June 6, 2011

Who killed DB? Is it really dead?

Filed under: Blog — Grove @ 4:05 pm

If you watched the hit TV series Dallas in the early 80′s, you’ll know that the lead character JR Ewing was shot by his sister-in-law at the end of one series. Stories of JR’s demise were premature though. At the end of the next series it was revealed that the intervening period and the shooting of JR had, in fact, been just a dream. Priceless.

If you’ve been following government pension policy over the years and in particular the cold hearted killing of the Defined Benefit (DB) approach that served us so well, you’d be forgiven for wondering if the Dallas script writers were involved.

I’ve just been reading the 2008 consultation document from the Department of work and Pensions (DWP) about risk sharing in workplace pension schemes. Yes, I know, this is 2011 and you’re thinking that I’ve been slacking. Not true!

There are, in fact, two reasons for looking at the consultation again now;

  • I probably did read it in 2008 but I’m in my fifties now. The hard disk still works but the search engine is unreliable so it’s good to revisit things from time to time.
  • The national pension saving scheme NEST is about to go live. This reminded me of my initial astonishment that the most tangible benefit to be derived from enrolling millions of workers into one scheme is the reduction of administration costs. Yet one of the biggest concerns that Mr and Mrs Average have is about risk. What will my retirement fund be worth? Is it worth saving?

Isn’t risk sharing the greatest potential benefit of dealing with groups instead of individuals?

Once upon a time  many employers took all the risks by providing DB pensions. Sadly, most people only cottoned on to the value of their DB schemes at the point of closure. DB, for private sector employees at least, is something that only a million workers still enjoy. For the rest us it’s the ‘devil take the hindmost’ uncertainty of Defined Contribution (DC) or, for 2/3rds of workers in sub 250 employee businesses, no scheme at all.

The key difference between DB and DC is that where the employer takes all the risks in a DB scheme, it is the members themselves who carry all the risks with DC. A compromise solution is really needed.

Getting back to the consultation then, the opening remarks track the demise of DB schemes and cite poor investment performance as the key driver. It doesn’t mention the many imposed benefit increases over the years, the government raid on pension funds, increasingly intrusive regulation or anyone falling off a yacht, but that’s another story (suffice to say that ‘it wasn’t me guv’ seems to be impregnated into the paper).

The report goes on to describe the most fashionable risk sharing arrangements on which to base the script for the next series. They are;

  • Cash balance schemes
  • Conditional indexation average salary schemes
  • Collective Defined Contribution schemes

Now, if you’re wondering what the heck those names refer to, I don’t really blame you. Of course, if you understood the terms straight away we’d have to reduce our fees. So, there it is. I’m sure you understand. But is that why these issues are discussed only by professionals? The mechanics of each of these options are actually quite complicated and I think that if a compromise is to be found it needs to be easily understood by all concerned.

My pet solution isn’t included in the document at all! It’s called Defined Retirement Fund (DRF). It does what it says on the tin, so maybe that’s why it’s been overlooked. As I say, we can’t have people understanding these things. I’ll explain how DRF works.

In simplistic terms, there are four risks involved in pension planning; Inflation, investment, longevity, and interest rates. The first two of these are taken BEFORE the members retire and the second two AFTER retirement. A simple way to share risk would be where the employer carries the pre-retirement risk and members take the post-retirement risk.

This can be achieved simply by running a DB scheme that expresses benefits as a cash fund which is made available for conversion to cash and income in the market place at retirement. For example, in rough terms a benefit of 20% of final salary for each year of service might cost about 15% p.a. in contributions. For a 40 year career that would produce a cash fund of 800% of the members’ ‘Final Salary’ that they would be able to spend in the market within prevailing pension rules.

The employer is now funding for cash and takes NO longevity risk. Crucially though, he is still shouldering the investment risk and inflation risk. You could actually cover off the inflation risk by expressing the benefit as a fixed amount of fund for each year of service.

Members get an easily measured, guaranteed retirement fund with the flexibility to access it in a way that best suits their circumstances. They are now shouldering longevity and interest rate risk. That’s the compromise. Having said that, now that compulsory retirement ages have been scrapped and people will work longer and increasingly part-time later in life, you have to question whether fixed retirement pensions continue to be relevent anyway.

If you want to sex DRF up a bit you could put some contributions in personal accounts to be compared with the guaranteed benefit when it comes into payment. A value for money guarantee, if you like.

Maybe, like JR, DB will prove to be alive after all? I guess we’ll have to wait until the start of the next series to find out.

By the way, the outcome of the consultation was that the DWP decided to take forward the Collective Defined Contribution approach. I’m not sure what happened then. It didn’t find it’s way into NEST and I don’t recall any legislation changes to facilitate it. Was it all just a dream?

Blast, it looks like the search engine is playing up again.

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