07.07.2023

The Last Remaining Defined Benefit Schemes: A Deeper Look

Introduction

The landscape of professional pension schemes is undergoing a significant transformation as defined benefit (DB) pension schemes face a steady decline. When Royal Dutch Shell closed its DB scheme to new members in 2013, it was considered the last FTSE 100 company to do so.[1] Even accounting for pension schemes that are now closed to new members, fewer than 800,000 of the 7.6 million people in active defined benefit pensions are in the private sector.[2]

This article examines and analyses some of the factors that led to this decline and explores some of the last few holdouts and examine how they managed their risk.

What are DB pension schemes?

Pension schemes are designed to provide financial security to employees in their retirement years. They are sponsored by accumulated funds from both employers and employees, where every month an employee contributes a portion of their salary to a fund, topped up by their employer, which is then invested over time to generate an income when the employee retires.

In a DB pension scheme, the retiree receives a guaranteed pay out for as long as they live. The real value of the pay-out is inflation adjusted and would not be affected by inflation or market changes. The present value of the annual pay-out depends solely on the employee’s years of service and earnings history. The annuity used to be determined by a multiple of the employee’s final salary based on their length of service; however, the majority of schemes in the UK have recently shifted to CARE (career average re-evaluated earnings) schemes.

Note that whilst the majority of these schemes are index linked and function as mentioned above, some are capped at how much they will increase in a given year and some are not necessarily linked to inflation at all. Due to the inherent risk in offering a guaranteed pay-out, several private sector pension schemes have stopped offering these types of pension schemes entirely. Whilst they are beholden to their previous employees, they are closed to new members. As of March 2022, only 9% of DB pension schemes remain open to new members.[2]Of those that are closed to new members, over half are also closed to future accrual. This means that although the existing members are entitled to receive annual payments for their previous earnings, they can no longer gain further benefits on their future earnings.

The rise of DB pension schemes

Occupational DB pensions have been around for centuries, long before defined contribution (DC) schemes came to fruition in the 20th century. An early example of a DB scheme was the Royal Navy Pension Scheme, which was introduced in 1672. It provided a lifetime annuity to retired naval officers that was equal to their final salary.[3] Whilst this was not adjusted for inflation, inflation in the 17th century was very low and believed to average well below 1% yearly, making it a very minor factor.

Over the two subsequent centuries, pension schemes became commonplace. The growth of social reform movements and increase in the strength and influence of labour unions in the late 19th and early 20th century led to a push for greater protections and security for workers as a whole. The National Insurance Act of 1911 around that time was a piece of legislation that mandated basic benefits for workers during illness and unemployment.[4] The push for social security was further enhanced by The National Insurance Act of 1946.[5] This legislation introduced a government-led pension scheme where workers paid weekly contributions to receive a pension once they hit state pension age. This contributed to the widespread adoption of DB pensions as it established the sentiment that workers should have access to a safety net for their retirement.

Industries with strong trade unions had started setting up pension schemes for their workers before this, with the London and North Western Railway scheme being one of the first in 1853.[6] However, these social changes helped normalise these benefits making them expected and commonplace. They were also compounded in rapidly growing industries such as railroads and coal due to the competitive labour market requiring additional benefits in order to attract workers. These types of pension scheme were often used as a way for companies to differentiate themselves, by demonstrating a commitment to the welfare of their employees. From then until the 1970s the popularity of DB pension schemes continued to increase. They peaked even earlier in the private sector, reaching 8 million active members in 1967.[7]

So, why did they decline?

Although initially seen as a required expectation, sponsoring defined benefit pension schemes soon became increasingly risky and unaffordable for employers. Some reasons why include increased life expectancy rates, the shift from a manufacturing-based economy to a service-based economy, increased market volatility and unpredictable inflation rates alongside regulatory changes.

We construct the above table from the UK’s national life tables[8] to showcase the increased pressure on employers to meet defined benefit payments over time. In the most extreme case, we notice that there has been 39% increase in the number of years a man would live post 65 despite the state pension age remaining the same throughout that period. Therefore, the value of a defined benefit pension would’ve increased by 39% over that time period as well despite his contributions remaining the same. As the burden of this increased cost would be placed entirely on their employer, it became significantly less desirable to provide.

The shift to a service-based economy meant an increase in firms with smaller number of employees and an increase in part-time work – both situations where it would be near-impossible for a workplace to sponsor a DB pension. Service sector jobs are also typically less likely to be unionised, and as the service sector becomes increasingly competitive, companies are under increased pressure to reduce costs including employee benefits like DB pensions.

We mentioned earlier that the popularity of DB schemes started to decline in the 1970’s, this makes sense as the decade signified a period of significant economic instability and political turmoil in the UK. The Oil Crisis in 1973 and subsequent global recession contributed significantly to this as oil prices quadrupled rapidly[9] which caused widespread economic disruption. The UK’s increased public spending on the military budget led a balance of payment deficit which pushed inflation higher. This, combined with the political turmoil and the rising of interest rates (to attempt to control inflation) led to further weakening of the pound.

The 1970’s also saw significant advances in both technology and communication, so the financial markets responded quicker and were more sensitive to both changes in economic and political conditions which led to increased market liquidity. To illustrate this increased volatility, we showcase the inflation rate in the UK since 1953[10] and changes in the housing price index[11]> during the same time period. Whilst you may note that volatility has never returned to it’s pre- 1970 levels, inflation was high then even by today’s standards.

