Historically, membership of defined benefit (DB) pension schemes was widely offered to employees of UK companies. Whilst employees may have been required to contribute, the balance of costs of such schemes were usually met by the employer, with many schemes being in the enviable position of having surplus assets and the employer taking a “contribution holiday”.
However, times have changed dramatically. Longstanding demographic changes and turbulent financial markets have meant that many companies with DB schemes now face substantial liabilities, resulting in ongoing financial pressures, and continued regulatory demands. In fact, according to PWC, at the end of July 2020, the UK DB scheme deficit was approximately £270 billion.
To attempt to deal with such deficits, many closed their pension scheme altogether to new entrants, whilst freezing further accrual of benefits for existing members. These deficits have to be incorporated into a company’s balance sheet, and for most UK private sector employers their DB scheme has become an awkward legacy issue that requires careful financial management.
What are the challenges in managing defined benefit (DB) pension schemes?
Managing DB legacy schemes is complex. Not only do employers remain responsible for the costs of meeting the accrued liabilities for existing members but they must honour these historic promises, when anticipated life expectancies much lower, and projected investment returns considerably higher.
Faced with such concerns, most companies’ preferred option would be to transfer the benefits payable under the DB scheme to an insurance company. The problem however, is that for many, the costs of such buy-out exercises are prohibitive and result in a hit to the P&L.
How can DB to DC pension scheme transfers help employers and trustees?
Introduced by the UK government in 2015, pension freedoms offers employers the opportunity of de-risking their DB Schemes. In other words, enabling companies to remove pension scheme liabilities from their balance sheets, thus reducing their financial risks.
If members decide to transfer some or all of their DB benefits to a DC arrangement, then the scheme’s liabilities will reduce accordingly; associated administration costs will be lower; the potential for future problems will be lessened and the related regulatory burden will decrease. Whilst not suitable for everyone, the increased flexibility is likely to appeal to certain DB members, for example:
- Single people without dependents
- Individuals in ill health
- Wealthy individuals who do not need to rely on their DB pension for income
- Those who have other DB and /or DC pensions or other assets with which to fund their income in retirement
- Those who would prefer to access their benefits in a different way other than just receiving a regular income through their DB scheme.
However, transferring out of a DB scheme is not a simple process. A plethora of rules currently exist to ensure that employees do not make any rash decisions and fully understand the implications of surrendering the guaranteed benefits that they and their family are entitled to under their DB scheme.
Employees must obtain independent advice for transfers over £30,000. However, face to face advice is expensive, usually ranging from £1,000 to £2,500, and is difficult for individual members to obtain. Indeed, many advisers are reluctant to offer such advice, firstly, because they need to be specially qualified and, secondly, because explaining to members in detail the guaranteed benefits they are intending to give up compared to any alternative future options is a difficult task.
Often seen as underpinning a company’s benefits provision, in recent years many DB schemes have become a financial burden on employers. Increased longevity, low long-term interest rates, and turbulent stock markets have all led to significant DB pension scheme deficits putting pressure on companies who are ultimately responsible for any shortfall.
The introduction of pension freedom legislation not only enables DB scheme members to take advantage of the increased flexibility in accessing their options at retirement, albeit by transferring their benefits into a DC scheme, but also creates a potential avenue to help employers discharge their DB liabilities.
How to adequately communicate the outcomes of DB to DC transfers.
Perhaps the pensions freedoms legislation can offer a possible alternative solution for employers with DB schemes, by allowing their members to take advantage of the new flexibilities by transferring their DB benefits to a separate DC arrangement.
EValue’s Flexible Retirement Options (FRO) tool helps employers to communicate the options clearly and impartially available to their employees by providing a safe area for DB members to fully explore and compare their retirement options if they were to transfer out their final salary benefits. It helps to demonstrate the advantages of each alternative option by providing realistic potential outcomes so members who should remain in the scheme understand why this is the case. FRO also allows appropriately qualified advisers to directly access these findings and provide mandatory advice in a more cost-effective and efficient manner.
So whats next?
Offering your employees and members a safe environment to explore the potential for a DB to DC transfer can ensure you protect them as well as your organisation. To find out how EValue can help digitally transform your DB pension scheme with the Flexible Retirement Options (FRO) tool, please click here. Alternatively, you can download the workplace factsheet by clicking here.