Defined benefit pensions: not dead yet

For the past 20 years — ever since UK companies started closing their “final salary” pension schemes to new members, and then closing altogether to existing members — headlines have announced the death of defined benefit pensions.

Defined benefit — where employers guarantee an inflation-linked pension for life — has been replaced with defined contribution — a glorified savings plan, with no guarantees.

The Parliamentary Work and Pensions Committee is holding an inquiry into private sector DB pensions, and the submission deadline has just closed.

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 tub-thumpers, the long decline of DB is not because of “bad” accounting or “strict” regulation, it’s all down to higher costs.

The annual cost of guaranteed pensions has ballooned in the past 25 years — look at the higher cost of individual annuities, guaranteeing a pension for life.

Not only are people living longer, but long-term interest rates, taking inflation into account, have fallen so much since 1997, when the new Labour government gave the Bank of England independence to set interest rates.

Lower real interest rates encourage investment, but reduce the interest which can be earned on amounts put away today to pay future DB pensions, so higher costs.

The good news is that the huge increase in real AA bond rates in the last year, compounded by September’s “mini” Budget debacle, has slashed the total value of DB liabilities and improved funding levels. A quarter of schemes are now well funded enough to transfer liabilities to an insurance company, and “buyout” deals are reported each week.

Higher real interest rates have also reduced the annual cost of new DB pension promises from about 50 per cent of salary to 25 per cent, for a 1/60th of salary pension.

About 900,000 people are still paying into private sector DB pensions, according to official data. Although many are in the quasi-public sector — including university and rail staff — there are still 500,000 in the “real” 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 standing in the FTSE350, including Croda International — still open to new members — Unilever, Shell, and BAE Systems.

Even companies which held out — BT, BP, BA, Marks and Spencer, Tesco, John Lewis and Rolls-Royce — have all closed.

DB pensions are often held up as a Wonder of the World. But the “golden age of DB pensions” is a myth — many private sector workers had no DB pension, and relied on their meagre old age pension

But can better funding and lower costs persuade employers to reopen their closed DB schemes? Last year, the union Unite said it would campaign to do just that.

Let’s see what happens, but this looks like extreme wishful thinking — DB is still much more expensive than DC and companies are on the hook for any future deficits.

DB pensions are often held up as a Wonder of the World. But the “golden age of DB pensions” is a myth — many private sector workers had no DB pension, and relied on their meagre old age pension.

And the DB “final salary” structure was biased against those with short service or career breaks — especially women — who effectively paid for the long servers. Those who did best were — surprise, surprise — senior executives.

The 500,000 still in private sector DB schemes and numbers will gradually fall as people retire or leave — are a fraction of the almost 10mn people contributing to a personal DC pension in 2020.

For the millions who will never have a DB pension, we should concentrate on improving DC. This means increasing amounts saved each year, and lowering running costs.

It also means changing the pension tax system, biased in favour of 40 per cent taxpayers versus lower-income earners on 20 per cent. As a matter of fairness and to encourage pension saving by the lower-paid, we should move to flat-rate tax relief for everyone — DC and DB — at, say, 30 per cent, leaving total pension tax relief unchanged.

Sadly, there are no magic pension beans and we shouldn’t waste time on “collective defined contribution” — which — despite all the talk of “intergenerational risk sharing” — has no investment advantages versus straightforward and transparent DC.

Parliament should also face up to reforming public sector DB pensions — including MPs — to close the unsustainable gap with the private sector — there are 6mn active members, including local government.

Civil servants, teachers and NHS staff earn inflation-linked annual pensions of around 1/42nd of salary — much more generous than traditional private sector DB, and much, much more generous than private sector DC.

But a pension — however generous — can’t 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 earned would be untouched.

The new, lower DB pension earned could be 1/80th of salary a year — around half the current value, with annual inflation increases capped at 5 per cent like the private sector. In exchange, public sector workers could get, say, a 10 per cent pay rise and save 5 per cent on their own contributions.

John Ralfe is an independent pensions consultant. Twitter: @johnralfe1