Defined Benefit Pension; a perfect storm!

This winter will long be remembered as the winter of storms.  Despite the carnage inflicted on some, for most the damage was temporary and the financial impact minimal.  However there is a much more significant perfect storm hitting defined benefit pensions which will have dramatic and long-lasting implications on individual’s finances.

For almost all employers in Ireland today, a Defined Benefit pension scheme is now a completely unsuitable model for the provision of retirement benefits. The dangerous uncertainty with costs together with the onerous burden of unreasonable regulatory requirements has created this perfect storm that most employers today must avoid. The same applies to schemes which are closed to new members – they are just less dangerous.

Having worked on numerous Defined Benefit scheme restructurings and wind ups, it is now clear to us that such schemes will in time become the exclusive preserve of the Public Sector. This does not change the fact that they are still completely unsuitable. The only reason that they can survive in this sector is that the government can continue to rely on every taxpayer in Ireland to fund them.

History lesson

For those of you who enjoy your history, it is generally accepted that Otto von Bismarck introduced the very first of what we now know as Defined Benefit pensions
in Prussia in the second half of the 19th Century. Bismarck was a master of complex politics and his objective with this offer of a state funded old age pension was to win over the support of working class Prussians which might otherwise drift towards his Socialist enemies.

The cleverest part of this political strategy was that the pension would rarely have to be paid to anyone. Life expectancy in Europe during the late 1800’s was 45 years and Bismarck’s generous offer of a State pension commenced at age 70!

Many Defined Benefit pension schemes in Ireland were established in the 1970’s and most were based on a retirement age of 65 years. Most members of these pension schemes were men and Irish male life expectancy in 1970 was 68.8 years. In other words, these pensions would on average be paid for less than 4 years. Most of these pension schemes paid fixed pensions with no annual increases. This meant that the high inflation during the 1970’s and 1980’s significantly reduced the real cost of pensions for these schemes.

Modern Reality

We live in a very different world today. Roll everything forward to 2016 and the membership of Defined Benefit schemes is much more mixed. Male life expectancy today is 78.3 years and female life expectancy is 82.7 years.  So, for a male employee retiring today, a pension will on average have to be paid for 13.3 years and for 17.7 years for a female employee.  Life expectancy is significantly higher again for 30 year old employees who won’t be retiring until well after 2050 and this is placing massive cost burdens on these schemes.

If you think that this issue alone is sufficient reason for Defined Benefit schemes to be closed down, it is only half of the picture.

The regulations governing the Trustees of Defined Benefit schemes severely restrict their options in terms of the assets they can choose for investment. These restrictions are particularly problematic for schemes with older age profiles as the Pensions Authority rules require the Trustees to maintain high exposures to long term EU sovereign bonds. This severely limits their ability to invest in true growth assets – such as equites and property. Sovereign bond yields in modern-day Prussia (i.e. Germany) are currently extremely low at 0.24%. These may fall even lower if the ECB decides to push interest rates further into negative territory at this week’s monthly meeting. Returns at these levels would hardly even cover the costs of running an average Defined Benefit pension scheme.

If you are in any doubt about the dangers of Defined Benefit pension schemes, just look at the complete mess that is the Irish State retirement pension scheme. This scheme is completely underfunded and represents one of the greatest risks to the financial stability of this country. Unfortunately, as it is a hidden time bomb which receives very little publicity, the politicians can conveniently ignore it, comfortable in the knowledge that they will be in receipt of their own very generous pensions before this bomb explodes.

Summary

To paraphrase Teresa Mannion; when faced with a perfect storm, employers and employees shouldn’t take unnecessary risks with their retirement planning.  Here at LHW we have assisted in a number of high profile restructurings of Defined Benefit pension schemes.  The goal here is to bring back financial stability for the employer and also for the scheme members for whom Defined Benefit schemes can be very risky too.  Often schemes can be stabilised by taking sensible decisions based on a rational assessment of the situation. We specialise in this area and welcome the opportunity to deliver effective solutions for employers and their staff.