Is it too late to stop the clock before defined benefit (DB) pensions are consigned to history? Stephanie Hawthorne urges a return to ‘DB lite’ in place of today’s defined contribution (DC) workplace “retirement roulette”.
One of the greatest financial achievements of the 20th century, the private sector final salary pension scheme, may be as dead as a dodo within six years, according to Barnett Waddingham's DB End Gauge index. By 2029, it says the last 5,000 or so DB schemes will be sufficiently funded to afford buyout.
DB schemes gave millions of ordinary people, from bus conductors to car workers, a decent retirement income. Now workers are usually auto-enrolled in sub-optimal DC pensions, where employees bear all the risk of catastrophic loss - as my article Retirement Roulette in the Mail on Sunday highlighted.
Outcomes also vary widely, not only from one provider to another, but even with one year of retirement compared to the next. To get the best out of new DC schemes, individuals need financial advice too.
With a good DB pension, an ordinary worker with 40 years' service under their belt, earning a final salary of £30,000 a year, could hope to enjoy a pension of £20,000 a year plus a state pension of roughly £10,000. Such employees needed no expensive adviser. They could probably just stuff their benefit statement in the bottom drawer and forget about it until retirement and be better off in retirement than in work.
This was too good to last. As First Actuarial partner Mark Rowlinson explains: "The downfall of DB pensions wasn't just caused by legislation but a perfect storm of a decade of poor growth, falling interest rates and large improvements in mortality."
WTW senior director Simon Eagle agrees: "When there were surpluses, governments intervened to force indexation, and later, when funding levels worsened, the extent to which pension levels were best endeavours was ultimately not accepted by society."
Can we rekindle the DB flame?
Is it possible to rekindle the flame and bring back, if not a gold-plated final salary scheme, at least a silver gilt DB lite alternative - a pre-Maxwell version; without expensive guarantees or such strict regulation on investments; and one that is back to best endeavours and employees sharing the risk, with The Pensions Regulator (TPR) guarding the door in case of employers finding loopholes?
I put this to a straw poll of 14 experts.
WTW's Eagle sets the scene: "DB schemes usually have predominantly fixed benefits. They require employer contribution top-ups when in deficit, or could give contribution holidays while in surplus, and have the Pension Protection Fund (PPF) as back-up if the employer cannot provide the top-up needed."
By contrast, he says: "Collective DC (CDC) schemes usually have fixed contributions and adjust pension increase levels for upside / downside experience.
"DB lite could come in various different forms, and in particular could deal with downsides through loss of discretionary increases, and then additional contributions."
He concludes: "Stable benefit levels is the antipodal objective to stable contributions - unless you pay for full insurance of benefits, you cannot meet both aims. For DB lite, benefit-level stability could be somewhere between DB and CDC."
Perhaps the strongest advocate of DB lite is AgeWage chairman Henry Tapper, who believes it is both feasible and desirable "to keep DB schemes open".
He explains: "Employers get a great value employee benefit and members get a proper pension. Scrapping the DB funding code and permitting schemes to fund as they did before mark-to-market accounting was introduced could be of benefit to millions."
"DB lite could either work as CDC or with guarantees from the sponsor based on best estimate funding," he says. "CDC offers a target pension with no guarantees and works on a defined level of contributions; DB lite would have variable employer contributions but more certainty on pension payouts."
"Risk sharing would work well in social housing, unions and many charities which want to keep DB schemes open", he adds.
Accounting rules would have to change, says First Actuarial's Rowlinson, "perhaps by redesigning the PPF to allow its value to be incorporated into accounts in some way".
He notes: "Even with a lighter regulatory regime there would still likely be a reasonable level of volatility in funding levels and, as important, the current expected cost of new benefits accruing."
But he says this could be managed through normal retirement ages that adjust automatically for mortality trends and by putting some discretion back into pension increases.
Rowlinson explains: "Such features start to share risks a bit more with members and move the scheme towards something that looks a bit more like CDC but under a DB rather than DC framework and still providing an absolute minimum benefit."
There are lots of good things about DB, he says : "It is efficient when done at scale. It is much easier to understand for members and it means that a reasonable retirement benefit is targeted from the start. A large collective fund is also capable of investing in the real economy and helping stimulate growth."
