The demise of the “gold plated” defined benefit pension scheme
February 2010
HR & Recruitment Ireland
By Fionan O'Sullivan, IFG Corporate Pensions
Defined-benefit pension schemes, once the workers most coveted asset, are quickly going out of fashion.
For employees, it was the holy grail of retirement saving – a pension that guarantees you a substantial annual income based on your final year's salary for the remainder of your lifetime. For employers however it has fast become a huge issue, putting companies under considerable financial strain. However, following high-profile casualties of the recession such as Waterford Crystal, serious questions have arisen about the long-term viability of defined-benefit pension schemes and whether they really have a future in the Irish market.
It is only too obvious to see why employees like defined-benefit schemes. Unlike a defined-contribution scheme, where your level of pension income is determined by how much your "pension pot" is worth when you retire, a defined-benefit scheme guarantees that, once you reach retirement age, you will receive a set annual income based on your final income (usually two-thirds for someone who has been a member all their working life). The risk is borne by the employer who has promised you a certain level of income, regardless of the cost of providing it. For that very reason, in the past employees have jumped at the opportunity to join a defined-benefit scheme, without much deliberation.
However, defined-benefit schemes are quickly going out of mainstream fashion. Most employers have taken steps to close them off to new members or have engaged in a project to commence the migration process from defined-benefit to defined-contribution. A study carried out by IFG Corporate Pensions in October of 2009 revealed that 64% of firms with a defined-benefit offering were actively considering migrating to a defined-contribution arrangement, while only 21% confirmed they were still committed to it.
The vast majority of employers and employees are realising the futility of the largely empty promises of many defined-benefit schemes. The inevitable mass migration from defined-benefit to defined-contribution will see realism replace idealism, with many companies concluding that it would be unwise to continue believing that every employee could ultimately receive their promised defined pension benefit.
The majority of Irish defined-benefit schemes are underfunded by 30% or more. They have been seriously affected by the riskier strategies employed by trustees in the boom years – a heavy reliance on equities and, more crucially, property, resulted in steep loses which many funds are still trying to recover despite the stock market bounce. Moreover, with most schemes closed off to new members, there are no new members joining to assist in the longer term funding of the scheme, and employers under financial pressure because of the downturn are unable to make up the shortfall.
The controversy surrounding scheme collapse has prompted government action with the recent creation of the pilot Pension Insolvency Payment Scheme. This will allow insolvent companies to purchase cheaper annuities for their existing pensioners, leaving a bigger fund to be shared among employees who have yet to retire. In practice, however, this will apply to very few companies due to the strict criteria that must be met before a scheme would qualify.
What is most apparent from this pension debacle is that in reality, the majority of us are going to end up on defined-contribution schemes in future. While this transfers the investment risk to employee, on the positive side, it offers individuals the opportunity to have more of a say in what happens to their money. This will become increasingly important if, as expected, the government decides to extend the Approved Retirement Fund (ARF) option to defined-contribution scheme members. ARF’s allow you to control directly how and where your money is being invested on retirement rather than purchasing an annuity; you can make withdrawals at your leisure and most importantly when you die, your pension does not die with you, but is considered part of your estate.
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