The defined benefit conundrum

It’s reflection of how much the pensions landscape is shifting that growing numbers of defined benefit pension scheme members are willing to consider exiting before they reach retirement in return for a higher transfer value.

On the face of it, it seems absurd to even consider opting out of a defined benefit pension scheme, even if you don’t work for the company anymore. After all, it’s the most valuable type of pension scheme as far as employees or former employees are concerned as the company is promising a guaranteed income in retirement.

But of course, there is a reason employers and the pensions industry call it the “defined benefit conundrum”. Most defined benefit schemes (including the ones that are closed to new members) are now underfunded. In fact, recent figures from HR firm Mercer show the DB pensions ‘hole’ at Ireland’s largest companies has doubled in the first seven months of 2016.

So it’s easy to see the appeal for the firms in offering members an enhanced transfer value (ETV) in order to get them off their books and reduce their liabilities.

Colm Power, financial planning manager at Davy, says many companies have been piloting “ETV exercises” to encourage members to leave the DB scheme by accepting a top-up to the standard transfer value.

“It’s a very finely balanced decision and will really come down to the individual weighing up a number of competing interests,” he says. “It also requires a certain level of crystal ball gazing.”

Crystal ball

Indeed, if you are offered an ETV, it soon becomes clear why you’ll need that crystal ball; it will be difficult to ascertain the long-term commitment of the company to maintaining the scheme. After all, there’s nothing to stop it winding up a scheme it if remains underfunded.

“For most people, it will involve weighing up the pros and cons,” says Power. “Staying in the scheme and drawing a DB pension provides a simple, easy-to-understand stream of income for the rest of your days – but on the assumption that the scheme is still there once you come to retirement age.”

Power accepts that if a scheme is underfunded, it may well raise some alarm bells, “but only if there is additional concern around the company’s ongoing commitment to funding the scheme”.

However, even assuming it is, Andrew Fahy, head of financial planning at Investec, says the conundrum for many is more to do with weighing up the guaranteed income for life versus the “mortality risk” of staying in a defined benefit scheme, that is, if you and your spouse die, your pension dies with you.

The alternative presented by products such as approved retirement funds (ARFs), whereby you can continue to invest your money after your retirement rather than the DB and annuity route, is becoming more appealing.

“People are viewing it as a component of family wealth, albeit with an ARF you do experience investment risk or replace mortality risk with investment risk, but people are happy to do that because they view their pension pot as part of a family wealth product,” says Fahy.

All the same, the onus is firmly on the company to make an ETV offer attractive to ensure a critical mass of uptake. “If a company runs an ETV programme with little take-up from members, they will simply incur a lot of consultancy fees for little financial gain,” says Power. “They have to make it attractive for the members.”

Transfer value

According to Power, the standard way of calculating a member’s transfer value applies a heavy discount to the sum of money available to younger members of the scheme. As a result, some companies are making proportionately higher transfer offers to younger members than those closer to retirement – which might mean a 50 per cent or even a 100 per cent top-up for the numbers to make sense for a young member.

How much the scheme counts in terms of a member’s overall retirement assets is another important consideration. “Where a scheme forms the bulk of an individual’s retirement assets, it may not make sense to accept the offer unless they had serious concerns over the future of the scheme,” says Power.

But even if your company’s commitment to your scheme seems water-tight for the moment, it will be a much harder decision if you are still some years away from retirement.

“The key question to ask is ‘can I reasonably expect to invest the transfer value and match the level of income the DB scheme would pay without taking excessive risk?’” says Power.

“Needless to say, taking an ETV and buying an annuity will almost certainly mean a reduced retirement income compared to the DB pension,” he adds.

So leaving a scheme will ultimately involve a higher level of risk and more hands-on management of your money in retirement if you want to make the sums add up.

However, Fahy challenges the notion it’s a bigger risk. “This is a personal view, but I sometimes think the term ‘defined benefit’ could be a bit of an oxymoron, or slightly misleading. At least with defined contribution, you can upgrade it, you know what you have in your pot, you know what’s there, whereas with DB, it’s a promise. How does one assess the robustness or otherwise of a promise? That’s extremely difficult.”

Needless to say, Fahy and Power strongly recommend getting independent advice.