Evaluating a defined benefits pension

[Fume troll]

Starting a new job soon, and part of the deal is a final salary (aka defined benefits) pension. Yes, they still exist!

Base case: the pension builds up 1/60th of final salary per year, with no contribution from me. I have the option to contribute to it, there are various options which increase the rate at which it builds up, from 1/60th to 1/54th...etc...to 1/35th.

I can work out what the future value of my contributions would be, and guess at a final salary and therefore final benefit, but I'm having trouble seeing if there's a particular metric that would show me which contribution rate is most effective.

Best one I can come up with is looking at the ratio of monthly contribution to monthly pension increase, which does seem to have a peak. Almost any other ratio I come up with just increases or decreases linearly with contribution size.

Any advice?

Cheers,

FT.

[jonah35]

a non contributory 60ths scheme is worth it's weight in gold.

very roughly 30% of your salary is what it's worth for a 60ths scheme but depends on loads of factors

but if you can contribute more then it will almost always be worth it to get the best accrual rate.
you are a lucky, lucky chap

[thepeoplespal]

For reference a 1/60th pension costs me 6.5% of my gross pay, so if you can contribute at less than that, I would think that you should fill your boots.

[nomisesor]

No help in answering your question, but my final salary pension (80ths) was as rock solid and (to coin a Daily Wail phrase) gold plated as they come... now it's to be linked to CPI rather than RPI, will no longer be available at 60, but ?66 and the total theoretical pot is capped, albeit at a level which doesn't affect me. How good are the guarantees? Mine was merely UK government-backed - as, any cynics will point out, are the NS&I RPI-linked certificates I espouse on this forum - but now it is "unaffordable" despite the fact that the true cost is set to decrease.

How much do you have to contribute to get 1/35ths? Sounds amazingly generous.

[Crafty_]

Just to echo the terms above my employer currently gives us a DB scheme, we pay 5% and get 1/60th for that. It costs my employer ~35% of the salary bill every month.

Not surprisingly they are looking at changing it.. If you can get in on a DB scheme go for it.

[fandango_c]

Fume troll said:

Starting a new job soon, and part of the deal is a final salary (aka defined benefits) pension. Yes, they still exist!

Base case: the pension builds up 1/60th of final salary per year, with no contribution from me. I have the option to contribute to it, there are various options which increase the rate at which it builds up, from 1/60th to 1/54th...etc...to 1/35th.

I can work out what the future value of my contributions would be, and guess at a final salary and therefore final benefit, but I'm having trouble seeing if there's a particular metric that would show me which contribution rate is most effective.

Best one I can come up with is looking at the ratio of monthly contribution to monthly pension increase, which does seem to have a peak. Almost any other ratio I come up with just increases or decreases linearly with contribution size.

Any advice?

Cheers,

FT.

Depends what you mean by most effective.

I would estimate the employers contribution rate for each option and probably go for the highest. It would depend on how affordable the employee contribution rate would be for me, if I had anything better to do with my cash, if I would like to save for my retirement though other means.

It's also worth thinking about when you wish to retire and what level of income you wish to have at then.

[The Leaper]

I've been in the pensions consulting business longer than I care to admit, and I've seen all manner of pension fashions come and go. As you have access to a non contributory 60ths based final salary plan, joining is a no brainer. Otherwise, why give up the significant contribution that will be put in by your employer? You'd have to have a formidable investment return to do better on your own.

Regarding you paying contributions to have an enhanced accrual rate, I would say pay as much as you can. Tax relief is available so it actually costs less than the gross amount. You simply cannot beat a decent final salary plan and the one you're looking at is RR standard (I think I could make a good guess as to your employer!).

There are comments elsewhere on this thread about employers being able to cease final salary plans and the consequences, all of which are correct. However, you will still have the funds put away..better to have done so than have no funds at all for retirment provision. In any case in a final salary plan you are guaranteed to get what you've accumulated to the point of cessation. In case of a serious failure 90% will be guaranteed via the Pension Protection Fund.

You may need to watch out for the lifetime limit. This is all about the total capital value of your accumulating pension benefits in the final salary plan. Once you look like exceeding the limit there are significant tax issues to consider. Your employer should be able to give you more information on this point.

All of the above is close to giving you personal advice and that is not my intention. I suspect that your employer could point you in the direction of a decent and professional pensions advisor if you needed personal help etc. If the advisor then says he can help you do better than the plan offered by your employer, think very very carefully...actually I'd bin him!

R.

[Fume troll]

Thanks folks.

fandango_c said:

I would estimate the employers contribution rate for each option and probably go for the highest.

