Give defined benefit scheme members the chance to choose

Alan Collins

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Last week, the Financial Conduct Authority (FCA) splashed onto the business pages extolling the virtues of choice for consumers in the pension annuity market.  Their review has found that 80% of consumers purchasing annuity from their existing providers could have got a better deal by shopping around in the open market.  I welcome the FCA’s continued efforts in this area and trust that, in time, it will lead to a better deal for consumers.

This drive to encourage consumers to shop around with their defined contribution pot should be mirrored in defined benefit (DB) arrangements. 

Typically, when a member reaches retirement, they are presented with two choices:  a full pension based on the rules of the scheme or a cash lump sum (still tax-free, for now at least) together with a reduced level of pension.   Under both options, a pension will be payable to the member’s spouse in the event of their death (unless they haven’t got one, in which case the scheme ‘keeps the change’).  A simple choice then: A or B.  That’s it, what more could you want?  Well, I believe members should have their eyes opened to the many other options that exist and that scheme trustees and employers may be failing their members if they don’t make such options available and give members access to the necessary level of advice.

Let’s look at the FCA review for reasons why DB members should be given a choice:

The FCA want “consumers to be able to make well-informed decisions about products that meet their needs”.  No argument there, yet the vast majority of DB members simply select the tax free cash and residual pension option without advice or further information on their options.

“Too many consumers purchase an annuity from their existing provider”.  Again this would suggest that the presumption that the scheme benefit is always best is flawed.

The FCA correctly notes that consumers should “buy the right ‘shape’ of annuity for them (e.g. single life or joint life, level or escalating…and with or without guarantee)”.   So why do we assume that all members want the type of pensions prescribed in DB schemes?  In fact, according to the survey, only around 5% of annuities sold in 2012 had escalation.  And, very few DB members with a high-value pension explore the various drawdown options, when these may be much more suitable and potentially tax-efficient too.

Finally, the review states that “those who would be eligible for an enhanced annuity but do not explore this option stand to gain the most from shopping around”.  Yet, in a DB scheme, those who would qualify for enhanced terms are essentially subsidising those who would not, at the expense of getting a better pension for themselves.

I have seen many examples where giving members access to advice at retirement has given them a higher lump sum and a higher initial level of pension than the scheme was going to provide.  And, this has been achieved at a lower cost than scheme was reserving to pay for the standard scheme benefit.

Employers and trustees should offer more choice at retirement, but they should also not shy away from offering members the choice to access their scheme benefits early or transfer them out to another arrangement.  The “presumptions of guilt” around incentive and exchange exercises is undoubtedly leading to many members missing out on a deal that is right for them.

In particular, death before retirement benefits in defined benefit schemes can be very poor, sometimes as low as a simple refund of contributions.  Therefore, it may be preferable for members to transfer the value of their benefits to an alternative arrangement to ensure that, if the worst happens, their spouse is not left with a very poor financial outcome.

Surely no-one can argue with the assertion that choice is a good thing – but can we have it for everyone, please?

Alan Collins

Post by Alan Collins

Head of Trustee Advisory Services at Spence he provides actuarial, funding and investment advice to trustees and sponsors of ongoing defined benefit schemes.

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