From time to time one comes across an article where the author hankers back to the days when most retirement funds were defined benefit (DB) in nature. DB pension funds, we are told, provided their members with much greater certainty when they retired.
From time to time one comes across an article where the author hankers back to the days when most retirement funds were defined benefit (DB) in nature. DB pension funds, we are told, provided their members with much greater certainty when they retired.
A DB typical pension fund might have provided a pension of 2% of final salary for each year of service, so after a career of 35 years a pensioner would be guaranteed a pension of 70% of their final salary for the rest of their lives. Annual increases too… and a pension to the surviving spouse if the pensioner died first.
Starting in the early 1990s South Africans transferred in great numbers from DB retirement funds to defined contribution (DC) retirement funds. In a DC fund a pot of money is built up in the fund for the member, based on the regular contributions that go into the fund and the investment returns subsequently earned on those monies.
When the member retires that pot of money must be used to provide for their old age. This is usually done by buying an annuity that pays a monthly pension for the rest of the pensioner’s life from an insurance company.
With DC funds members are exposed to a lot of different risks, which they need to manage. Firstly, there is the investment risk. If the investments in their retirement fund perform well, they will get a bigger pension, but if they perform badly, they will get a smaller pension. What if the investment markets crash just before they retire?
They also have to manage the risk of converting the capital that they have built up in their retirement fund into some form of annuity that will pay them a pension until they die. What sort of annuity is best? A level annuity? A with-profits annuity? An inflation-linked annuity or an equity-linked annuity? So much to choose from! What if they make the wrong choice?
With all this uncertainty, surely DB funds were better? Not necessarily.
The truth is that very few people ever retired from the same employer they worked for early on in their careers. That meant that when they came to retire they had relatively little service in their final employer’s pension fund. The overly romanticised notion is that after 35 years a member would have retired and received a pension of 70% of their last salary.
This was rare.
A more typical example would be similar to the following. In his 35-year career our pensioner worked for three different employers. After working for his first employer for ten years he left that employer’s pension fund with a paltry withdrawal benefit and not surprisingly he took the benefit as cash.
After a further ten years he again switched jobs, but this time he was a little more aware of his future retirement and he preserved the benefit from that fund in a preservation fund. The benefit was still not much, certainly less than the value of a deferred pension based on ten years’ service.
Finally, after a further 15 years, he retired from his final employer’s pension fund with a pension of 30% of his final average pensionable salary. His final average pensionable salary was based on his last three years of employment and his pensionable salary was only 70% of his annual package, so his pension was in fact only about 20% of his pre-retirement earnings.
Add to that what he got from his preservation fund and some other top-up payments he made when he realised how poorly he was provided for and he ended up with an income in retirement of about 30% of what he was earning just prior to retirement – a far cry from the 70% we might have expected. What is more, a sizeable portion of that benefit was subject to the vagaries of investment markets and annuity purchase terms.
Why did he receive so little? Our fondly remembered DB funds relied on a large proportion of the members leaving the fund before they retired and receiving low value withdrawal benefits. The members that eventually retired and received high value pensions needed to be cross-subsidised by the members who left the fund before retirement for the finances of the fund to work out.
As soon as DB funds began to be pressurised into increasing their early leaver benefits to more equitable amounts, DB funds started to become unaffordable to the companies that sponsored them. Employers were naturally keen to fix their costs and so, closing their DB retirement funds and opening DC funds made a lot of sense to them. Fund members, most of whom did not expect to retire from their current employers, were attracted to the higher withdrawal benefits that the new DC funds offered and happily switched when given the chance.
So, let’s not hanker back to the days of funds that we are unlikely to see again, but rather learn how best to manage our DC retirement funds both while we are still in employment and also when we retire and need to choose a pension.