Refining the benefits of Defined Benefit pension schemes

Published: 16 Jun 2017

The countdown for final salary or Defined Benefit (DB) schemes has been a long time coming as they are gradually replaced by Defined Contribution (DC) schemes. But the pace is picking up as the realisation grows that the economics behind DB schemes no longer stack up and they become too expensive to provide – posing a series of questions for anyone with this type of scheme.

The market environment has continued to deteriorate to the point where the viability of established DB schemes has been brought into question, with the UK Government undertaking reviews of the DB landscape. At the heart of the shift are two major challenges: People are living longer and benefitting from longer retirement periods, while in the wake of the global financial crisis and measures such as Quantitative Easing, financial markets can no longer adequately provide the low-risk yields needed to generate sufficient, long-term retirement income.

In response to the EU Referendum the Bank of England cut the base rate to 0.25% in August 2016 from an already record low level of 0.5%, where it had remained for more than seven years. The impact is clear – the combined deficit of UK DB schemes was £500 billion as of the end of March 2017, according to PwC. It estimates the 5,800 DB schemes had aggregate assets of around £1.53 trillion compared to liabilities of £2.03 trillion. Research by consultancy Hymans Robertson concluded that half of FTSE350 schemes are already, or soon will be, cashflow negative (paying more out to pensioners than they are receiving in contributions).

The issue has become a political hot potato. The UK Government has begun to examine ways to reduce the DB burden on the UK economy, and to make them sustainable. A Green Paper published by the Department for Work and Pensions (DWP) in February suggested, among other things, that companies might be allowed to stop inflation-linked income rises to former workers’ DB schemes to cut deficits. The paper noted that, as at October 2016, about 90-95% of DB pension schemes are likely to be in deficit.

Many stakeholders are suggesting ways to address the DB deficit problem. Hymans Robertson believes the deficit could be reduced by £175 billion if all schemes could switch from RPI inflation to CPI for pension increases and revaluation. It would deliver, but at a cost of around £20,000 for the benefits of an average DB scheme member.

Any such changes would likely be very unpopular with scheme members and challenging for any political party to execute. In its Green Paper, the DWP itself admitted: “The Government is not persuaded that there is a case for across-the-board changes that would reduce members’ benefits in order to relieve the pressure on employers.” However, as concerns about the strength of the post-Brexit UK economy rise, and pressures mount on the solvency of DB schemes, it is highly likely that the debate and focus will intensify – and there’s a sense that very difficult decisions will need to be made sometime in the near future by employers and scheme members.

Advice on the best approach for scheme members in the UK and expats is vital as they balance whether to stick with DB schemes and guaranteed benefits, or look to the flexibility of DC schemes.

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