It's got to be highest at the highest rate, but it's not so easy (for me) to work out what that contribution would be. One thing I did was look at annuities, and look at what sort of lump sum I'd need to accumulate to buy an annuity which would match the expected pension. In all cases the lump sum would be significantly more than the total future value of my contributions, i.e. a better rate of return. However that has to be offset against the fact that I'd have access to the money if it were in other forms of investment. With the pension I'd get 25% lumpsum tax free but after that it would be like an annuity.

fandango_c said:

It would depend on how affordable the employee contribution rate would be for me, if I had anything better to do with my cash, if I would like to save for my retirement though other means.

Yes, I suppose that's the key. If I didn't put the money here it would be invested somewhere else. It seems unlikely that I could get a better rate of return in other investments, than going for the maximum contribution.

The Leaper said:

Joining is a no brainer.

The Leaper said:

Tax relief is available so it actually costs less than the gross amount.

Yes, I'd get tax relief at the highest rate of tax I pay.

The Leaper said:

There are comments elsewhere on this thread about employers being able to cease final salary plans and the consequences

Yes, I'd thought about that. The trust is funded and regularly assessed to ensure it's keeping up with its commitments, with assest held separately from the companies finances. That doesn't mean they couldn't close it down at some point though. It has already been made unavailable to almost everyone, my hope is that if the management are relying on this scheme they will look after it quite well!

The Leaper said:

You may need to watch out for the lifetime limit.

Yes, that's mentioned in the handbook.

Thanks again for the help.

Cheers,

FT.

[sidicks]

To the OP: Join immediately and pay as high an employee contribution as you can afford!

nomisesor said:

....but now it is "unaffordable" despite the fact that the true cost is set to decrease.

/to nomisesor, please can you clarify exactly what you mean?!

Sidicks

[onedsla]

We're currently in consultation about closing our final salary pension scheme completely, having stopped new members joining a couple of years back. This is the company who's founder put forward the bill which became the Old Age Pension Act, so came as a big shock. I'm sure it will be the first of many large companies moving to career average over the next few years.

I think it's a real risk that the scheme won't last forever, so therefore I'd look to contribute as much as you can reasonably afford to accrue as much final salary benefit as possible and review again in a few years. Had I been able to earn 35ths in my 10 years it would have made a massive difference to my current projected pension after the changes.

[Beardy10]

You also need to consider the financial position of your company and whether they will be around in the future. Many of these schemes are currently under funded and if the company goes bust your pension will not be worth as much as you think.....it's maybe an unlikely event but the reality is that a company that still runs these schemes is either very well run, very profitable and believes a high quality pensions scheme is a very good way of retaining staff or it's a very badly run company that is not addressing the right issues.

[5pen]

I'm lucky enough to be in a similar scheme (not quite as generous and the scheme is now closed to new entrants) and I'm allowed to alter my accrual rate every year. I agonise over what to do every year. The cost-benefit analysis is always difficult because a)I don't know how my salary will increase in the years until I retire, and b)I don't know when I'm going to croak it.

If you are still reasonably young and feel there is a good opportunity for salary increases (especially if they're greater than inflation) then contributing at the highest rate you can afford would probably make sense.

Do you have an indication of the cost of each accrual rate?

For information I contribute 5% which gives me a 1/60th accrual rate. The cost to accrue at 1/45 or 1/30 vary each year but generally are around 14% and 30% respectively. My employer contributes around 23%. Private sector before anyone starts!

[sidicks]

5pen said:

For information I contribute 5% which gives me a 1/60th accrual rate. The cost to accrue at 1/45 or 1/30 vary each year but generally are around 14% and 30% respectively. My employer contributes around 23%. Private sector before anyone starts!

Well, it obviously depends on the scheme retirement age, spouse's benefits, inflation link in retirement etc but a typical final salary scheme would cost around 30% p.a. for a 1/60ths scheme, which is clearly consistent with the numbers you've provided above.

On that basis (and ignoring any inland revenue benefit limits), a 1/45ths scheme would give you 60/45 = 4/3rds the benefits which would imply a total cost of 40% p.a.

Similarly a 30ths scheme would provide 2x the benefits of a 60ths scheme, so a cost of 60% p.a.

On that basis, the 1/60ths and 1/45ths look broadly equivalently priced, whereas the 30ths scheme looks slightly more generous (but as alluded to above, not sure whether this might like to excessive benefits and hence a tax charge, reducing the value to you).

Lucky you!!

Sidicks

[Crafty_]

So how do you equate the benefits ?

As I said earlier my company are looking at changing the scheme they offer. the DB scheme will be closed to new joiners and they've given us a choice:

1) stay in the DB scheme and continue to contribute 5%, this will now only buy 1/80th
2) stay in the DB scheme and increase contribution to 9%, this will buy 1/60th
3) move to the new contribution scheme. You don't have to put anything in to it and can decide yearly what contribution to make. They will put in a fixed 10%. The scheme is run by General & Legal I think and you are able to manage the portfolio if you so wish.

