We are currently living through the most severe financial crisis in living memory. Many employers with a defined benefit pension scheme will be tempted to see it as expensive and unwieldy. They may feel a strong temptation to wind it up and put their employees into a cheaper defined contribution scheme. We have been assisting an increasing number of employers over the past couple of months in finding solutions to the difficulties they are facing with their defined benefit pension schemes.

This note outlines some reasons why employers should not give up on their defined benefit schemes, and suggests some ways in which the costs associated with defined benefit schemes can be reduced.

Why not to give up on defined benefit provision

  1. Defined benefit schemes extinct. Despite some perceptions to that effect defined benefit pension provision in Ireland has declined in recent years, as it has elsewhere, but the rate of decline in the number of defined benefit schemes has been falling (though the effects of the current crisis remain to be quantified). At the end of 2006, the number of defined benefit scheme members still exceeded the number of defined contribution members by a ratio of over 2 to 1, and the number of defined benefit scheme members still appears to be increasing in absolute terms.
  1. Recruitment and retention. This is the principal commercial justification for continuing with defined benefit provision. A defined benefit pension can be a powerful incentive to change, or not to change, one's job. While it is naturally easier to recruit and retain staff during a recession, the impact of radically changing pension provision will be felt long after the current troubles have passed. Offering a defined benefit scheme to employees is likely to be of particular advantage to an employer where defined benefit provision in general is under pressure.
  1. Industrial relations. Radically changing pension provision for what is perceived to be the worse raises obvious potential IR problems. Trade unions seem to have developed quite a sophisticated understanding of pensions matters, and the Labour Court has been involved in several high-profile disputes between unions and employers over pension changes in the last few years.
  1. Paternalism. An employer may feel that the security offered by defined benefit provision sits better with its moral obligations to its employees than does defined contribution provision. Security in retirement is a matter of enormous importance, and the risks placed on employees by a defined contribution scheme may not be consistent with the fixed and definite nature of the other elements of the remuneration package promised by the employer.
  1. The regulatory climate. The regulatory incentives to move away from defined benefit provision do not apply in Ireland to the same extent as they do elsewhere. In particular, the legislative regime is less strict than it is in the UK.
  1. Bad publicity. The issue of closing defined benefit schemes and switching to other means of pension provision is a somewhat sensitive one, with a profile in the national media.
  1. Inherent inadequacy of defined contribution pension provision. While it can depend on the level of contributions, defined contribution pension provision is usually not an adequate substitute for defined benefit provision. Defined contribution schemes also tend to be relatively "young", and further problems with them may emerge in the future. The trend from defined benefit to defined contribution pension provision may not survive even in the medium term, and businesses will not wish to make the wrong strategic decision at this point.
  1. Cost of winding-up. Terminating a defined benefit scheme is not a cost-free option in financial terms. Even leaving the legal, actuarial and other professional fees aside, the scheme documentation may permit the trustees to demand a final contribution from the employer to secure the members' existing benefits. While there is considerable scope for debate on this issue, the trustees may choose to calculate this demand on an extremely generous basis, thus saddling the employer with a very large, unwanted and perhaps unexpected bill.

Some arguments against defined benefit provision

We may also briefly look at some arguments that are sometimes raised against the future viability of defined benefit schemes and point out some of their weaknesses.

  1. Financial unsustainability. The funding issues enveloping defined benefit schemes are well documented. The days of surpluses and contribution holidays are over, at least for the time being. This is in part due to wider economic trends. Yet there may be strategic reasons for believing that highly profitable investment opportunities will be on offer in the future: for example, as a result of changes in energy necessitated by climate change and developments in technology.
  1. Longevity. Life expectancy is increasing, and it is sometimes said that Irish society as a whole is facing a "demographic timebomb" – though the implications of this would extend far beyond defined benefit pension provision. In fact, increased longevity can be counterbalanced by adjusting retirement age under the defined benefit scheme, and the development of financial products to offset longevity risk is ongoing.
  1. Changes in the employment market. Defined benefit schemes originated in a time when workers could expect jobs for life, and it is sometimes said that they are not appropriate to modern conditions for this reason. Applied consistently, this argument would have the somewhat extreme effect of discrediting occupational pension schemes in their entirety. Yet even if workers today can expect to have a series of jobs before retirement, it is not clear why it is better for them to rely on defined contribution pension provision throughout their working lives. Indeed, the prospect of working for a series of different employers could be expected to encourage an individual to apply to work for or to remain in employment with a company that offers a defined benefit scheme whenever he or she has that option.

