Tackling the tropes within the pensions landscape
It is now an established practice in Defined Contribution pension schemes for members pension funds to derisk as they approach Normal Retirement Age (NRA) so that the member does not suffer an unwelcome drop at the point they reach retirement and will be accessing their benefits. Photo: iStock
of Independent Trustee Company helps clear the fog that can develop in people's understanding of pensions
An alternative point of view Certain recurring themes or tropes occur in every industry. Today I want to address a few that occur in the Pensions Industry.
A DB or Defined Benefit scheme provides a promise of a particular amount of benefit in retirement — the risk arising from investment performance falls on the employer.
It is a common trope to say that this is better than a DC or Defined Contribution Pension scheme where the employer defines the amount that will be paid into the scheme but the degree of benefit this will secure is unknown.
My first challenge to this trope arises from investment performance. The investment approach of a DB scheme is far more conservative than a DC scheme typically averaging 3% per annum. By investing in conservative assets such as government bonds the DB scheme can better track the rising and falling costs of providing the guaranteed benefit. This certainty is bought at the expense of investment growth. For example, a DC scheme would typically achieve 7% per annum growth.
Consider two employees, one in a DB scheme and one in a DC scheme, where the cost to the employer of each employees’ benefits happens to be €10,000 per annum. After 30 years of 3% investment growth the DB scheme will have accumulated a fund of €490,000. The DC scheme will have a fund of €1,010,000.
For the same contribution the DC member gets double the amount of benefit. The DB member may have had a more secure journey (although see next example) but is ultimately worse off.
My second challenge to this trope relates to the supposed security of the DB benefit. Whilst some individuals have experienced good protections related to DB Schemes others have not. The most famous example in this regard is the Hogan case which related to the guaranteed benefits of Waterford Glass workers. Their employer became insolvent as did their pension scheme and they had to go all the way to Europe to receive 90% of the benefit that had accumulated at the time the scheme failed. Note however, that occurred many years later thereby depriving them of the value of investment growth that would have occurred in the interim. As the examples later in this article make clear – that is a real and significant cost.
The Waterford Glass workers is not an isolated case. Currently I am involved with a scheme for former employees of Protim Abrasives, that in 2009, like Waterford Glass employees, suffered a double insolvency. Despite being recognized in the Dail record a decade ago as being on all fours with the Waterford Glass case, the workers are still awaiting their compensation. As the matter is embroiled in litigation with the relevant department, I cannot comment further save to point out that any compensation they do receive will be based on the pension value in 2009. No recognition will be given for the enormous investment losses suffered due to lack of investment in the intervening period, a Nil % return versus the 7% per annum that a DC scheme would have achieved.
It is now an established practice in DC pension schemes for members pension funds to derisk as they approach NRA (Normal Retirement Age). In practice, this means that members funds are moved out of higher risk/higher return assets as they approach retirement. This ensures that the volatility of the investment returns reduces thereby ensuring that the member does not suffer an unwelcome drop at the point they reach retirement and will be accessing their benefits.
This approach makes sense in a context where the capital sum is to be used to purchase another asset – such as an annuity. The sudden loss of value that occurred prior to retirement is now locked-in and has become a permanent hallmark of the members retirement benefit. The annuity can never recover the sum lost.
The same is not true when the annuity purchase is not in question. An individual reaching retirement may have another 25 or 30 years of investing ahead of them. The cost to such individuals can be significant. Assume an individual had managed to accumulate a fund of €500,000 by age 52. At that stage a glide path kicked in reducing the rate of return on the assets from 7% per annum to 3% per annum by age 60. The net effect is to reduce the fund at age 60 by €135,000. The lump sum available to the individual is €36,000 less.
The problem grows worse if you assume the individual could defer receipt of income benefits for another 10 years. They may have other sources of income — rent, part-time employment — which can be supplemented by the lump sum received. By age 70 the difference in performance amounts to a whopping €537,000.
Note that the individual has been deprived of this additional value as a means of ensuring they have a more secure retirement!
Note this is not a criticism of any particular scheme or provider. It is standard practice across schemes and pension providers in Ireland.
This issue was highlighted to me by witnessing the approach of financial advisors whose clients had transferred their benefits to our scheme in Malta. Advisors focused on two characteristics of the Malta schemes:
- The lump sum can be distributed in specie. This means it doesn’t have to be brought to cash at the moment the lump sum is extracted from the scheme. Any negative market corrections can be managed by waiting — it's no longer necessary to time the market.
- In the Malta scheme, the extraction of a lump sum at age 60 does not mean that the income drawdown will immediately kick-in. In contrast to the Irish based option the Malta scheme will permit the remaining fund to continue to roll-up to a later date – giving the member a chance to accumulate a much larger fund. In the example outlined above the amount gained was €537,000.
These options are available to all employees who have access to advisors with the expertise to recognize these issues and adapt accordingly. Note no employee is forced to follow the glidepath provided by their pension fund. More than 95% of them do so because they are not aware of the alternative ways they can manage retirement risk.
The debate in relation to auto-enrolment (AE) has gone on for many years. Various reasons have been given for the need for auto-enrolment:
- People won’t save for retirement unless you make them.
- 50% of people are not saving for retirement.
- Employers wont finance pensions unless you force them to do so.
- We are facing a demographic time bomb as our population is aging.
- We are the only country in the OECD that does not have some form of auto-enrolment.
Each of these points have certain flaws attached to them. Back in 1998 the NPPI report identified that Social Welfare pensions provided an adequate replacement income for 30% of the population. Therefore, additional funding was only required for 70% of the population – a significant closing of the gap. Recent CSO figures have got more detailed in their assessment of the pension coverage issue noting that some 69% of people have some form of pension saving by retirement age. This pretty much eliminates the gap.
These factors have encouraged the argument to move from being one of coverage to adequacy. Yes, people will have a benefit by NRA (Normal Retirement Age) — but will it be enough? What about the cohorts of the population that are very poorly pensioned — the low paid, the young, the self-employed. It’s interesting to note that the current AE proposal due to go live in 2025 excludes three groups from its remit — the low paid, the young and the self-employed!
But what about the demographic time-bomb? And the concerns expressed by the OECD in this regard. This is a real issue. It needs to be understood where the problem arises and how the current AE solution does nothing to address the problem.
Social Welfare pensions work on a pay as you go basis. This means that contributions by current employees and employers are used to pay benefits to those that have already retired. The amount you pay in PRSI has no impact on the benefit you receive. The number of contributions you make does.
As our population ages the number of people paying in to the Social Welfare system will reduce whilst the number of people being paid out of the system will increase. As there is no substantial fund accumulated to cover this shortfall (we used to have one, but it disappeared in the Financial Crisis) one of two things will happen — PRSI contributions will go up or Social Welfare pensions will fall.
Governments to date have chosen to rule out both of these possibilities without specifically providing any way to provide for this gap. Could it be that the fund accumulated under auto-enrolment is a way to fund this gap? In effect you are paying additional PRSI but will not necessarily get any extra benefit when you retire. This seems highly plausible when you recognize that those covered by auto-enrolment are already covered by the compulsory PRSI/Social welfare system.
The earlier part of this article has identified two ways in which individuals saving for retirement can look to enhance the amount of funds they will have available to enhance their pensions in retirement. I remain sceptical as to whether auto-enrolment can be added to the list of retirement enhancing measures!
