Controversy over defined benefit occupational scheme in the UK
There are different kinds of pension schemes operating in the UK. One of the most prevalent schemes is the defined benefit scheme. The scheme has been widely talked about and there is a major controversy surrounding it primarily because of the risks associated with it. The defined benefit occupational pension schemes are found not just in the UK but also in other countries. However, the challenges facing them are forcing members to shift towards defined contribution. The rules that govern how members will contribute and their pension at retirement are defined by the specific organisation that sponsors the employees and are often not subject to interpretation by other legal organs. Defined benefit schemes are fraught with risks such as longevity of members, investment risks, inflation and decision on dealing with surpluses. There are suggested solutions that would make the schemes to be much safer but many members and countries are shifting gradually to defined contributions to minimise these risks.
This piece of research will cover a detailed view of defined benefit schemes, the problem and risks associated with them, the problem of underfunding, how the pension is calculated under the schemes, and finally what measures can be taken to overcome the risks associated with these schemes.
The two funded pension schemes involve the workers to fund a given contribution for the members that are working and often are employees of a given organisation. Defined members occupational pension scheme is unique in the sense that members’ earnings at retirement is defined by the length that the workers contributed to the fund and the immediate last salary that they received before retirement. Under these conditions, the members can be given a given designated figure, say, 1/80th or 1/60th of the final salary. In the case where the members are committed to receiving 1/80th in addition to other benefits that are lumped together for the years that they worked such as 3/80th of the final salary as a lump sum that is tax free. In essence, the 1/80th means that the worker would receive 1.5 times the final salary that was received at the time the worker retired for a typical worker that worked say, for forty years, when all benefits have been included. What makes the scheme even more risky is the fact that the benefits are based on the total funds that have been accumulated over the years and the rates of annuity used when the funds were used to buy an annuity (Buckle & Thompson, 2004).
Problems with defined benefit schemes
Just like issues with most such schemes, defined benefit schemes also have their own issues. Other issues that need to be addressed under the defined benefit occupational scheme include the need to have the rights of workers that leave early for retirement to be preserved and transferred. Due to limited funds that such schemes are known to experience, the pensioners that leave lose certainty of having their contributions secured by the management of the scheme OECD, 2001). As a result, the members’ mobility is restricted as they fear losing their contributions in the risky pensions scheme. OECD (2001) also added that such schemes have lost much attention due to the nature of having few members. In the recent survey, only 110000 members were registered under the defined contribution occupational pension schemes. Despite the negative side that the schemes have been put on focus, the defied benefit occupational scheme do offer benefits such as extending benefits to family members in case a contributor dies before retirement or who are incapacitated to work because of a debilitating illness of health.
According to Pizutti, (2001), the problem with the initial method of calculating the benefits meant that the risk was borne on the members and before then, the value depended on the investments that the members’ contributions were used to make. According to the Parliament of Canada, such schemes are also used and they are plagues with issues such as solvency of funds, financing the solvency plans, ownership of pensioner surpluses and how the employees’ contributions would be handled in case the employer providing the scheme is unable to sustain it. This exposes contributors’ benefits to lose and nowadays, members and their sponsors are opting for alternative schemes that are deemed to be safer.
Another issue that is known with the UK DB (defined benefit) schemes is that of being underfunded and employers engaging with their employees in the long term contract. The issue to solve this is to increase Solvency II which increases the value of liabilities of the pension schemes. The aim is to provide a buffer that would solve the issue of being underfunding of pension schemes. Again, the aim is to reduce the extent of exposure to equity such that employees’ contribution is exposed to minimum risk. However, the impact in the long term is reduced expected returns for the pensioners. This was a solution that was proposed by the European Union in view of the underfunding risk that of DB (Buck Consultants). According to Folpmers (2012), underfunding is a key issue that makes defined benefit schemes to fail to live to the promise to their employers. The issue that cause this, according to Folpmers is more often the interest rates being low which makes the liabilities to increase significantly. The life expectancy of members especially in the developed countries has increased and pension schemes take too long to adapt to these societal changes.
