The liabilities of DB schemes are often seen as a burden on younger savers, but is this really the case? James Phillips explores the arguments
- More money is spent on DB to plug deficits
- Low interest rates could be to blame for small DC pots
- Collective DC schemes could provide a solution
- Government needs to introduce national savings target
Most defined benefit (DB) schemes have now shut to new members, some closed to further accruals, but DB liabilities still total around £1.75trn.
Promises made to scheme members decades ago are now haunting DB schemes who are saddled with huge and rising deficits.
In the process, younger defined contribution (DC) members are losing out, at least according to the Intergenerational Foundation (IF).
According to IF, these huge liabilities are "placing a severe economic burden on UK companies." As a result, DB schemes are funded by private companies up to 20 times more than their DC counterparts. In a recently published report it claimed £42bn is being spent on DB per year, compared to just £1.8bn on DC.
This report has been met with a mixture of scepticism and agreement. In a Pensions Buzz earlier this month respondents were split, with 45% believing the young's DC funds were being "sacrificed" for DB schemes, while another 45% disagreed.
DB contributions higher
Hargreaves Lansdown senior pensions analyst Nathan Long adds the IF's report echoes 2013 Office of National Statistics data, which shows 50% of DB members receive contributions of 15% or more. Meanwhile only 4% of DC members benefit from the same level of contributions.
"The figures going in per employee into DB schemes is far in excess of DC schemes," he says. "This is commonplace – there's a massive difference between the two.
"When you factor that the employer must provide sufficient contributions for deferred members too, it's clear you've got complete disparity. It will probably be holding back the amount employers are prepared to put into the DC scheme, partly because they're not in a position to afford that."
Nevertheless, Dalriada trustee representative Mike Crowe says trustees will do only what they can afford to do, against a backdrop of rising DB deficits.
He says: "A finance director has to service a DB recovery plan and, on the other hand, set up a DC scheme. You've got the golden generation with DB, against millennials who are relying on DC. If you ask most trustees, we have to make a DC pot available but only to the extent of the affordability of the pot."
Redington co-founder Rob Gardner agrees, arguing there is no impetus for companies to raise DC contribution rates.
"You need decent contributions occurring over a long enough time, combined with decent investment performance. In a DB world, every three years that's monitored and the underperformance is made up.
"In a DC world contributions are lower and have gone down since auto-enrolment (AE). This is because there's not a compulsion to comply. Why would you put more money in?"
Government policy to blame
However, perhaps the problem cannot simply be blamed on one thing. ShareAction chief executive Catherine Howarth believes a wide range of problems are responsible for the huge financial gap between generations.
She says: "There is a big intergenerational problem but it isn't as simple as blaming DB. It's true that baby boomers are doing well compared to millennials, but the IF report is a little overblown.
"There will be some employers where it is a fair point, but there'll be others thinking about DC as an important employee benefit. It would be dangerous to generalise.
"The idea this is just a problem with DB is far from the truth. There are many other aspects of what needs to be done to get a truly world-class, fit-for-purpose and socially just pension scheme for the younger generation."
Pinsent Masons head of strategic development for pensions Robin Ellison believes the gap is a consequence of government policy and interest rates.
"Discount rates go up and down and, at the moment, they're on their knees. This is partly to do with quantitative easing and other macro-economic issues.
"Although the regulator makes companies put more money into DB schemes, employers don't think they really need it. They certainly wouldn't put that money into DC if it was available.
"The IF has got a point, but it's superficial and misleading. DB schemes are hoovering up money because regulators are making them, not because old people are trying to screw up young people."
Independent Trustee Services director Peter Askins agrees, arguing DB sponsors are simply fulfilling their legal obligation to counter scheme deficits, not neglecting DC members.
He says: "Much of DB 'investment' is not investment at all. It's driven by a regulatory regime saying deficits must be filled as soon as possible.
"People who live in the pensions silo seem to forget the goose that lays the golden eggs is the company. Resources are finite, so if you are paying down your debts, you can't invest in whatever you want. That's the trap DB schemes are in."
These are policies that could potentially be changed, easing the difficulties faced by DB scheme sponsors.
IF co-founder Angus Hanton believes government policy on DB taxation and alignment with the retail price index are boosting the cost of DB schemes.
He says: "Government could make tax treatment of DB schemes closer to those of DC schemes, and could legislate to require only consumer price indexing and to require that pensions trustees always include young people. It's also possible to review accounting rules so that low interest rates don't have the effect of exaggerating the deficits of DB schemes."
He continues: "Difficult choices have to be made but at the moment the economic costs of increasing longevity are being borne exclusively by younger workers rather than shared between generations."
New DB provision
So, what should the pension landscape look like to ensure younger savers get a decent retirement pot?
Howarth believes they would be best served if there were fewer DC schemes and master trusts.
"There are far too many DC schemes," she says. "We need a small number of high-quality DC schemes with members sitting on the board. And, there are 103 master trusts in the UK, which are all competing. This is a bad idea. We need choice in the market, but we should have 10-15 providers at scale.
On the other hand, Ellison believes the future of DC is numbered. He suggests low interest rates will cause the rebirth of DB schemes, albeit not as 'gold-plated' as before.
"In the next few years, it will be discovered that because of low interest rates DC schemes are very inefficient and don't give enough benefits. We will inexorably move back to some kind of DB, much simpler than before. People need some DB protection.
He continues: "Government should be encouraging collective defined contribution (CDC) schemes. What you need is a system protecting you whether you die tomorrow or in 30 years. DB schemes mostly cope with that, and DC doesn't.
"Over the next five to ten years, new DB systems will begin to be developed as people get cross with what they're getting."
Hanton agrees that CDC could be a good approach, as long as younger savers don't face the burden of topping up the scheme if more funding is required.
He says: "The Dutch have explored CDC, and this approach has some serious attractions. Not only do they pool longevity risk but they give the potential to pool workers in a similar industry which can avoid the ‘injustice' of the manual worker with his shorter life expectancy cross-subsidising the pension of the female professional desk worker with her much longer life expectancy.
"However, these have to be carefully designed so where pension needs turn out to exceed the resources available, you don't see younger members of the scheme required to make up the shortfall."
Long disagrees, arguing CDCs are too similar to with-profit funds which failed to cope well with market difficulties in the early 2000s.
"We saw a move to look to create a CDC scheme at an industry level under the coalition government, but that looks like with-profit funds," he says. "I'm not convinced they would work. The direction of travel is that collective DC schemes have been left behind."
Askins believes additional state provision might provide a solution.
He says: "There must be more state provision of some kind, because it is clear people earning less than the median wage can never afford to save enough for a meaningful outcome.
"There is no reason why you couldn't have a state-funded second pension underpinned by government guarantee. People will be encouraged to save into that. That would be one way of bridging the gap."
However, Gardner believes the answer lies in higher DC contribution rates: "We need to up the contribution rates for DC. The closer we get to 15%, the better. It would also be helpful if the government set up a national savings target, explicit on how much people need to save."
Although there is a sizeable gap between the amount contributed to DB and DC retirement pots, there appears to be no general consensus on its cause. A mixture of DB deficits, government policy, and low AE contribution rates, among other factors, seemingly affects the growth of DC pensions. Nevertheless, without renewed scrutiny on DC policy, savers may find themselves disappointed when they reach retirement age.
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