The British Academy has today published a report on the ongoing shift from Defined Benefit (DB) to Defined Contribution (DC) pensions. The report is published in advance of the first British Academy Debate to discuss ageing: ‘Benefit or Burden? Coming to terms with ageing Britain’, which takes place in London on Wednesday 26 February.
The shifting face of workplace pensions: The retreat of employers and growth of defined contribution by Professor Anthony Neuberger explores the shift from DB to DC pension plans and analyses the many alternative structures and choices in the design of DC pensions around the world.
The changing landscape of pensions has been widely analysed and discussed, but there are a wide variety of DC schemes with alternative structures and choices. This report looks beyond the Defined Contribution label and explores the variety of designs of DC and their implications.
Summarising the features of DC schemes that have been implemented around the world, Anthony Neuberger tackles thorny issues such as the extent to which participation in pension schemes should be voluntary; investment strategies and balances of risk; how the pension should finally be paid out; and issues of governance.
With DB pensions, employees are entitled to a particular level of benefit depending on their length of service and their final salary. This is calculated using a formula linked to the member’s earnings and/or the length of their pensionable service. This differs from DC pensions, in which an employer pays a regular contribution fixed as an amount or percentage of the employee’s pay. The benefits are then determined by the contributions paid into the scheme, the return on investment on those contributions and the cost of purchasing an annuity at retirement.
Professor Colin Crouch, Vice President (Social Sciences) at the British Academy said: "This shift in convention from DB to DC underscores an important phenomenon, that individuals increasingly bear the risk of such investments, rather than employers or institutions. Pensions are often intricate and steeped in technical language, a fact which is exacerbated by incomprehensible, swift changes. These changes need to be communicated at the policy and practitioner level, but also to wider society. This report provides a level of detail and clarity that is often lacking in the current UK pensions debate and will hopefully serve to inform those who design or undertake DC pensions."
Professor Anthony Neuberger, author of the report said: "Countries round the world are placing increasing weight on occupational DC to meet the need to support people in retirement. In designing a DC system, Governments face important choices.
"The collective DC route offers an alternative model to individual DC [but] depends heavily on a trusted system of governance.
"With defined benefit pensions, we have learnt painfully how long-term and unpredicted economic and demographic changes combined with political pressures and legislative interventions can ultimately destroy collective risk-sharing institutions. Hopefully, we will put those lessons to good use if we decide to go down the collective DC route."
The report illustrates several key points:
- DB schemes create value in areas of recruitment, retention and retirement. These gains are largely absent with DC schemes.
- The main gain in occupational DC pensions comes from the reduced transaction costs associated with collective rather than individual provision.
- The main advantages of DC pensions are simplicity, transparency and flexibility.
- These advantages of DC pensions also pose problems: the simplicity and transparency expose the individual directly to the volatile nature of the market prices of financial assets, and the flexibility may lead myopic individuals to under-provide for their own needs.
For DC pension schemes, careful design of default options provides a way of mitigating the disadvantages without losing the advantages. Auto-enrolment into pension schemes with a standardized contribution rate and an automatic investment allocation helps reduce under-provision.
Guaranteed rates of return, given either by the employer or by a financial institution, present an unattractive way of dealing with uncertainly as they add complexity and greatly reduce flexibility and transparency because their value is hard to determine.
Download the full report.