contribution holidays, improved benefits or taxed refunds.

All of the above, plus, Gordon Brown’s tax raid on dividend
income, falling stock market values, improving mortality,
Pension Protection Fund levies and the requirement to
include actuarial liabilities on company balance sheets
have weighed heavily on the viability of schemes.

Finally in 2007, the government announced measures in the Pensions Bill to ease the burden on employers, but it is too little too late. The voluntary concept of employer DB schemes has long gone. In cold terms, for most employers, rising and uncontrollable costs are disproportionate to the value of the scheme.

Some employers have increased employee contributions and/or scaled down accrual rates for future benefits. But such changes just add to the complexity and costs are still not predictable. For these reasons, Defined contribution schemes (DC) are the preferred choice for most employers.

Retain the target benefit concept
An issue with DC schemes is that retirement benefits are not predictable. Consumer research consistentlydemonstrates people grossly underestimate the saving required to secure a decent pension. If and when they do understand what is required it is usually too late and/or unaffordable.

Young people must be encouraged to save for a pension as soon as they have regular earnings. Even low level contributions are better than no commitment, providing they recognise the need to step-up savings in future.

However, the ideal approach is to use the target benefit feature of DB schemes. Each employee is asked to consider the proportion of their pre-retirement income they will need as a pension.

Providers have on-line tools which calculate contributions required to achieve the target. Contributions are expressed as a percentage of earnings. The calculations can make an allowance for spouses’ pensions, indexation of pensions, state pension benefits etc. Calculation tools usually provide a ‘what-if’ facility, enabling the individual to consider various scenarios before settling on an affordable
contribution rate.

Information must be absolutely clear that quoted pensions are estimates not guarantees. Contribution rates should be reviewed periodically, to take account of actual earnings growth, current fund values, prevailing annuity rates, state pension benefits, etc. This process help members understand if they need to save more or less to stay on target.

The targeting concept within DC pension schemes is a positive planning tool and is gaining wider recognition.