In a “defined contribution” pension? Cheer up!

Twice a year, it seems, Treasury mandarins climb on their favourite hobby horse and urge the chancellor to reduce the tax breaks on private pensions.

They leak their arguments to sympathetic journalists – probably over lunch at a Pall Mall club – and there follows a wave of gloomy articles about the dire outlook for members of “defined contribution” (DC) schemes, unlike in the Good Old Days of “defined benefit” (DB) schemes.

As someone who is approaching the statutory age of retirement but has never been a member of a DB scheme, I have a much more optimistic view of DC schemes.

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Why today’s pensions are better than the defined benefit schemes of old

Conventional wisdom has it that those of us with defined contribution pension schemes have it rough compared with those on defined benefit schemes.

DC scheme holders pay in their contributions with no guarantees of what they’ll get out at the end of the period. Members of DB schemes, on the other hand, think (I use “think” for reasons that will become apparent later) they know what they'll get – a predetermined percentage of average or final salary. Who wouldn’t prefer the latter?

Yet for most of us, the latter is not an option. The majority of pension savers who are currently still working are now in DC schemes.

According to the government, there are 23.2 million members of DC schemes and 17.8 million in DB and hybrid schemes. Only 3.4 million members of DB schemes are active (ie, still paying in), so 98% of benefits paid in the last quarter of 2020 were from DB schemes.

This caused one pundit to conclude (and it’s a familiar argument, made by many): “You may not be as rich as your parents in retirement, because the lion’s share of money being drawn from pensions at the moment is from generous defined benefit schemes... there’s a risk today’s workers are being lulled into a false sense of security by the enviable lifestyles of many of today’s pensioners.”

Yet this is a misconception. As any economy grows, national wealth increases. The accumulation of wealth may disproportionately favour the better off – but rising income per person will mean that, on average, each generation is wealthier than the last.

The indolent, the spendthrift and the unlucky will be exceptions – but most people will, much to their surprise, come to realise that they are better off than their parents, whether they inherit or not. This isn’t a prediction, it’s mathematics.

OK, you might argue, but while it’s clear that rising real incomes make those in work better off than previous generations – what about in retirement? Surely DB schemes were better?

The “certainty” of private sector DB schemes was always an illusion

As a DC pension holder, I have to disagree. There are good reasons to prefer today’s DC pensions to the old DB model – within the private sector, certainly, where schemes have to be funded rather than paid for out of current taxation.

For members of DC schemes, pensions are a function of contributions, the timing of them and returns.

The recipe for success here is straightforward: start saving early (by the age of 30), achieve consistently good investment returns, and let the compounding of returns over decades turn moderate contributions into a substantial nest egg.

Keep your costs low – ideally by investing it yourself using a platform – trade as infrequently as possible (investment trusts are ideal) and forget about market timing.

The returns in the good years will dwarf the drawdowns in the bear markets. In time, your chief worry will be the threat of rapacious taxation on excess returns.

Those who contribute less while working and so enjoy a better standard of living may have to tighten their belts in retirement. But even then, given that people are living longer and healthier than earlier generations, retiring later may be an attractive option for those with insufficient pension pots.

DB schemes, in theory, gave people certainty, but reality – for the private sector at least – was more complicated. Corporate schemes were used to encourage loyalty, favouring those who stayed over those who changed jobs or were made redundant.

Later on, DB schemes were required to treat early leavers fairly and to increase pensions in line with inflation. But the cost of these changes made DB schemes unaffordable for the private sector. Funded schemes that have survived, like the Universities Superannuation Scheme (USS), have had to move from pensions based on final to average salaries, while employers have had to squeeze academic salaries to fund ever-rising costs.

The key problem for any DB scheme is to ensure that it can meet its liabilities not just now, but decades into the future. Any deficit falls on the employer, who might face bankruptcy if it is not addressed.

The calculation of a DB scheme’s current standing – and any deficit that needs addressing – is the job of the actuaries. But it produces bizarre results; a rise in bond yields and consequent fall in the value of both equity and bond assets will usually leave the scheme better funded, while rising valuations may put the scheme into crisis (at the risk of over-simplification, this is because falling interest rates increase the assumed value of future liabilities).

The resulting deficit will not only force the trustees to demand higher contributions from employees and employers, but also to “de-risk” the portfolio. This means investing the portfolio so as to reduce the downside risk, but also the upside potential. The result is a doom loop from which, for example, the USS is struggling to escape.

DC schemes also offer flexibility

This is the key reason why DC schemes are better than DB. They can seek to maximise returns without worrying about the short-term downside risk, safe in the knowledge that market setbacks are highly likely to be recovered, and that most DC pension investors have time on their side.

The better the returns, the less you will need to contribute. Higher returns for the same contributions will always make the DC scheme member better off than the DB. Framed in this way, it becomes clear that the “certainty” of a DB pension is an illusion, based as it is on uncertain future earnings.

DC schemes have other important advantages: members can tailor their risk to their age, prioritising returns early on, but protecting the downside as they approach retirement; they can manage the fund themselves or choose their manager rather than being at the mercy of someone more focused on the trustees and actuaries than them; and from the age of 55, they can withdraw 25% of their pension fund (up to a fixed limit) tax free and then, perhaps, invest the proceeds in ISAs.

Following reforms introduced in 2015, retiring DC scheme members can also keep their pension pots invested, rather than having to cash them in to buy over-priced annuities. Instead, they can draw down from their pension pots as and when they need the money. This explains why pensions in payment from DC schemes are so low relative to DB payouts.

Finally, on death, DC pension pots can be passed onto the next generation; DB schemes pay a reduced pension to widows or widowers but then stop.

There is one group of people, however, for whom DB schemes work well – the civil service. Theirs is, according to Which?, one of the most generous schemes of its kind, unfunded and guaranteed by taxpayers.

So when those mandarins lobby for a squeeze on DC pensions, they do so from an ivory tower. But until they meet a chancellor too gullible, distracted or disgruntled to resist them, DC scheme members should relax.