The Defined-Benefit to Defined-Contribution Transition
Hi everyone,
This week we have been looking at the decline of “defined-benefit” (DB; or otherwise referred to as salary-related) occupational pensions and the rise in defined-contribution (DC; or money-purchase) occupational pensions. Why are more employers closing their door on DB schemes and only offering new employees DC pensions? And what does this mean for you as an employee?
Occupational pensions were originally set up as an incentive to attract and retain employees. The modern schemes began with Louis XIV of France to entice people to sign up to the Navy and was partially subsidised by the sale of the booty captured by their warships. This was an example of today’s DB scheme, where the employer shoulders the burden of supplying the employees? pension income based on their pay and length of service.
In contrast, DC schemes appeared around 30 years ago and shifted the risk to the individual, with the eventual pension total dependent on investment performance and amount contributed. Previously, the majority of occupational schemes were DB, however by 2014 the amount of money saved in DC pensions will exceed the amount of money invested in DB. The switch has been prompted by the realisation that DB pensions are unmanageable and increasingly expensive when including protection against inflation and provision for longer retirements.
Much of this was concealed by the bull market of 1982-2000, where investment returns outpaced the rise in pension liabilities, but with the bear market of 2002-03 and falling interest rates, the cost of DB schemes have become unsustainable. The current economic downturn may speed up the conversion of DB to DC schemes with the proportion of employers expected to switch new employees to DC pensions rising from 21% in July 2008 to 45% in January 2009.
The uncertainty of your final DC pension pot is by no means the only drawback of these schemes. One of the principal disadvantages is that the level of contributions from both employers and employees into DC pensions are significantly lower than those invested in DB schemes. In October 2007, the average employers? payment into DC schemes was just 5.8% of payrolls compared to 14.2% paid to DB pensions. The difference is not made up by employee contributions either with an average of 3% of salaries invested in DC schemes, bringing the total to just 8.8% in contrast to the 19.1% contributed to DB pensions.
Ultimately, it is the final value of your pension pot that suffers.
The estimated difference calculated by Watson and Wyatt is over a 50% reduction in pension return with a median 25-year old contributing at the British DC rate earning about 30% of their final salary compared to 66% of their final salary when contributing DB rates for 40 years. Furthermore, this valuation does not even take into account annual costs of DC schemes that can reduce the overall return.
With the rise in the proportion of companies only offering DC schemes the number of people in these plans will increase and many may remain oblivious to the consequences of DC pension membership.
Hopefully, this blog will bring to your attention the shortcomings of DC pensions (if you are not already aware) and prompt you to appraise your DC pension plan (if you are contributing to one).
Will it be sufficient to fund the retirement lifestyle you dream of?
Warm Regards,
Dr Danielle Aw, PhD
Senior Research Analyst
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