Private sector defined benefit schemes may be few and far between but are still immensely valuable to members.
Such schemes, which can guarantee an income for life, based on years of service and final salary, have long been considered the Rolls Royce of benefits, particularly when index-linked to rise with inflation.
However, in an age of investment uncertainty, when employers are incentivising members to swap out of defined benefit into defined contribution schemes, figuring out what is the best way forward can be hard.
The fact is, regardless of how it is perceived, a defined benefit scheme isn’t all it’s cracked up to be if, for whatever reason, the scheme isn’t fully funded by the time you retire.
The question, according to Brian Mulcair, head of corporate consulting at Willis Towers Watson, is often "Should I stay or should I go?"
There are about 560 private sector defined benefit (DB) pension schemes, a little under half of the number there were in 2010. These schemes, which look to provide benefits to over 300,000 members, face many challenges, he says.
“Typically, a DB scheme is a balance of cost arrangement, with the active employee members contributing a fixed percentage of salary while the sponsoring company funds the rest of the cost,” says Mulcair.
“These costs have increased significantly in recent years, driven by a low interest rate environment. Generally, the companies which sponsor DB schemes are keen to settle some or all of the underlying liabilities in order to manage the risks associated with managing a DB scheme.”
Bar raised
In addition to the increase in the cost of providing benefits, the EU’s IORP (Institutions for Occupational Retirement Provision – that is, pension schemes) regulations, which were recently signed into Irish legislation have raised the bar, and costs, in terms of the level of governance and risk monitoring that is expected from the trustees who oversee the running of DB schemes.
“This is likely to mean that a number of smaller schemes will no longer be viable as compliance costs are expected to increase significantly. Of the 560 DB schemes, 235 have fewer than 50 active employee members,” says Mulcair.
Faced with these challenges, many companies have run or are planning to run Enhanced Transfer Value (ETV) exercises. Under these, deferred members of a DB scheme are offered a capital payment, calculated on enhanced terms, payable to a new pension arrangement, instead of retaining their right to a pension under the company’s DB pension scheme.
“Whether or not to accept an ETV offer is a significant financial decision for the member. If they accept the ETV offer, they will no longer have a defined level of pension in retirement. Instead, they will need to manage the investment of a large capital sum and draw down retirement income from their pension investment account – an Approved Retirement Fund – when required,” he says.
So what should a member consider in deciding whether to “stay or go”?
“This is often a really difficult decision,” says Mulcair, because the company is likely to have set the ETV offer amount at a level that “engages the individual member but which will require the member to take investment risk and longevity risk – basically, the risk of living ‘too long’ – throughout their retirement”.
On the other hand, despite the Rolls Royce perception, the DB pension is not necessarily a 100 per cent guaranteed amount.
“The main risk in leaving the pension in the DB pension scheme is that the scheme will wind up before the member has retired. There is no guarantee that DB schemes will have sufficient funds to pay the benefits promised. It is therefore possible that the benefits payable under the DB scheme may have to be reduced in some circumstances,” says Mulcair.
Nasty surprise
If a DB scheme winds up it is likely to result in an enforced reduced transfer amount being paid to members who have not yet retired. The risk of this happening depends on the funding position of the pension scheme, as well as on the company’s covenant to the pension scheme – its ability and willingness to fund any deficits that emerge – and on future market developments.
Typically 30-40 per cent of members who are offered ETVs will accept the offer.
Currently about 80 per cent of the DB schemes in operation are closed to new members, says Colm Power, a director at Davy.
People who are retired and in payment from their scheme already shouldn’t worry needlessly. “Defined benefit schemes are very well protected if you are in payment. Really the risk is for those who have deferred a pension from a previous job,” he says.
If you have left that employer, but haven’t yet retired, “that’s where the risk is concentrated because if the scheme is wound up, those in payment are the first to be looked after. It’s those yet to reach retirement – if a scheme hasn’t been sufficiently funded – who are more at risk from a nasty surprise,” says Power.
He advises anyone who leaves a deferred pension when they change jobs to keep abreast of what’s going on with that scheme.
“You should be in receipt of an annual statement from the pension scheme. There can be tell-tale signs in that, but you may have to dig a little deeper and make sure to ask for a copy of the trustees’ annual report, too, for which there is a requirement each year. It will give you more information about how well funded your scheme is, and how committed the scheme is to future funding,” says Power.
Gathering information is only part of the decision-making process. Working out enhanced transfer value calculations is complicated. There are a variety of considerations in relation to tax-free lump sum, flexibility and inheritance, so it’s important to make sure you are getting the best possible advice.
“This is a one-time decision,” says Colm Power. “You can’t re-enter a scheme, so it is a decision that has to be taken very carefully.”