Defined Benefit Pensions

Defined Benefit Pensions

Jim Osborne – March 3rd, 2022

The future of pension provision in Scotland is one of the key issues in the debates about Scottish independence. Over recent years the main focus of the discussion has been about the future of the state pension in an independent Scotland. However state pensions are only one element of pension provision in developed countries; everywhere retirement incomes are made up of a mix of state pension and private pensions. Private pensions are in two categories; occupational (workplace) pensions, provided by schemes established by employers, and individual private pensions. The UK has relied heavily upon occupational and individual private pension provision alongside a relatively ungenerous state pension compared with elsewhere.

Occupational pensions fall into two types – “defined benefit” schemes (DB) and “defined contribution” schemes (DC). All individual pensions are DC type funds. There are important differences between DB and DC:

DB schemes provide a retirement pension which is based on some relationship to earnings from employment. The formula on which this relationship is based is built into the rules of the scheme and this provides a degree of predictability to the resulting pension (hence the term “defined benefit”).

DC scheme rules set out what the level of contributions are (hence the term “defined contribution”) but provide no method which allows the final pension to be calculated or predicted. The pension depends entirely upon the returns made over the years by investing the contributions. The “pension pot” which exists at retirement is made up of all the contributions made over the years plus the investment returns, less management fees. The “pot” can then be used to buy an annuity which provides a guaranteed annual income during retirement. In simple terms, the annual pension is derived from the amount of money in the pension pot to be spread over the remaining period of life expectancy. Alternatively, the pot can be “drawn down” by the pension holder and managed effectively like a bank savings account in a way that often provides a higher income than the annuity but carries the risk of “running out” before the holder dies.

In DB schemes the risks associated with investment of the funds are borne by the employer who has an obligation to ensure that there are sufficient funds to enable pension benefits (the fund’s “liabilities”) to be paid to every beneficiary of the fund until the time the very last one has died and the fund finally closes, having discharged all its obligations. The funds must be sufficient to meet these liabilities even in the event of the employer going out of business. DB schemes offered by private sector employers have now largely disappeared because companies are unable or unwilling to keep paying the costs of eliminating “deficits”, which are the difference between the value of assets in the fund and the cost of the long term liabilities owed to each and every beneficiary. The closure of DB schemes has brought with it increasing insecurity in retirement for the vast majority of workers who now only have the option of being a member of a DC scheme. 

In a DC scheme it is the members (workers) who bear the investment risk. Risk has been transferred from employers to employees and along with this comes the uncertainty about what level of pension will result when it comes to retiring. In addition to the risk of your pension running out if you choose to draw it down, your retirement income may be based on the whims of “the market” either not raising expected investment returns, suffering a major crisis shortly before your retirement – leaving you no time to recover that lost income, or other risks including moral risks such seeing your pension invested in sectors, companies or countries that you object to.

If we want to provide greater security and a decent level of overall pension provision in Scotland then we must consider how we can restore DB pensions as well as provide a decent state pension and also consider how these two components of the pension system should work together.

The first issue to note is that a restoration of DB pensions is highly unlikely if we rely on employers to provide them. There is one critical difference between private sector employers and the public sector; the public sector is part of the state. The state has a permanence that companies do not enjoy – private companies can and do go out of business at some point in time. The state cannot and does not go out of business unless there is some catastrophic political crisis. Perhaps more importantly, a state guaranteed DB scheme opens the possibility of securing pensions not just on the income of workers but on other sources of revenue such as wealth taxes or profits from public-owned assets like a National Energy Company. This would eliminate the oft-cited “problem” of the demographics of an ageing population with fewer workers compared to the number of pensioners.

It follows, therefore, that the restoration of DB pensions depends upon the creation of a public pension scheme for which the state acts as ultimate guarantor. A public DB scheme can be designed as a universal scheme, open to all citizens who make contributions into a national pension fund during their working lives. This large fund built from regular contributions by everyone during their working life, plus investment returns and other revenue sources, would then be the basis of a National Pension Fund providing a defined benefit pension for all citizens when they retire. The DB nature of the scheme would mean that the eventual pension is related in some way to earnings from employment. 

Another important advantage of a national DB pension scheme is that everyone would only have one pension (plus a state pension) instead of having several separate pensions from different schemes provided by different employers during a working life. When changing employers the employee and the new employer just carry on making contributions, at the established national rate, into the same single pension fund. 

The provision of an earnings related pension from a national pension fund, guaranteed by the state, means that the investment risks are borne by the state and not by either employers or employees. 

There are compelling reasons to restore DB pensions and equally compelling reasons to believe that if this is our objective then the best way to achieve it is by creating a national earnings related pension scheme guaranteed by the state, but designed in such a way that it is highly unlikely that such a guarantee would ever be called upon. If this is what we want to achieve then the next stage is to turn to a discussion about the design, costs and management of such a scheme and the pension fund which supports it. 

4 thoughts on “Defined Benefit Pensions”

  1. I sympathis with teh wiews above. But I’ve having an internal struggle with the idea of a pension funded by the state wich is based on previous earnings – so richer people get more money from the state.

    1. Hi Robert
      The first thing to say is that there used to be an earnings related state pension in the UK – it was known as SERPS (State earnings related pension scheme), later known as SP2 (Second state pension). Occupational pension schemes could “contract out” of SERPS provided they offered a guaranteed minimum pension (GMP) equivalent to SERPS. To gets the SERPS you had to pay additional NICs.

      Secondly, the proposal for a National Pension Scheme does not involve state funding – it would be funded out of regular pension contributions by all workers and all employers. The state would act as guarantor, not funder.

  2. Ian Davidson

    Jim. Agreed. The only decent pension is a DB type and only the state has the capacity to finance these. It is now unfair and inappropriate to expect employers in the private sector to take this on. So a big rethink is required. However, the present Scot Gov seems to have a very limited capacity to analyse complex issues, ask the right people, listen to them and then produce practical proposals. Much easier for “Funeral Plan* Man” to shout and bawl in the House of Commons about the Westminster Government’s current state pension failings, the WASPIs etc. So, whilst welcome, the chances of anybody in the “inner circle” listening to you, seems rather low at present?

    *FPs being a good example of a lousy financial product?

  3. Hi Ian
    the state wouldn’t be the financer of a national pension fund – it would act as guarantor. If the scheme is properly designed the guarantee should not have to be invoked – if it were it would be limited to providing short term liquidity for unexpected short term income/expenditure mismatches.

    You are right about the problem of “deaf ears”. A paradigm shift is involved in order to establish and manage the kind of NPF I have in mind. That means that those with a vested interest in the present paradigm (the status quo) have no inclination to listen to new ideas. A lot of big salaries and big bonuses depend upon not understanding the need for change and big money has the loudest voice when it comes to government and policy making

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