For the last 20 years, pensions have steadily shifted from “defined-benefit” (DB) to “defined-contribution” (DC) schemes. Under the former, pension payments are tied to final salaries, adjusted for the number of years of contributions, while under the latter, they are dependent on the amounts paid in and the investment performance of the fund.
The accepted wisdom is that DB schemes, with their pension entitlements visible, are better than DC schemes, in which future payments are uncertain. But this is not generally true. If the investment performance of a DB scheme is good, the surplus belongs to the employer, who will then have an incentive to lower contributions. Under a DC scheme, it belongs to the employee, who will receive a higher pension. If performance is poor under a DC scheme, that means a lower pension.
But the fixed entitlement under a DB scheme is an illusion. The fund will be in deficit with its assets estimated to be insufficient to pay out future pensions so the employer will have to pay in more. This money has to come from somewhere – either from reduced employment or squeezing pay.
This means not just less income now, but also a lower pension in the future. If the employer can’t cut employment costs, it risks going broke and the future pension entitlements of its workforce will become highly uncertain.
It gets worse. If a scheme is in deficit, it will be advised by its actuaries to “de-risk” promptly. This means reducing the probability of further losses by adopting a more cautious investment strategy – but also restricting the potential for future gains. If poor performance is the result of weak markets, it is the equivalent of selling at the low. A DC scheme can take a longer-term view knowing that periods of market weakness are recovered sooner or later; equity markets, for example, have historically produced positive returns three years in four.
This goes to the heart of the recent row about academic pensions, which has resulted in protests and strikes at Britain’s universities and colleges. The Universities Superannuation Scheme (USS) was in deficit at 31 March 2017 to the tune of £7.5bn (11% of estimated liabilities), and is seeking to move future pension payments from DB to DC. Academics retiring now will get a DB scheme, those starting now a DC pension ; those in between will get a DB for past contributions and a DC for future ones.
A DC scheme makes more sense
This deficit is not because USS returns have been poor. They compounded at over 12% for the five years to 31 March 2017, and the subsequent year is said to have been good. Nor is it attributable to inadequate contributions: these comprise 26% of salaries, 8% from the employee, 18% from the employer. Rather, the deficit is the result of the liabilities expected to accrue in the future as a result of lengthening life expectancy, assumed lower investment returns, rising numbers in the scheme and assumptions about inflation and salary increases.
The assumptions behind this calculation may prove too conservative, exaggerating the funding problem, but USS’s view that returns over the next ten years will be lower than in the past is entirely reasonable. In addition, the deficit requires them to de-risk the DB scheme, resulting in estimated returns over the next 30 years of inflation (CPI measure) + 1.9%. Under the proposed collective DC scheme, returns would be 1.5% per annum higher.
Why academics are upset
While 1.5% extra per annum doesn’t sound much, compounded over 30 years it means a pension pot 56% larger. This is what makes the proposed changes attractive to members; those at the start of their careers will get a significantly better pension than they would under a DB scheme, while those half-way through will get the security of a fixed basic DB scheme with an enhanced DC top up. A continuation of the current DB scheme would require higher employer contributions and necessitate a relentless squeeze on employment and salaries.
So why are academics not welcoming this proposal? Communication has been poor and few understand the implications of the changes. Rumours (unsupported by analysis) that members will be worse off have not been challenged and many academics appear not to realise that the existing DB scheme is not being shut down, merely closed to new contributions. Discontent has been stirred up by a few political troublemakers and an atmosphere of resentment has spread. Hopefully, a cooling-off period before negotiations resume in September will make the academics see that the custodians of the USS continue to work in their best interests. Finally, they should appreciate that one of the reasons for the USS deficit is that the actuaries expect the average academic to live until nearly 90. How can that be bad news?