Options for defined benefit schemes

So much for the "Why" – now for the "How". If an employer decides to maintain its defined benefit scheme, how can it reduce the cost of doing so? Several options suggest themselves:

  1. Increase the employees' contribution rate, or introducing employee contributions where they are not currently required.
  1. Use a "contingent asset". A contingent asset is an asset that becomes available to the scheme on the occurrence of a particular event, such as the employer's insolvency. An example would be money held by the employer in a bank account with a charge over it in favour of the scheme trustees, enforceable if the employer becomes insolvent. The effect of such an arrangement is that the trustees have the comfort of knowing that assets will be available if the scheme needs them while the employer need not give up ownership or permanent control of the assets. The Pensions Board accepts the use of contingent assets in order to satisfy the statutory funding standard for defined benefit schemes, subject to certain conditions.
  1. Raise the normal retirement age. This naturally reduces the time for which pensions will normally have to be paid and increases the time for which assets remain in the fund earning investment returns. The possibility does remain, however, of employees accruing extra benefits during the additional time for which they will be working.
  1. Cut members' future benefit entitlements. This can be done in several ways, including the following:
  • Imposing a cap on future pensionable salary.
  • Freezing each member's pensionable salary at its current level.
  • Halting members' year-to-year accrual of benefits (members will usually be entitled to a pension of 1/60th of their final pensionable salary for every year worked).
  • Reducing the rate of accrual of benefits (from, say, 1/60th of final pensionable salary per year to 1/80th).  
  1. Withhold increases in current pensions. Many schemes will give employers the power to withhold consent to increases in pensions proposed by the trustees.

One or more of these options may be utilised to reduce the cost of your defined benefit scheme. However, there are a number of legal difficulties associated with these options, relating both to pensions law and to employment law as well as the particular provisions of each defined benefit scheme. We have extensive experience in advising employers in this regard, and in addition we have produced a further briefing note setting out some of the potential obstacles.

A middle way: hybrid schemes

A hybrid scheme is a scheme that combines features of a defined benefit scheme and a defined contribution scheme. It spreads the risk of poor investment performance between the employer and the employee, and gives the employee a degree of security that would be lacking in a defined contribution scheme and should reduce the cost of the scheme for the employer when compared to a traditional defined benefit scheme.

While hybrid schemes are still relatively uncommon, they have grown in popularity over the last few years. They may represent the future of pension provision in Ireland.

There are various different types of hybrid scheme, including the following:

  1. Career average schemes. These can be seen as a variation on defined benefit schemes and operate in a similar fashion, except that the member's pension is calculated on the basis of the average salary earned during his or her employment rather than on the basis of his or her final salary.
  1. Combination hybrid schemes. These schemes operate on a defined benefit basis in respect of the first slice of the member's salary and on a defined contribution basis in respect of any earnings in excess of that level.
  1. Underpin schemes. In these rather complex arrangements, retirement benefits are calculated both on a defined benefit basis and on a defined contribution basis, with the member receiving whichever entitlement proves to be the more generous. Underpin schemes usually lean towards either defined benefit or defined contribution type provision.
  1. Cash balance schemes. As with defined contribution schemes, cash balance schemes yield a lump sum on retirement, with which the member can buy an annuity rather than receiving an income from the scheme. However, the basis on which a member's lump sum is calculated will incorporate a stabilising or guaranteed element, so that he or she is not dependent solely on the investment returns achieved.

These examples of hybrid arrangements are not exhaustive.