Ownership of pensioner surpluses
In the event that a company or sponsor that was a custodian to the members’ contributions has a surplus of the same, there has been a usual step of stopping contributions altogether or reducing the amount that the members are supposed to remit monthly. In other cases, when the sponsor decided to wind-up the organisation, it presents a lot of challenges to the contributors. In the event of surplus contributions, it is expected that the same amount should be used to cushion pensioners’ of an unforeseen eventualities where there savings are put at risk. In the case where the company is bought or for any other reasons it is winding up, this DB scheme can put an increased level of risk to the contributions. The remedy for cases is to have a policy or statutory regulations where surpluses remaining after paying benefits are returned to the employer (Eich, 2010). In this case, this could be subjected to taxation and notifications on winding up intentions are made known. There has to be rules governing the Scheme operations that give directions on how such event are handled. In absence of guidelines, such cases have been pursued in courts where courts have been met with indecisiveness on the right person to receive the surpluses.
Calculation of defined benefit pensions
The new method of calculating final salary ensures that the calculation considers all the payments that workers earned while in employment. Thus, all the benefits that were received as a result of promotion or award due to performance are considered in the final calculation of the final pension that will be paid. Under this new method, called career average scheme, the workers’ annual pension is based on the workers’ annual earnings over the period in which the workers were members. The result is that the workers will receive an annual salary that is a percentage of an annual salary they received as worked and while as members of a given defined benefit scheme. One thing that is noticeable in this new method is that the amount or size of the workers’ contribution does not determine that annual pension that they will receive in retirement (Monetos). The method that is used in calculation is as thus:
Annual pension = number of years x accrual rate x average salary received while in scheme.
This differs from the Final Salary Scheme where rather than the average salary; it is the final salary that is used in the calculation (as shown after this section). The accrual rate is that percentage of the annual salary of the that the workers they entitled to by being a member of the scheme. The accrual rate could be one of the following that is commonly used, i.e. 1/60, 1/80 and 1/100. The implication of this is that this fraction will be used of the annual salary the workers received while they were members of the scheme. All the years worked will be considered though there are limits of the number of years that will be considered, above which, no more benefits would accrue. This is often forty years although some may work for more or less years than that.
For example, if a worker had a total of £40500 over a period of 30 years, using an accrual rate of 1/60, the pension will be calculated as follows:
30x 1/60* £40500= £20250.
Sometimes, this pension is adjusted for inflation to reflect the current value of money.
Final salary would be calculated basing on the final salary. This is said to the standard with common schemes that are used in the UK. The only difference is that only the last salary is used and other periods are not considered in the calculation.
Even though defined benefits are especially a burden to large organisations but it is difficult to control the business given that such schemes operate on their rules that they create and members accept before joining as members. The issues that affect defined benefits are many and are widely known, especially the risk that the members are exposed to in event of winding up of a sponsor. Others such as longevity of members, investment risk and inflation risk have been variously cited in the same breadth across OECD and non-members. Several counties in the OECD are transitioning from DB to DC due to the challenges explained in the article. Success of any such schemes depends on the presence and effectiveness of statutory social security and personal pensions. In such cases, occupational benefit are but complementing the main social security services that are provided by the state.
Buckle, M J & Thompson, J (2004) The UK Financial System: Fourth Edition, Manchester University Press
Eich, F (2010)The importance of defined-benefit occupational pension schemes in selected OECD countries, Pensions Corporation, available online, http://www.qfinance.com/insurance-markets-white-papers/the-importance-of-defined-benefit-occupational-pension-schemes-in-selected-oecd-countries/46I-41243_-3970.pdf [Accessed 22 Feb 13]
Folpmers, M (2012) “The Defined Benefit Occupational Pension System: Calling for a Financial Overhaul”, Risk Techniques, http://www.garp.org/media/1018760/081612_risktechniques_folpmers.pdf
International Network of Pension Regulators and Supervisors. Conference, Organisation for Economic Co-operation and Development. Private Pensions and Insurance Unit, (2002) OECD Regulating Private Pension Schemes: Trends and Challenges
Monetos, “Occupational defined contribution schemes”, http://www.monetos.co.uk/pensions/non-state-pensions/occupational/defined-contribution/
OECD, International Network of Pension Regulators and Supervisors. Conference, Organisation for Economic Co-operation and Development. Private Pensions and Insurance Unit
Pizutti, F R (2001) Globalization, Institutions and Social Cohesion, New York: Springer
Proposals on Surpluses in Occupational Pension Schemes (Dec. 1998) - Report of the
Pensions Board, Department of Protection, http://www.welfare.ie/en/Pages/Proposals-on-Surpluses-in-Occupational-Pension-Schemes-(Dec.-1998)---Report-of-the-Pensions-Board-.aspx