DB or not DB, that is the question

Interpreting Hamlet’s famous soliloquy is a breeze compared to the intricacies of a defined benefit pension plan but anyone with a ‘DB’ scheme must get their head around the risks and rewards, writes Declan Hanley, Head of Financial Planning at Davy.

Defined benefit (‘DB’) pension schemes were originally designed to provide retired employees with a monthly payment for life. That payment was based on a percentage of salary, which largely depended on the employee’s level of service, so after 40 years of service an employee would get a pension of two-thirds of their salary. At their best, DB schemes worked both ways – employees got a regular retirement income linked to salary, while employers could retain and reward employees who committed themselves to the company. What could possibly go wrong?

Steady decline of DB schemes

First of all, Irish people started living longer… a lot longer. According to the Central Statistics Office life expectancy in 1950 stood at 66 years but by 2012 this had increased by a full 15 years, to 81. That’s a phenomenal increase in a very short space of time. Of course, this is fantastic for most people who can look forward to a long and healthy retirement, but for the companies responsible for paying their pensions it’s a massive headache.

Other factors have contributed to a steady decline in DB schemes, including recent investment market crashes, low bond yields, increased regulation and accounting requirements, plus the general rise in salaries during the Celtic Tiger years. At this stage, when it comes to DB schemes, many companies have decided that the maths simply don’t add up – they cost too much and those costs are fraught with uncertainty; a company’s worst enemy.

DB system “inherently unfair”

As the costs associated with DB schemes grew, many companies limited the costs and uncertainty by reducing benefits or freezing current benefits and moving to a defined contribution arrangement. According to the Pensions Authority the number of DB schemes in Ireland fell from 2,557 in 1991 to 1,541 in 2003 and fell further to 703 at end of 2014 and today, many people are wondering whether their pension scheme will still be there when they retire.

The level of protection in place for members of DB schemes is also relatively weak in Ireland compared to our closest neighbours. There have been some improvements, largely as a result of the Waterford Glass workers’ case to the EU, but the system is inherently unfair. Where a company decides or is forced to wind up a DB pension scheme, pensioners get first call on scheme assets for the majority of their benefits while those who haven’t reached retirement age have to make do with what is left.

What’s the alternative?

Many people with retained benefits in defined benefit pensions are reviewing the option to take a transfer value from their plan and manage their own retirement income. For some, this decision will reflect the uncertainty outlined above but increasingly, people are also focusing on the positives of moving to a defined contribution arrangement:

• Potential to pass on wealth to the next generation (DB pensions end with the current generation)
• Income flexibility
• Potentially a larger tax efficient lump sum payment

More employers are also topping up transfer values to incentivise members to exit DB schemes – ultimately reducing the cost and risks of maintaining a DB scheme.

What factors need to be weighed up?

The first issue to consider is whether you can reasonably expect to invest your transfer value and draw an income that at least matches the pension you expect from your current DB scheme at retirement. This will depend on the initial transfer value, the investment growth you’re hoping for, and how long you live. Unfortunately, you’ll only know the first of these factors when you’re looking at your options, so it’s worth considering a variety of scenarios. In particular, factor in the downside scenarios like the impact of a credit crisis or a possible tech bubble. These considerations may also form the basis for your investment strategy, if you do decide to take a transfer.

The numbers are not the only consideration. Managing your own wealth to provide an income for you and your family is a very different approach to the regular income stream that people traditionally received from defined benefit pensions. You need to consider the following:

• Do I want the job of managing all of my wealth myself in retirement along with the risks that go with it?
• How does this decision fit in with my other non-pension investments?
• Is passing on wealth to the next generation a priority for me?
• How confident am I that my DB benefits will be there for me?
• Does a transfer give me more flexibility in my retirement?

You should also make sure your spouse is comfortable with the answers to these questions, as they may need to step in and take over at some stage. The optimal financial decision can never be known without the benefit of hindsight, but time and advice can help you make the decision that is right for you.

What are your next steps?

As mentioned earlier, this is a complex and important decision. If you have a substantial DB pension, it is likely to make up a significant – if not the majority – of your wealth in retirement, so your next steps are vital. Here are some suggestions:

1. Request up-to-date pension statements and information
2. Engage a qualified adviser and actuarial support
3. Bring your family into the discussion
4. Take your time and consider all your options

So in the end, DB or not DB? Shakespeare probably put it best when he wrote that ‘the golden age is before us, not behind us’. Take your time, review your options and make a decision that gives you and your family the best chance of enjoying your own golden age.