Defined benefit pensions – also called final salary or average salary pensions are harder to come by these days. About 1.6 million private sector workers and 5.4 million public sector workers are still actively paying in and building up benefits in this type of pension scheme.
However, up to 10 million of us (me included!) are no longer active members, but are entitled to a pension from a defined benefit pension scheme at some future date. People with an entitlement to a future pension are called ‘preserved’ members. Together with active members, that means more than 16 million people have still to collect a pension from one of these schemes. These pensions will make an important contribution to their future financial welfare.
How employers fell out of love with defined benefit schemes
Defined benefit pensions have been available to civil servants since the 19th century, but only became popular in the private sector after World War II. Active membership of defined benefit schemes hit its high water mark of 8 million members in 1967.
But now things have changed.
There are many reasons for the decline in private sector defined benefit schemes, but these can be summed up as ‘too costly’ and ‘too uncertain’ (for employers).
The additional costs have come mainly through rising longevity and government intervention to improve benefits, the most expensive of which was compulsory indexation of pensions in line with inflation.
The employer also takes most of the risk when it comes to defined benefit schemes. For example, the risk that their ex-employees live longer than expected, that inflation is higher than expected and investment returns lower. Previously some of these risks were shared, for example, in a year with poor investment returns there were no inflation increases on pensions in payment. But today, inflation increases are compulsory.
Employers could have mitigated increased costs by raising retirement ages, calculating the pension on average salary rather than final salary, reducing the pension built up each year or raising employee contributions.
While all of these measures have been implemented in the public sector to keep these schemes affordable, employers in the private sector have decided to close defined benefit schemes altogether. This is perhaps in part due to increasing global competitiveness where only a few overseas employers offer this sort of pension. Societal change has also meant that employees no longer work for the same employer for their whole working life.
Whatever the reasons for their decline, it is unlikely that many of us will be joining a defined benefit scheme in the future and, if we do, we’ll be paying more, receiving less and retiring later, like those who work in the public sector.