Following this increased volatility, in order to ensure that employers were able to meet their long-term obligations to retirees, there has been increased regulation of UK pension schemes. Pension plans in the UK are required to have sufficient funds which are determined by an independent government body The Pension Regulator (TPR), there are restrictions about what type of assets pension plans can invest in as well as requirements for regular reporting and disclosure of investment performances alongside contingency planning and regular risk assessments.[12]

Other smaller factors include the changes in tax regulations which have made it increasingly unaffordable for companies to pay defined benefit schemes. Firstly, Chancellor Nigel Lawson imposed a cap of 5% on pension fund surpluses. This was done to avoid companies using pension schemes to avoid taxes. Companies that crossed that 5% threshold would incur fines of 1/3 of the surplus, so as to incentivise companies to pay out the surplus to their employees. However, it meant that companies would be less willing to invest in more volatile assets with higher yields due to this tax. This regulation was later abolished in 2004.[7]

The Advanced Corporation Tax (ACT) was a tax system where UK companies paid corporation taxes and then had to pay additional taxes on the dividends paid to shareholders. This made dividend stocks less attractive to invest in at the time. However, pension funds were given partial tax credits which meant that it was comparatively cheaper for them to purchase high yield dividend shares. However, as this tax was abolished, shares with higher dividends price corrected and became more expensive, thus forcing pension fund managers to choose other equities for those returns. The removal of the ACT system at the end of the 1990s indirectly hurt funding of defined benefit schemes, although it removed compliance costs and simplified the tax system.

Current status of DB pension schemes

Whilst the number of active members in the public sector has continued to rise due to the increase in the number of government jobs, as schemes closed in the private sector most of the remaining members are either deferred or pensioners.

The majority of active schemes in the private sector come from colleges and other education institutions or charities.[2] These organisations tend to be more community oriented, and staff tend to stay with the company for longer, so employers may be more likely to offer generous pension schemes to support the welfare of their employees and support their continued engagement with the organisation’s mission. Several of these organisations are also quite old and may have already set up resources and teams to manage DB pension schemes and shifting away from that and administering a new plan could potentially be expensive.

How the private sector managed their DB Pensions

As the risks of managing defined benefit schemes continued to increase, companies bolstered their attempts to mitigate them. Some of these ways include closing their plans to new employees, longevity swaps, bulk annuity purchases, and pension buyouts.

All FTSE 100 companies in the UK have now closed their defined benefit pension plans to new employees. This allows them to reduce risk as defined contribution plans shift the market risk from the employer to the employee. However, this still leaves the employers liable to pay for the existing members of the scheme. There are two key methods of managing this liability: bulk annuities and longevity swaps.

If the pension provider has surplus capital, it could setup a bulk annuity. This is a type of insurance policy that pension providers can purchase whereby it pays a large one-off premium based on the value of the pension to pass on the responsibility of paying pension benefits to an insurance provider. It is worth noting that the bulk annuity market is currently highly competitive, with many pension providers seeking to transfer their pension liabilities to insurance providers. This heightened demand may make it more challenging to secure favourable terms for a bulk annuity, underscoring the importance of exploring a range of options and acting quickly.

If the pension provider does not have surplus capital, or if it wants to use capital for other purposes, it can instead take part in a longevity swap. This would involve the pension scheme agreeing to pay the insurer a fixed set of cashflows and in return the insurer will pay the more volatile true cashflows required to service the pensions. This way, if pensioners were to live longer than expected the insurer would cover the excess cashflows.

Both these plans are beneficial for several reasons. Firstly the pension provider reduces its exposure to investment, longevity, and inflation risks. Further, the pension provider no longer requires a team to manage the obligations of the pension plan, which frees up human capital to work on the core business objectives. Being under fewer regulations and not having reporting requirements would mean that the company would also not need to hold as much excess financial capital to comply with these requirements, which it could then use in different investments. Furthermore, when setting up a bulk annuity, pension providers could also avoid the pension protection fund levy (a government-backed scheme where firms pay a fee that protect them in case their scheme becomes insolvent and unable to pay its benefits).

Closing remarks

Rising interest rates could create unique challenges relating to defined benefit schemes with liability-driven investment (LDI) strategies. LDI strategies aim to match the pension scheme’s assets with its liabilities to create a portfolio with a duration similar to that of the liabilities. By entering into swap positions, DB schemes can synthetically create long portfolio durations as swap contracts have durations that match the long-term nature of the liabilities whilst still maintaining its growth assets. However, when interest rates rise significantly, they will face increased pressure as their floating-rate repayments will increase compared to the fixed rate payments they receive. To maintain the swap agreement, the scheme must post collateral in the form of highly liquid bonds or cash to cover the potential losses.

Employers sponsoring DB schemes may need to contribute more to the pension fund to cover potential losses and collateral demands resulting from LDI issues. Although government backing and regulatory oversight help ensure that DB schemes remain reliable for employees, the increased risks may lead to reduced benefits or require increased employee contributions. Insurance companies that offer pension risk transfer solutions, such as buy-ins, buyouts, and longevity swaps, may also see increased demand for their services as DB schemes seek to mitigate their risks. However, they should also be aware of the challenges of managing the long-term risks associated with taking on pension liabilities, particularly in this volatile environment.

For a more in-depth analysis of how rising interest rates affected pension schemes with LDI strategies and the necessary subsequent involvement by the BoE see the “Gilt Yield Movements- why the BoE had to intervene” article by Alan last October.

In conclusion, the challenges faced by DB schemes underscore the need for collaboration among employers, employees, insurance providers, and regulators. However, in the ever-evolving landscape of pension schemes, insurance providers have proven their resilience. By understanding their past, addressing current risks, and continuing to implement innovative solutions, they will ensure a secure retirement future for generations to come.