The curse of the defined benefit pension

Trapped in the world of pensions

I went to a very interesting finance seminar today. I work in public sector finance and the seminar was focused on defined benefit pensions the public sector and I tell you…the discussion left me perplexed.

For those that are not aware, a defined benefit (DB) pension is a workplace pension very common in the public sector (and historically available at large private sector companies but less-so now) where your employer guarantees you a pension income in retirement based on a predetermined calculation. Most schemes, mine included, also include life insurance as part of the deal. Here is an example (and this is a completely made-up scheme but loosely based on my current scheme):

  • You contribute 8% of your gross salary to the scheme
  • Your employer contributes 10% of your gross salary to the scheme
  • You work for 20 years under these conditions
  • Your accrual rate is 1/60th
  • Your gross salary at retirement is £60,000
  • In this example, you would be guaranteed to receive an annual pension at retirement of 20 years x 1/60th x £60,000 = £20,000, which is usually linked to inflation.
The typical reaction to pension calculations

So on the surface, this seems like a great deal right? As an employee you have a guaranteed income in retirement linked to inflation. You will have a stress-free retirement in exchange for a long and successful career in the public sector. Simple.

But here is the thing which became clear to me as I listened to the seminar: in a defined benefit pension scheme you will contribute an amount from your salary during your employment which has absolutely no direct link to the pension income you will receive. This is risky and means you have little control over when and how you you receive your pension.

Furthermore, in the current economic environment, the total contributions made into DB schemes are normally not enough to fund the scheme. With interest rates low and people living longer, the schemes are becoming riskier and the deficits higher. Eventually, the scheme trustees will have to either: (1) reduce pension benefits; (2) take on more risk; (3) require higher contributions into the scheme; or (4) CLOSE THE SCHEME. The problem is employers can’t increase their contributions infinitely and employees will start opting out of the scheme if employee contributions are too high. Employers then have to plug their pension deficits even more. It is a vicious downward spiral and the reason many private defined benefit pension schemes have closed.

Personally as an employee in the public sector, now that I have contributed to the scheme for a few years, I feel a bit stuck. I can obtain a valuation of my pension and transfer it to a personal plan, but then would lose out on the guaranteed pension in the future and the life insurance benefit I am currently receiving. In fact, the UK Money Advice Service states:

“Any potential advantages of transferring from a defined benefit pension scheme to a defined contribution one are often outweighed by the costs, risks and loss of benefits involved”

I am also worried about the possibility that the pension I think I am going to get when I retire is actually nowhere near the pension I will actually get because it simply isn’t affordable.

As I walked back to my car from the seminar, I reflected on my journey to financial independence and my hopes to retire earlier than the standard pension age. A specific part of the presentation stuck with me. The presenter spoke about the lack of freedom that one has in a defined benefit scheme.  He had a slide which depicted the three typical phases of retirement:

  • The first phase is the ‘ACTIVE PHASE’ –> this is the phase in retirement where the retiree is still active, traveling the world, visiting friends and family.  Spend in this phase is high.
  • The second phase is the ‘WIND-DOWN PHASE’ –> in this phase the retiree is less active and takes fewer trips as mobility starts to decrease. The retiree is still relatively healthy but less able to travel and therefore spend is modest.
  • The third and final phase is the ‘CARE PHASE’ –> this is where the retiree is elderly and requires increasing amounts of care, possibly in a care home. Mobility is close to zero and spend is very high (but likely funded through assets).

Looking at these phases, clearly retirees will want income to be geared towards the start of their retirement. This is when retirees will have high expenses that they do not want to fund through assets. However, inflation-linked defined benefit pension schemes provide the majority of their value towards the back-end of retirement. Only around a third of the value is realised in the first 10 years. And if I want to retire at say, 50 or 55, then my ACTIVE PHASE will be even longer than most. So does this mean my ‘gold-plated’ defined benefit pension scheme is less valuable then I thought? Perhaps.

Above all, the thing I have taken away from today’s presentation is the realisation that I must continue on my journey towards financial independence and debt reduction on my own terms. This does not mean I am considering withdrawing from my workplace pension scheme. To replicate in a personal pension the pension I would get through my workplace scheme I would have to invest around 40 to 45% of my gross salary (rather than the 8% I currently contribute) and even then it wouldn’t be guaranteed!  So I will continue contributing, but when running early retirement forecasts, I will reduce any dependence on workplace pensions and focus on robust post-tax investments to fund the majority of our early retirement years.