Is DB really dead or can it be salvaged?

The mantra ‘DB is dead' has become the norm as sponsors struggle with ballooning deficits on the back of ‘lower for longer' interest rates. In the past year alone a string of major FTSE companies have announced the closure of their ‘gold-plated' pensions.

With the end of contracting out It is inevitable that the few remaining companies with open defined benefit (DB) schemes will consider closing them, many replacing them with defined contribution (DC) arrangements. While better for the company financially, this is generally a downgrade for employees. Is there another way? Can employers avoid closing DB but at the same time make cost savings so the scheme is more sustainable?

Unsurprisingly, a lot of success in keeping DB open has been in heavily unionised sectors. For example, Tata Steel kept open the British Steel Pension Scheme while agreeing a series of cost-cutting measures to lower liabilities following pressure from unions.

Trades Union Congress (TUC) pensions policy officer Tim Sharp says: "One of the weaknesses in the British system is that too often when DB schemes are closed, we're finding employers move to straight individualised DC where all the investment risk is on the shoulders of employees."

Keeping DB alive
Yet where companies must make cost savings, the costs must fall somewhere.

Tata Steel, despite keeping its scheme open just weeks later announced 1,200 job cuts. JLT Employee Benefits chief actuary Hugh Nolan says this felt like a "trade-off", and speculates that maybe the job cuts would not have been so swingeing if the pension cuts had been harder. If the costs are unsustainable, then something has to give.

On the other hand there can actually be a cost benefit to keeping schemes open in some cases.

Nolan says: "Upon closing the scheme, members become deferred pensioners, which means they will get inflation-linked increases before they retire under statutory rules. That will be more than the company expects to give in salary raises for the next few years, so in actual fact closing the scheme may put the costs up."

A bigger problem is where schemes have old-fashioned statutory rules that guarantee members fixed pension increases every year before they retire, as these can be very expensive and significantly ahead of current rates of inflation.

"So with inflation at negative and a risk of deflation, closing the scheme and triggering that guaranteed 5% increase for every year for the next ten or 15 years, is a very expensive trick to pull," he says.

One of the benefits of keeping the scheme open is being able to cap pensionable pay - which is likely to lower costs. Nolan explains: "If you can cap pensionable pay to a level that's no more than inflation, the chances are this does not make the scheme's funding level any worse for the past than it would be by closing it. Changing the accrual rate leads to future service coming in at a lower rate as well."

Innovative ways
First Actuarial chief actuary Hilary Salt argues strongly against the belief that DB must end and thinks there are a number of innovative ways to make schemes more sustainable.

She says it is important to differentiate very clearly between changes to future service benefits and changes to those already accrued.

There are several ways to tweak future service benefits with the most obvious one being moving to a lower level of accrual or increasing the pension age. But Salt believes such mechanical changes often do not go far enough and that there are alternative ways to design sustainable benefits.

One option is to link the retirement age with the state pension age to give a control mechanism if longevity improves in the future.

Some employers could opt for a lower level of guaranteed benefits within the scheme with additional targets such as pension increases or lower level of retirement age, according to Salt. As these are paid on a discretionary basis and not in the scheme rules, they can be taken away if employers need to control costs.

This is quite different to reducing accrued benefits, which is the effect of capping pensionable salary increases. "I'm much less supportive of those kinds of things because often people have a dagger at their throats being told ‘if you want to retain DB accrual, you have to do this'," says Salt.

"That's very different to entering negotiations where members agree they'll do something to keep DB accrual."

Another option where fixed pension increases are very expensive and significantly ahead of current inflation, is to ask members to give these up in return for continued benefit accrual. Legislation under section 67 prevents these benefits being removed unless members give consent on an individual basis. Salt says it is worth exploring but that employers tend to shy away from this partly because it involves talking to members to properly explain the switch.

Hybrid structures
While small tweaks are welcome, some employers may wish to spend time developing DC/DB hybrid structures which let workers continue to accrue something in a DB section while having a DC top up. Hybrids are becoming increasingly popular, with John Lewis and the Universities Superannuation Scheme recently choosing to do down this route.

Salt says this can work really well as people can use DC to draw down cash and use their reduced DB benefits for retirement income.

Former pensions minister Steve Webb is "all in favour" of these structures. "Otherwise it's a pretty dramatic move after years of DB to move to purely DC. If you can give employees a layer of certainty, that's clearly going to be valued by the scheme members."

Negotiating with sponsors to get these kinds of compromise deals is very difficult where employers wishing to close down the scheme treat the consultation as simply a notice period. PP understands that in recent days the TUC has raised this issue with The Pensions Regulator (TPR).

"TPR needs to be more vigorous in ensuring the statutory 60-day consultation period is a genuine consultation," says Sharp. "Too often it is treated as a notice period. Proper consultation would allow scheme members to work with employers on arrangements that would suit both parties' requirements. I would expect this would lead to fewer knee-jerk closures of DB schemes."

Prudent funding rules
There is also an argument in some spheres that DB would more be sustainable were it not for very prudent funding requirements on schemes.

Sharp believes the regulator's funding approach is too short-term: "Schemes are being put under unnecessary pressure by what can be an excessive conservative approach by TPR in terms of funding, with what's happening with quantitative easing and discount rates. Schemes have very long-term liabilities."

While he agrees with TPR's objective about sustainable growth plans for scheme sponsors to ensure they are healthy, he suggests the watchdog should also have an objective to protect the existing benefits of DB members.

Webb, who in government was involved in adding the sustainable growth of employers to TPR's remit, argues there is "already a lot of flexibility" in the system as recovery periods are quite often rolled over. He says it's a "delicate balancing act" but points out that some big name companies have gone bust surprisingly quickly.

A TPR spokesperson says in an emailed comment: "In line with our objective to minimise any adverse impact on the sustainable growth of an employer we are supporting economic growth by encouraging a balanced approach to the funding of defined benefit schemes - benefiting businesses and strengthening security for pensions. Our DB code goes further than before in setting the expectation that trustees and sponsoring employers will work collaboratively to agree balanced funding plans that meet both their needs.

"The code recognises that risk-taking is an essential feature of the system - it is not necessary or possible to remove all risks and an appropriate amount of risk can actually improve a scheme's ability to meet its pension promises to members - but effective risk management is a key aspect of a healthy scheme."

The spokesperson adds that while schemes and sponsors should be able to implement funding plans that both benefit the business and strengthen long-term security, there are a "small number" of schemes with a large deficit relative to the employer's size that may struggle to meet their pension promises.

It says there is "sufficient flexibility" in the funding framework to ensure that, in most cases, appropriate solutions can be reached. "Where pension schemes and their sponsoring employers are in a precarious position, we are prepared to work closely and creatively with them to try to deliver a solution that balances the interests of the members, PPF and employer."

The government will need to tackle the issue of the startling gap between DB and DC. Webb says although there have been other priorities with auto-enrolment and the pension freedoms, "the need for risk sharing and pooling hasn't gone away - so I hope the government will turn to it as soon as possible".