Guest blog from Malcolm Small, Executive Chairman, Retirement Income Alliance, 16th June 2016
Recent events have seen businesses threatened, and in one case arguably destroyed, by the promises they have made to their staff for their retirement. These are what are known as 'Defined Benefit' (DB) pensions, where employees are promised a set amount of money each year in retirement, and the employer must put aside the funds required to meet that promise, no matter how much that promise winds up costing.
This contrasts with 'Defined Contribution' (DC) pensions, where the contribution amount is set, but there is no guarantee about the amount of pension or the income that results. This will depend on the fund growth, and how big the fund is when you come to draw on it.
DB pensions used to be the 'standard' way of providing staff pensions, but they have become very rare in the private sector. The vast majority are closed to new staff, and employers are increasingly seeking ways in which to limit their future liabilities around these schemes.
Because people are living longer, pensions now need to be paid for many more years than would have been the case when the scheme was established. This means much more money needs to be paid in by the employer.
A funding shortfall can result, which is called a 'deficit', and 'legacy' DB schemes can prove toxic to a business. Unless these deficits are kept under control, they can get very large. This, in turn, will mean that prospective purchasers of a business can be put off, as they may face an immediate requirement to inject many millions of pounds into the pension scheme.
This is why most modern pensions are DC plans. DC schemes are easier to operate, easier to understand and cheaper to run. However, there remains one sector where DB schemes still predominate. That is the public sector.
The even more uncomfortable truth here is that relatively few public sector DB schemes have any real funding behind them. It’s a bit like being on the film set of a Western movie. You can see the saloon bar and it looks utterly real, until you swing open the doors and realise there is nothing there.
With public sector pensions, there can be real employee contributions, and notional employer contributions in some cases, but there is no fund. Pensions are paid out of general tax revenues made by you and me. The forward liabilities are now a staggering £1.5 trillion, as big as the national debt, and growing.
Recent attempts at reform have proved timorous and ineffective. The elephant in the room here is that these pensions are unsustainable, and room for successive governments to “kick the can down the road” will soon run out. What happens then is anyone’s guess, but none of it looks good. Whether private or public sector, the sad news is that DB pensions are probably obsolete in the 21st century.
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