They've gone to some effort to send us lots of information and even provide a website that does illustrations of each option. Me being a cynical type wasn't surprised to see option 3 as being by far the best in these illustrations I need to run through it all again as there are lots of bits and pieces like salary sacrifice tied up in this too.

I should add there is a bit more to this as they are also looking at flexible benefits, so you'd be able to buy/sell benefits and even put some of the "sold" stuff into the pension - DC scheme only though, they don't want AVCs going in the DB scheme.

This is only in the early stages (they are going through staff consultations right now), but it will happen sooner or later.
Instinct says stay in the DB at 9% but I need to wait for the final schemes to be defined I think. Does the panel agree ?

[sidicks]

Crafty_ said:

So how do you equate the benefits ?

As I said earlier my company are looking at changing the scheme they offer. the DB scheme will be closed to new joiners and they've given us a choice:

1) stay in the DB scheme and continue to contribute 5%, this will now only buy 1/80th
2) stay in the DB scheme and increase contribution to 9%, this will buy 1/60th
3) move to the new contribution scheme. You don't have to put anything in to it and can decide yearly what contribution to make. They will put in a fixed 10%.

Well, as above - depending on the exact nature of the scheme (what is the retirement age, what spouse pensions are included, is there a lump sum on retirement, is the pension inflation-linked?), the 1/60ths scheme is worth around 30% per annum. The 80ths scheme is therefore worth 60/80 * 30% = 22.5%

Under 1), the employer contribution is therefore worth around 17.5%
Under 2), the employer contribution is therefore worth around 21%
Under 3), the employer contribution is worth 10%

On this basis, I'd certainly favour 2) over 1).

Now under 3) the benefit at retirement will depend on a number of factors:
a) investment return pre-retirement
b) interest rates at retirement
c) longevity expectations at retirement
d) inflation expectations at retirement

The 30% 'cost' of a typical final salary scheme will make prudent assumptions i.e. a prudent level of investment return, low interest rates at retirement, increased longevity and higher inflation.

Under 3) if you therefore invest the company contributions successfully, if interest rates are higher at retirement, if inflation is lower at retirement and if life expectancy at retirement is lower than currently projected then you may be able to achieve a higher pension under approach 3), even under a lower contribution rate.

However, the above could work against you, and you could end up with a much lower pension under 3) - it is certainly a much higher risk option.

Personally, I'd let someone else take the risk and go for option 2)

Sidicks

Crafty_ said:

The scheme is run by General & Legal I think and you are able to manage the portfolio if you so wish.

You mean Legal & General?!

Crafty_ said:

They've gone to some effort to send us lots of information and even provide a website that does illustrations of each option. Me being a cynical type wasn't surprised to see option 3 as being by far the best in these illustrations I need to run through it all again as there are lots of bits and pieces like salary sacrifice tied up in this too.

As above, the value under 3) is entirely driven by the assumptions made. Future assumptions don't affect the pensions options 1) or 2).

Crafty_ said:

I should add there is a bit more to this as they are also looking at flexible benefits, so you'd be able to buy/sell benefits and even put some of the "sold" stuff into the pension - DC scheme only though, they don't want AVCs going in the DB scheme.

This is only in the early stages (they are going through staff consultations right now), but it will happen sooner or later.
Instinct says stay in the DB at 9% but I need to wait for the final schemes to be defined I think. Does the panel agree ?

Yep, agreed!

Sidicks

Edited by sidicks on Thursday 14th July 22:22

[Fume troll]

5pen said:

Do you have an indication of the cost of each accrual rate?

contribution buildup rate
0% 60ths
2% 54 ths
3% 51 sts
5% 45 ths
10% 40 ths
15% 35ths

The %s are pre-tax so would actually work out lower.

Cheers,

FT.

[nomisesor]

sidicks said:

To the OP: Join immediately and pay as high an employee contribution as you can afford!

nomisesor said:

....but now it is "unaffordable" despite the fact that the true cost is set to decrease.

/to nomisesor, please can you clarify exactly what you mean?!

Sidicks

http://careers.bmj.com/careers/advice/view-article.html?id=20003143

Admittedly this is a politicised interpretation of the Committee of Public Accounts review, published in a trade union journal, and of course depends on what the term "affordable" means - the same amount means different things to different people.

About 20 years ago, pondering whether to buy added years to take me to 40/80ths rather than the 35/80ths I'd otherwise have at 60, I realised that the employer's and my contributions were remitted to the Exchequer rather than put into a fund, so I diverted what would have bought added years into paying down mortgage, ISA (then PEP) and independent pension provision - a form of DC if you like. It didn't look like a good idea, but nor did wholly relying on an unfunded DB scheme based on a promise to pay, largely a promise on behalf of people like my children who were yet to be born. My colleagues thought I was being unduly cynical but now, when the DBs are reducing (e.g. CPI vs RPI), the lifetime cap has been introduced and like IHT, is likely slowly to hoover up more and more people via fiscal creep, the contributions rising, the retirement age moving further away the closer we get, and privatisation looming with TUPE only applying to the first new employer they're not so sure!