Despite this, he warns that some risks are easier to pass to members as they're more easily understood than others. He notes: "It can work well when workforces are stable but can break down when workforces reduce and pensioner members (where risk is more difficult to share outside of a CDC framework) much outweigh active members."
He points out with DB lite: "Outcomes, are likely to be much fairer with a much lower variance in outcome for members retiring from one year to the next". He adds: "DC also has a lot of advisory cost leakage, with individuals needing lots of personal advice."
With DB lite, one answer would be to link benefits to the funding position, says Barnett Waddingham partner and Society of Pension Professionals (SPP) DB committee chair Chris Ramsey.
He says: "A significant part of the members' benefit could be granted on a discretionary basis, for example discretionary pension increases, which would be awarded as and when the funding position permitted."
He notes; "This is similar to how many DB schemes were set up in the UK before the government introduced compulsory indexation. Similarly, increases to members' accrued benefits before and after retirement could be explicitly linked to the scheme's funding position."
Ramsey warns, however, that "a scheme would need to be very careful not to grant pension increases while funding positions were high, only to later find that they could not in hindsight afford to fund those benefits if the funding position dropped unexpectedly."
Core for ballast with a top up in good times
Alternatively, he says members could be entitled to a guaranteed "core" pension and a "top-up" pension that could be reduced if the funding position of the scheme deteriorated.
He adds: "The risk of DB schemes would reduce considerably if schemes were allowed to automatically convert DB benefits to DC when a member leaves employment, or even when they retire. This risk would be much more manageable from the employer's perspective and would allow it to focus resources on its current staff."
He notes: "This would, of course, have the disadvantage of reduced certainty for members no longer employed by the sponsor."
Another way of cutting the risk of pension schemes would be to reduce the future value of benefits. He explains: "DB schemes could provide non-increasing pensions only, single-life pensions only or even fixed-term pensions. Additional benefits that the member requires could then be obtained elsewhere."
Not all suggestions are possible with current legislation.
If DB lite were reintroduced, it would be essential to explain clearly the extent to which benefits are guaranteed, and also to ensure there is no legislative temptation to force surplus to be used in any particular way when funding positions are good.
Eagle suggests "For employers currently providing DB, or the public sector, DB lite could represent an easing of burdens."
Existing legislation makes it very difficult to achieve an effective DB lite design in practice.
Sackers partner Fuat Sami believes "a wholesale simplification" is probably needed to make a DB-lite approach feasible, jettisoning some legislation and stripping out unnecessary complexity.
He adds: "The spectre of the Maxwell scandal still looms quite large when it comes to DB legislation, so parting the sea of protections put in place in its wake may be a no-go zone as far as the DWP is concerned."
The Work and Pensions Committee has held a call for evidence on DB schemes, including asking whether the right regulatory framework is in place to enable open DB schemes to thrive. Ramsey's answer is a definite "No".
He says: "The current regulatory framework makes it very difficult for any form of DB scheme (whether pure DB or DB lite) to thrive in the private sector because of the risks to sponsors - both financial risks and the risk that legislation/case law changes in future to increase costs (as has happened many times in the past for DB schemes).
"Multi-employer CDC schemes are being consulted on by the Department for Work and Pensions (DWP)", notes Isio director Iain McLellan. He says these have broad political and industry support, so probably have a more realistic prospect of reversing the move to DC, rather than ‘DB lite'.
Tapper is more radical. He urges the DWP "to scrap the DB funding regs and TPR's DB funding code". He wants to draw the best from the successful system before "Maxwell and financial economists turned the payment of pensions into such a palaver".
Essentially, the great British worker has to vote with his feet. If a major employer dared to introduce DB lite, assuming the DWP enabled the policy in the first place, then others would surely follow. Time to stop the DB pensions clock.
Stephanie Hawthorne is a multi-award winning journalist and former editor of Pensions World
Thanks to: Aon, Mercer, First Actuarial, WTW, Quantum Advisory, the Pensions Management Institute, SPP, Spence & Partners, Cartwright, Zedra Governance, Sackers, Isio and others for their detailed responses to Stephanie Hawthorne's call for information.