If you have been listening to the discussions about the future prospects of defined benefit (DB) pension schemes, you might have wondered what it means for you.
In the past, someone in a DB scheme would have been in a privileged position, with a guaranteed income on retirement based on their final salary.
Now this guarantee looks anything but secure, leaving many to wonder just what they will be entitled to when they hang up their briefcase for the last time.
"It's fair to say, at a very general level, that the future for DB schemes is very bleak. In future there will be one of two outcomes: benefits will be reduced or the scheme will be wound up," says Sandra Rockett of Davy Private Clients pension advisory service.
So what does this mean for you? If you are in a DB scheme and are starting to get scared about its prospects on retirement, how do you decide whether to stay or go?
If you have . . .
already retired
If you are receiving a pension based on your final salary, you are in an enviable position.
"The reality is that if the scheme is fairly well funded, you have the extra layer of protection from other members' assets," says John Tuohy, chief executive of Acuvest.
However, while contributions from employed members of the scheme might be propping up your income in retirement, this does not mean that it is entirely safe, as retired members of Independent News & Media recently discovered when the group proposed a 46 per cent cut in pension benefits.
That may be an extreme case, but with pension schemes battling to survive, benefits such as inflation-matching are regularly being cut. Not only that but, up until recently, anyone who had already taken their pension could be reasonably confident that their benefits would be secured in the event of the scheme being wound up.
Now, however, the Government has made moves to change the preferential order in the event of a wind-up, so that retired members don’t receive preferential treatment at the expense of members who are still working.
“That could be a very significant factor that’s playing on many people’s minds,” says Rockett.
But while the move was recommended in a recent OECD (Organisation for Economic Co-operation and Development) report, the legislation has been deferred yet again.
“First of all, it was stated twice by the Minister that it’s going to happen but it hasn’t happened. So whether there will be political will or not to introduce it in the future remains to be seen,” says Tuohy, adding that it may be seen to be unfair to members who have already retired.
“If you or I were receiving a pension already, would we be arguing that it was encroaching on our rights, by making a change after the event?”
What is clear is that, if it was to happen the way it has been mooted, it would significantly affect pensions, with Tuohy noting that it would "undoubtedly reduce the value of the benefit of a pension".
If you are . . . within two years of retiring
If you fit into this bracket, then it might be time to pack up your pension bag and get the hell out of Dodge. It might go against everything you have so far believed, but some pension experts advise that it could be the right option.
Indeed, Rockett has encountered many senior executives who are actively taking this option by voluntarily exiting their pension scheme.
“Anyone approaching retirement should be actively considering this. There is now an understanding that a DB scheme isn’t as guaranteed as we were once led to believe,” she says. “I think that the number of people actively considering it has increased significantly.”
For Rockett, there are two key points to consider:
The likely level of income payable from the DB scheme.
The security of benefits in the event of a scheme wind-up.
“The key reason to stay within a DB scheme is because your transfer value is so heavily reduced” if you were to cash out now, says Rockett. But, if you’re close to retirement, your employer will appreciate that their liability is going to increase significantly if you stay within the scheme.
“Companies are in a position to negotiate with people to give full transfer value,” says Rockett, adding that a key reason for them to do that is because they will be effectively discharging your pension liability and getting it off their balance sheet.
For Tuohy, the decision is not as straightforward. “It’s really, really difficult if you’re a couple of years from retirement. People are hoping that they fall over the line,” he says, noting that once you become a pensioner, under the current system, you move to the top of the queue and become a secured creditor in the event of a wind-up, although, as noted previously, this may change.
“It’s a very big incentive to try and hold on,” he says, but adds that there is a flip-side, which echoes Rockett’s argument.
“Look at the example of Waterford Crystal – you can wind up with very little left, even though you might be just one day away from retirement.”
So, if you want to take control of your income in retirement, an option might be to negotiate with your pension-fund trustees for a decent transfer value and move your money into an Approved Retirement Fund (ARF) once you retire.
Of course taking responsibility for your own pension brings its risks. “You’re transferring responsibility for the investment of the pension fund from the trustees to yourself. Decisions that are made on the ARF are very much the responsibility of the individual,” says Rockett, adding that if you want your new fund to provide the same benefits as the DB scheme, you would typically need to generate a 4.5 per cent return net of fees and charges.
It’s not an insignificant figure and may prove difficult to achieve, particularly if you don’t take on some risk.
“If you follow a low-risk strategy you may see a lower level of income, that can be supported over your lifetime, than a DB scheme,” says Rockett, adding that it’s a “trade-off” between a search for security and growth.
If you have . . . more than two years to go While retirement may be a distant possibility for you, it doesn’t absolve you from potentially making some difficult decisions.
“There is a cohort of people – and these are the same people who have significant mortgages and young families – who are most at risk,” says Tuohy. “If they really understood that there are significant risks in a DB scheme, and that they are well back in the queue towards retirement, they simply wouldn’t be there.”
In such cases, he advises people to ring-fence what they have in their pension schemes.
“It’s the bird-in-the-hand or two-in-the-bush argument,” says Tuohy, noting that if you think there will be enough left in the pot to pay you a pension at the age of 65, you may be better off staying in the scheme. On the other hand, depending on your age, that leaves a lot of time for something to go wrong with the pension scheme.
“If a company is willing to put in extra money, put it into an individual pension,” says Tuohy, although he notes that defined contribution (DC) schemes should be “significantly over-hauled in the interest of members”.
Rockett, on the other hand, suggests that scheme members in underfunded DB schemes with some time left until retirement should typically remain within the DB scheme, even though it may be underfunded and may be wound up in the future.
The key reason for doing so, she says, is that a transfer value may be higher in the future.
“A transfer value is calculated based on prescribed assumptions which effectively discounts your future payments to a present-day lump sum.
“The discount rate used to determine the transfer value is 7 per cent. Therefore, each year – even if the funding position of the scheme does not improve – the transfer value would increase by 7 per cent,” she says.
So, even for underfunded schemes, she says that there is a likelihood that between additional contributions and/or positive investment performance, the funding position of the scheme will increase from here and the reduction to the transfer value would be less at some later date.
“You can build a retirement plan around the portion of the DB scheme getting paid, and you can look to fund the balance through AVCs and something else,” she suggests.
After all, AVCs – even those that are made to DB schemes – are generally fully protected, even if the main DB scheme is underfunded.
