DC versus DB schemes during the crisis

If a person is retiring now and has worked for different employers over their career, they may have some defined benefit (DB or final salary) benefits and some defined contributions (DC); group pension, personal pension, master trust type arrangements. 

Focusing on the defined contribution schemes, a person approaching retirement will have received packs outlining their options which usually consist of four approaches.

1) An annuity – a guaranteed income for life

2) Flexible access (drawdown) - keep your pot invested and withdraw what you need as you need it

3) Take it all as cash

4) Leave it for now and decide at a later date.

It may be advisable to hold off making any decisions just now if you can afford to do that.--Pete Glancy

Options

Pete Glancy head of pension policy at Scottish Widows says making decisions about what to do with pension investments right now is more difficult than normal, due to the volatile nature of investment markets.

This may mean the fund a person has at retirement is changing markedly on a daily basis.

Purchasing an annuity with a pension pot provides a guaranteed income in retirement. The insurance company will pay a guaranteed income for the rest of the person’s life; removing the concern about future stock market performance. 

But annuity rates are at a near record low, partially linked to the current environment which has led to historically low interest rates, and fund values may have been impacted negatively by the current crisis, so it might be worth delaying this decision.

With flexi access (drawdown), you are taking tax-free cash from your plan and investing the remaining pot to provide you with an income in retirement.  

Tax-free cash available is usually 25 per cent of your fund value – so the amount of cash available is dependent on the fund value on the day you move it into a drawdown contract. 

Many have no idea what type of pension scheme they are in, could be DB, could be DC, they do not know. --Maxine McIntyre

Mr Glancy adds: “It may be advisable to hold off making any decisions just now if you can afford to do that, but the best thing is to get advice as it is a complicated decision to decide what to do, when to do it and then where to invest the remainder of the pot.”

Maxine McIntyre, head of financial strategies at WPS Advisory, says although people are aware the value of their savings can go up or down, the recent falls have been painful for individuals, which she says may also be partly down to the industry not helping individuals enough to establish a relationship between their savings and retirement plan.

Ms McIntyre adds: “They are in a pension scheme because someone else pays in, someone said they should join or they pay less tax.

“If we had done this, it would not be about whether the money was up or down in the short-term, it would be about whether they were still on track to have enough money in order to retire at some point in the future.  Most people we meet in DC pension schemes do not even have a plan, not even a sketch plan.

“Very often they are in default funds because they got some vague level of help which meant they did not feel sufficiently informed to make an actual choice.

“Many have no idea what type of pension scheme they are in, could be DB, could be DC, they do not know.  They also do not know that the amount of money going in will deliver a much poorer retirement future than their parents and grandparents.”

Better engagement

Therefore, the industry needs to improve the way it engages with customers, Ms McIntyre argues.

She adds: “We need to forget about DB and DC; they are phrases that mean something to us, not real people. 

"We simply have to find better ways to engage, which means not speaking in obscure language they find intimidating, presenting wonderful charts which mean a lot to us and nothing to regular people.  

“Instead, we need to change the music and realise we have to learn more about them, get them to relate the savings to their future in a way which is real. 

"It means talking in language they are familiar with, adapting our language.  We need to ensure all planning is about how they provide for their future in the safest way, not taking risks they do not understand.

“We also need to learn how to leave more of their own money in their own pocket. 

"Some of the charging we see is, bluntly, ridiculous and leaves the industry at risk of being accused of looking after their own interests first and consumer interests second.

“When a member is in a DC scheme there is no hiding place. The higher the charges we take as professionals, the less money that person will have to live on when they are older.  It is time for a major change in our industry and it needs to happen now."

DB scheme concern

The deficit in the UK’s defined benefit pension schemes increased by more than £10 billion between February and March according to the Pension Protection Fund, the industry’s ‘lifeboat’ for schemes where the backing employer has gone bankrupt.

They have been hit not only by the collapse in global share prices but also the Bank of England slashing interest rates to new historic lows in the wake of the pandemic, which means more money is having to be put aside now to pay future pensioners at a time where many companies, due to the lockdown, may not have these extra funds.

The funding of DB schemes was already complicated, even prior to the addition of coronavirus uncertainty.

As explained by Mr Glancy, actuaries are continually calculating the total amount of retirement income the scheme will need to pay out in the future (the liabilities of the scheme) and informing the amount of money that the employer has to contribute towards the pot of money that will eventually pay for all of those incomes.

That pot of money is known as the scheme assets. 

Where the assets are greater than the liabilities, the scheme has more money in the pot than it will need in the future and these schemes are referred to as being ‘in surplus’. 

Where the assets of the scheme are less than the expected liabilities, the scheme is referred to as being ‘in deficit’.

According to data from the ONS in early April, one in four firms are currently shut and one in five employees are furloughed.  

Ms McIntyre says the ultimate security of the promise arising from a DB scheme, is often contingent upon the ongoing existence of the sponsor.

She adds: “So, if there is a risk to the sponsor, if Covid-19 has created a situation where the sponsor is no longer a going concern, then of course there is a risk.  The fact that Covid-19 has impacted so many companies means that the many DB schemes may currently be considered 'under threat'.

“However, we need to remember that many of these DB arrangements are increasingly mature in the sense that sponsors and trustees have worked to de-risk the scheme, recognising many are closed to new entrants and future accrual, with a large proportion of members being pensioners.”

And as Ms McIntyre explains, trustees have typically done this via a range of investment strategies, with many targeting “self-sufficiency”, the point at which they believe that in the majority of scenarios they will not be reliant upon sponsor contributions, many more targeting ultimate buy-out of the scheme liabilities with insurance companies, perhaps new consolidators.

She adds: “It is also important to remember the existence of the Pension Protection Fund (PPF)

If the crisis puts the future of the employer in jeopardy then there is a risk that members will end up in the Pension Protection Fund.--Steve Webb

“It can mean a reduction in the members’ income expectations depending upon their membership status, but overall it could be a lot worse.  

“It is also worth noting that often cash equivalent transfer values are lower than the value of the compensation individuals would receive from the PPF.  There are also attractive terms for early access to income and cash, compared to some schemes.”

Deficits

Steve Web,b partner at pensions consultant LCP, says for DB schemes, the impact on the deficit will depend on how far the schemes were hedged'against movements in shares or interest rates.  

For those who did not have this insulation against market movements, deficits could increase significantly.  

At the same time, employers may be looking to delay paying contributions that were due to tackle any deficit, so there is no doubt that the financial position of many DB schemes will worsen in the short-term.  

“But the key remains the health of the sponsoring employer,” he says. 

“If the employer is in a sector largely unaffected by the crisis, then the long-term prospects for scheme members will remain good.  

“But if the crisis puts the future of the employer in jeopardy then there is a risk that members will end up in the Pension Protection Fund.  

“While the PPF provides a good level of protection, workers are likely to get lower pensions than they were expecting.”