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To DB or not to DB?

The mass migration from defined-benefit pensions to the defined-contribution alternative is attracting the attention of politicians, the media and the public. DC is often made out to be an inferior mode of pension provision but this is patently not the case.

With DB, the employer effectively makes a promise – not a guarantee – to provide benefits at retirement that are a pre-agreed proportion of the employee&#39s salary at that time. The employee&#39s contributions are known – and, with a non-contributory scheme, there will not be any. However, the retirement benefits, in terms of a monetary amount rather than a percentage of the final salary, and the employer&#39s contributions which will be required to fill any funding gap are the great unknowns.

With DC, the employer and employees make contributions to build up a retirement fund for each member. This is then applied to provide tax-free cash and taxed pension income. Here, the great unknown is said to be the level of benefits. This will depend on the size of the individual&#39s fund and the terms – usually, the levels of annuity rates – for converting it into a pension income at retirement. But are these factors really so unknown?

There are tools available which can enable the employer and employees to plot a path to a standard of living in retirement to match anything that DB can offer. It is a case of inputting data and assumptions on contribution levels, planned retirement date, investment returns, annuity rates, inflation and so on to calculate the projected levels of tax-free cash and pension income at retirement.

If there is likely to be a shortfall, the main solution is obvious – to increase the amounts paid in. Another solution, which would need to be handled more carefully, might be to change the investment strategy.

A review of this kind should not be a once-and-for-all exercise. Instead, it should be repeated regularly to check whether an individual employee&#39s fund is on track to meet its benefits in retirement goal.

The planned introduction of integrated benefit statements that will include state pensions as well as those projected from private DC arrangements will help get the message home. However, with many DC schemes, the facility exists already for employer and employees to monitor pension fund progress in real time. An individual member can phone a dedicated call centre and ask for a current fund valuation and the projected benefits at retirement or they can access the scheme website. This comes with the advantage of colour graphics and is ideally suited to dealing with such questions as: “What if I increase my monthly contributions by £50?”

The employer, trustees and scheme adviser can access the website to check on the scheme&#39s progress at different levels – the scheme as a whole, the various sections of the workforce, for example, clerical staff and workers on the shop floor, and individual members&#39 funds.

With DB, it is the trustees, working with scheme advisers, who decide the investment strategy. But, with a DC arrangement, it is usually up to the members to make the key investment decisions. The onus is on the provider working closely with the scheme adviser to give them the background material they need.

Some may argue that it is better to provide ongoing advice, including face-to-face advice if needed, at the individual member level. However, the harsh economic realities leave little or no scope for this. There is plenty of evidence, notably based on North American experience, to show that, given the right education and up-to-date information, members are quite capable of deciding for themselves.

DC is not immune from the problems that are currently plaguing DB. The increasing regulatory burden and accounting standard FRS17 may have little relevance but the key issues of the taxation of UK share dividends, recent disappointing stockmarket performance and increasing longevity can have a major impact on a member&#39s standard of living in retirement.

The main challenge is to raise combined employer and employee contribution rates for DC to DB scheme levels. Successive NAPF annual surveys have shown that average payments by employers to DC schemes consistently lag some way below those for DB. Close that gap, persuade employees to contribute at a realistic levels, closely monitor a fund&#39s progress to its retirement benefit target and take any corrective action needed to get it back on course – DC will then deliver. The keys to that delivery are information and education – of employers as well as their employees.

DB will live on, for example, in businesses which have a low staff turnover or where some form of transfer club exists. However, DC is probably better suited to today&#39s environment, where the cycle of downsizing, restructuring and then expansion is common.

At the employee level, it fits modern career patterns, with their frequent moves from one employer to another, shifts between employment and self-employment, career breaks and so on.

For many employers, DC comes with one extra vital advantage – there is no open-ended financial commitment. Even when contributing at realistic levels and reviewing funding levels regularly, a business should be able to budget accurately in advance.


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