Defined benefits pension schemes are self-explanatory – on retirement the member receives a pre-arranged amount that is usually based on an agreed formula. A prime example of this is a final salary scheme, where the amount received on retirement is a percentage of your final salary, adjusted by a formula based on the number of years you have worked for your employer.
The people or organization responsible for managing the scheme must ensure that the fund is sufficient to pay out at the appropriate rate when the member retires. The fund will typically be made up from contributions from employees and employers, and possibly from investment gains the fund has made. Accordingly, the risk here remains with the administrators of the scheme. As an employee, as long as you make the contributions required of you and complete the requisite number of years of qualifying service, you are entitle to receive the pension you signed up for.
Defined pension schemes are used to attract and retain high calibre candidates for top level jobs, and are generally seen as a signal that an employer values its employees.
Phased Out
However, defined pension schemes are dying out. Virtually no one offers final salary schemes to new employees anymore. The Association of Consulting Actuaries estimates that 80% of employers who operate final salary pension schemes no longer offer them as standard to new employees, as opposed to only 68% some 2 years ago. Barclays, IBM and BP to name but a few have taken this step. Several companies have even closed their existing schemes, forcing their employees to transfer to defined contribution arrangements.
The reasons for this are twofold. Firstly, many companies just cannot afford to continue them. With the level of payments for defined pension schemes having been crystallised so many years ago, they simply have not performed well enough to meet the needs of their members on retirement. Many funds have been invested in equities, whose performance has disappointed in recent years. However, notwithstanding the poor performance of the fund, the trustees are still obliged to pay out at the predefined level, which means that gaping holes are commonplace and have needed to be filled with cash. Also, as a population we are living longer. So not only have the funds not performed as well as their managers might have hoped, but they are expected to pay out to members for longer as most people survive well into their eighties.
Where have the employers got this extra cash from? This is not just a balance sheet adjustment that can be conjured up by a clever accountant. It has to be pinched and scraped together from other areas of the business – from cost cutting, reductions in investment and research and development, and possibly from cutting staff numbers. In a financial climate where some employers are struggling to weather the storm, the obligation to fill a hole in a pensions fund can be the last straw.
In fact, some commentators say that it was the pensions bill that brought down General Motors. It was widely reported that when you bought one of their cars, the proportion of the purchase price going towards the employees’ pension fund deficit was greater than the cost of the steel it took to make the car.
So it stands to reason that cost and unpredictability is the main driver for companies who cease to offer final salary pension schemes. However, the regulatory burden they carry is also becoming prohibitively heavy, with employers and scheme administrators being subject to scrutiny about the decisions they make. Pensions administrators have to notify to their regulators if they have any concerns.
Financial Future
What is clear about this move away from defined pension schemes is that the financial future of those who previously thought that they were heading for a comfortable retirement is less certain. With defined contribution schemes, the risk is born by the employee. Notwithstanding a working life characterised by dutiful payment of pension contributions; if the stock market or other fund investments fail, your quality of life in retirement will suffer.
Increasing longevity and a poor financial outlook are conspiring to make pensions higher on everyone’s list of priorities, and possibly higher up the political agenda. The question is, from an employee’s perspective, are you prepared to bear a reduction in your take home pay now to secure your retirement income by padding your pension fund with higher contributions? If your final salary scheme has closed its trap door and pulled up the rope ladder, you may have no choice.
