Can you believe the pension promise?
Members of defined benefit schemes are potentially paying a high price for an increasingly uncertain pension promise
They might be “gold-plated”, but the so-called Rolls Royce of pension schemes are likely soon to be a thing of the past. A host of Irish corporates, including Independent News & Media, Permanent TSB and Aviva in just the past month have opted to either wind up, or significantly reduce, the benefits they provide under their defined benefit (DB) schemes.
But why are so many companies opting out of DB pensions and should you be concerned if you are a member of such a scheme?
For most companies, the decision to wind up a DB scheme, which promises a pension based on your final salary and length of service, is taken for financial reasons. Permanent TSB, for example, has indicated that such schemes “are no longer viable”.
Indeed, while official figures show that about 80 per cent of DB schemes are currently in deficit, John Tuohy, chief executive of Acuvest, puts the figure closer to 90 per cent. While most of these schemes are now closed to new members, with such significant deficits they are still incapable of meeting the needs of existing members in their future retirement.
At an already challenging time, this is putting an unwelcome strain on the finances of many companies.
Samantha McConnell, chief investment officer of IFG Corporate Pensions, notes that a DB scheme represents an open-ended liability on a company’s balance sheet.
“It’s very difficult to forecast. You can’t control how long people will live, and you’ve no idea how much it will cost to pay out annuities at the far end,” she says, adding that as a result, the days of DB schemes are numbered.
“The Waterford Crystal case (see below) put the final death nail in DB schemes. If you’re a member in a private sector scheme, you really need to think if that scheme will be around when you retire,” she warns.
“Defined benefit schemes may be seen as a valuable benefit, but they only have a value if there is something there at the end”.
It is for that reason Tuohy asserts that the decision to wind up your company’s pension scheme is not necessarily something to be feared. For Tuohy, the DB model is “irreparably broken” and both companies and members of their pension schemes would be far better served by a well-managed and properly-resourced defined contribution (DC) scheme.
“The first thing you have to realise is there are a lot of risks inherent in a DB scheme, and the principal risk is you don’t have a guarantee on a pension,” says Tuohy.
“People hear that a DB scheme is being wound up and the assumption is that it’s bad news; yes it’s bad news on the basis that you had an expectation that was wrong, but it wasn’t a guarantee”.
The trouble, of course, is that most members of DB schemes understood it to be a guarantee, in large part because that is how the pensions industry generally referred to them – at least until the collapse of the Waterford Crystal scheme in 2009, which left 1,700 members with pensions far below their expectations.
At that point, the reference to “guarantee” was swiftly amended to the less committing “promise”.
Indeed, while in the UK employers are required to honour the terms of DB schemes, no such compulsion exists in Ireland. Rather, an employer has simply “promised” to honour the scheme – but has no legal obligation to do so.
“Unlike in the UK, employers can walk away from it – it’s not a guarantee,” warns McConnell.
While the OECD may have criticised this in its recent report on Ireland – suggesting that healthy plan sponsors should not be allowed to walk away from DB plans unless assets cover 90 per cent of pension liabilities – the situation is unlikely to change in the current economic climate.
So for now, a DB scheme is really only as good as this “promise”.
“You have to make a judgment that on the date you retire there will be enough money in the scheme, and that, if there isn’t, your employer will step in and make good on it,” says Tuohy.
And for those who do find themselves in a scheme with a shortfall, there’s a further problem. Where the scheme assets might have been substantially eroded, you will find there are other people in the queue ahead of you who have prior claim on those remaining funds.
“The second issue is that the inherent structure of an Irish DB scheme is unfair. If there are lots of people who’ll retire before you, the way the DB scheme structure is set up is that they will take what they need before it gets to you,” says Tuohy.
“You could have a scheme that’s fully funded today but, if 10 people retire tomorrow, you will need more than what’s in the kitty after they take what they need.”
In this regard, moving to a DC scheme, in which your pension pot will be based solely on the amount of contributions from you and your employer, and the fund’s investment performance, can be a positive and offer substantially more certainty.
On the downside, where employers have traditionally carried the financial risk in DB schemes – at least until the recent move to wind-ups – in a defined contribution arrangement, it is the often financially unsophisticated employee who carries all the risk.
“The advantage of a DC scheme is ring-fencing. You have your own account and you can make your own investment decisions. Some people turn it into a negative, noting that all the risk is transferred to you, but you have more control over it and the big risk that is removed is erosion – unless you make poor investment decisions,” says Tuohy, adding, “I’m not saying it’s [DC schemes] perfect in its current form, but it can be very good”.
McConnell agrees. “If your company collapses it’s still your pot of money. It’s much more mobile and you’re not dependent on your employer effectively,” she says.
However, while DC schemes do have their advantages over final salary equivalents, there is no getting away from the fact that benefits available in such schemes are likely to be significantly lower than those granted under a DB scheme.
“If you believe the employer is absolutely gold-plated and committed to keeping the scheme open – then DB is definitely better,” says McConnell.
A DC member looking to get €60,000 as an income at retirement would need a pension fund of about €2.4 million. With employer contribution rates typically about 6 per cent for DC plans, the onus will be on the employee to contribute a significant chunk of their annual income towards planning for retirement.
In comparison, employer contributions for DB schemes are typically of the order of 18 per cent. “I would think contributions are a little low,” says Tuohy, pointing out that it’s “early days” in terms of the contributions companies make for DC schemes.
But it’s difficult again to compare like with like. Going back to the earlier point, a final salary pension is just a promise – and one that the employer might renege on.
In this respect, even if your company appears to be holding firm to its DB plan, could a case be made that you should switch to a DC fund anyway?
“I think there is; I think the bird in the hand is worth two in the bush,” advises Tuohy.
Another issue is whether you have the option. Most occupational DB schemes function by requiring incoming staff to join – you don’t have a choice to opt out.
Forcing younger employees to join a scheme already in deficit and which holds little prospect of delivering a pension 30 or 40 years down the line is an issue that has yet to be addressed. It seems only a matter of time before someone challenges the legality of such arrangements.
For McConnell, it’s worth posing some serious questions to yourself.
“If you’re under 40, you definitely won’t be in a DB scheme by the time you get to retirement, and what you’re doing now is paying to subsidise pensioners –you’re paying in now but will you ever get it back?”
The Waterford Glass experience
Anyone thinking that the closure of their company’s defined benefit scheme is never going to happen need to look no further than the example set by glass manufacturer Waterford Crystal.
The luxury goods firm went into receivership in 2009, and its pension fund was wound up some two months later, leaving about 1,700 workers with a pension which represented between just 18 and 28 per cent of their entitlements.
It was a shocking outcome but, following a ruling from the European Court of Justice (ECJ) last month, there is some light at the end of the tunnel for these particular workers.
The ECJ ruled that, under EU law, workers should be entitled to at least 49 per cent of their pension, with the State required to step in and foot the bill.
It sent the case back to the High Court to decide the precise level of pension to be paid. In the UK, workers at Wedgwood who were also left shortchanged by the collapse of Waterford Wedgwood received 90 per cent.
For Aidan McLoughlin, managing director of Independent Trustee Company, the court’s decision was “the only logical conclusion that could have been reached”.
However, if you think that the State might step in and cover any potential shortfall in your employer’s scheme, think again. The ECJ ruling, which has yet to go to the High Court, only applies in cases of “double insolvency” where both the scheme and the employer are in wind-up.
“If the scheme has been restructured in order to maintain solvency, then this ruling wouldn’t apply,” says McLoughlin.