[sidicks]

nomisesor said:

http://careers.bmj.com/careers/advice/view-article...

Admittedly this is a politicised interpretation of the Committee of Public Accounts review, published in a trade union journal, and of course depends on what the term "affordable" means - the same amount means different things to different people.

Well, my view is that something that requires a taxpayer subsidy of 20%+ (of salary) per annum at a time the country is spending £160bn more than it earns can't be described as affordable!

(unless you decide to fund this by spending less money on education or the NHS....)

The point is that there is often a focus on the 'cost' of these schemes based on net outgo (i.e contributions less benefit payments) whereas the true measure of cost needs to take into account benefit accrual (which is currently around £50bn per annum...)

nomisesor said:

About 20 years ago, pondering whether to buy added years to take me to 40/80ths rather than the 35/80ths I'd otherwise have at 60, I realised that the employer's and my contributions were remitted to the Exchequer rather than put into a fund, so I diverted what would have bought added years into paying down mortgage, ISA (then PEP) and independent pension provision - a form of DC if you like. It didn't look like a good idea, but nor did wholly relying on an unfunded DB scheme based on a promise to pay, largely a promise on behalf of people like my children who were yet to be born. My colleagues thought I was being unduly cynical but now, when the DBs are reducing (e.g. CPI vs RPI), the lifetime cap has been introduced and like IHT, is likely slowly to hoover up more and more people via fiscal creep, the contributions rising, the retirement age moving further away the closer we get, and privatisation looming with TUPE only applying to the first new employer they're not so sure!

Interesting - I think that's consistent with my post above - basically the DC route can be advantageous but you are taking all the risks and this may or may not pay off!

Sidicks

[sidicks]

nomisesor said:

Sorry to stray so far from the OP's question.

I think the OPs question has now been answered (hopefully)!

nomisesor said:

I think that the argument was that public sector workers were historically paid less than those in the private sector and the more generous pension terms were deferred pay (perhaps the 20%+ you suggest). That suited the governments of the time, as they didn't have to pay people up front, and as the markets were doing well the private sector could take pension contribution holidays. Then public sector pay increased under successive Labour governments and a combination of (what I see as Gordon B's most reprehensible move, removing private pension fund dividend credits), coupled with the overhang of contribution holidays and equity underperformance made the private sector pots shrivel at a time when salaries started to drop. We ended up in a position where public sector pay and pension provision now appear overly generous, but this is a snapshot, and pensions, if one looks at them as deferred pay, should be interpreted in the context of what was happening several decades ago. When I started work my basic, pensionable rate of pay was about £4 p/h for the first 40 hours and then, for the subsequent 60-80 hours per week (we did a level of on-call which is now banned by the EU) we were paid 4 x 0.36 = £1.44 p/h - regardless of whether this was Sat, Sun, or Christmas Day.. A fairly good hourly rate at higher levels of our pay scale and a DB pension scheme were regarded as deferred pay.

Agreed, but as you suggest, if public sector pay has now caught up and is "overly generous" then there is no reason for a subsidy to pensions going forward (and changes are predominantly about future accrual, not earned benefits).

nomisesor said:

The question as to whether is is affordable now that the country is in massive deficit is also complex - why are we in that position? Is it because greedy public sector pensioners are asking for their deferred pay or
is it because a combination of poor regulation of the financial sector, taxation of pension funds, a lax approach to private employer responsibility for pensions, a short term outlook with massive rewards for clever financial engineering (Southern Cross is a small but obvious recent example), government encouragement of grossly expensive never-never deals like PFI which keep spending off the books.. I could continue.

Well it's debateable if it ever was affordable - these contributions were never put aside and instead were frittered away by previous governments.

It's been quoted before, but:
I think the Labour government ran a deficit in something like 8 out of 13 years depsite the economy doing well - it was inevitable that cutbacks would be required at some point, regardless of the cause of any recession.

Allowing for PFI, the previous government doubled debt in their time in power - so that we now spend £50bn per annum in interest...

Current monies owed to banks amount to less than £50bn.

nomisesor said:

Re: "(unless you decide to fund this by spending less money on education or the NHS....)"

Well, it's happening - I'll continue later...

Second order at the moment - as discussed above, the true cost of public sector schemes (i.e. cost of each years accrual) is around £50bn+ per annum - that would be a pretty hefty chunk out of the schools or NHS budget !!

Sidicks