Over the past 20 years – ever since British companies began closing their ‘last salary’ pension schemes to new members, then closing altogether to existing members – the headlines have heralded the end of the defined benefit pensions.
The defined benefit – in which employers guarantee an inflation-linked pension for life – has been replaced with a defined contribution – a glorified savings plan, without guarantees.
Parliament’s Work and Pensions Committee is conducting an inquiry into DB private sector pensions and the deadline for submissions has just passed.
What conclusions should MPs – with generous DB pensions guaranteed by taxpayers – reach? Is Private Sector DB really dead or just in a coma, waiting to be revived?
Despite some drifters, DB’s long decline isn’t due to “bad” accounting or “strict” regulation, it’s all due to higher costs.
The annual cost of guaranteed pensions has soared over the past 25 years – look at the higher cost of individual annuities, which guarantee a pension for life.
Not only are people living longer, but long-term interest rates, adjusting for inflation, have fallen so much since 1997, when the new Labor government gave the Bank of England the independence to set rates of interest.
Lower real interest rates encourage investment but reduce the interest that can be earned on the amounts set aside today to pay future DB pensions, hence higher costs.
The good news is that the huge rise in AA real rates over the past year, compounded by the September “mini” budget debacle, has sharply reduced the total value of DB liabilities and improved funding levels. A quarter of the schemes are now well funded enough to transfer the liabilities to an insurance companyand “ransom” offers are reported each week.
Higher real interest rates have also reduced the annual cost of DB’s new pension pledges from around 50% of salary to 25%, for a 1/60th of salary.
According to official figures, around 900,000 people are still paying DB private sector pensions. While many are in the semi-public sector, including university and railway staff, there are still 500,000 in the “true” private sector.
Better funding and lower annual costs will certainly encourage companies with open schemes to stay open, but there are only a handful left in the FTSE350, including Croda International – still open to new members – Unilever, Shell and BAE Systems.
Even the companies that resisted – BT, BP, BA, Marks and Spencer, Tesco, John Lewis and Rolls-Royce – all closed.
But can better funding and lower costs convince employers to reopen their closed DB schemes? Last year, union Unite said it would campaign to do just that.
Let’s see what happens, but this seems like extreme wishful thinking: DB is still significantly more expensive than DC, and companies are grappling with any future shortfalls.
DB guesthouses are often regarded as a wonder of the world. But the “golden age of DB pensions” is a myth: many private sector workers did not have DB pensions and relied on their meager old age pension.
And DB’s “final salary” structure was biased against those with short service or career breaks, especially women, who actually paid for long servers. The ones who did it best were – surprise, surprise – the senior leaders.
The 500,000 still in private sector DB schemes and the numbers will gradually decline as people retire or leave – that’s a fraction of the nearly 10 million people contributing to a personal DC pension in 2020.
For the millions who will never have a DB pension, we should focus on improving DC. This means increasing the amounts saved each year and reducing running costs.
It also means changing the pension tax system, which is biased in favor of the 40% of taxpayers versus the bottom 20% of income earners. As a matter of fairness and to encourage retirement saving by the low paid, we should move to a lump sum tax relief for all – DC and DB – at, say, 30%, leaving the total pension tax relief unchanged.
Sadly, there are no magical guesthouses and we shouldn’t waste our time on the “collective defined contribution” – which – despite all the talk of “intergenerational risk sharing” – has no investment advantage over simple, transparent DC.
Parliament should also address public sector DB pension reform – including MPs – to close unsustainable gap with private sector – there are 6 million active members including local government.
Public employees, teachers and NHS staff earning inflation-linked annual pensions of about 1/42 of salary, far more generous than traditional private sector DBand much, much more generous than private sector DC.
But a pension, however generous, cannot be spent today and the government should allow all public sector workers to choose higher pay, in exchange for a lower DB pension in retirement. Pensions already accrued would remain intact.
The lowest new DB pension earned could be 1/80th of salary a year, about half of present value, with annual increases in inflation limited to 5% as in the private sector. In return, public sector workers could get, say, a 10% pay rise and save 5% on their contributions.
John Ralfe is an independent pension advisor. Chirping: @johnralfe1
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