Deficit contributions: the retrospective pension pay rise

It is clear that valuations of defined benefit pension schemes’ liabilities have escalated over recent years, with many employers being required to pay ever-increasing contributions to recover deficits. Read Danny Wilding’s thoughts.

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It is clear that valuations of defined benefit pension schemes’ liabilities have escalated over recent years, with many employers being required to pay ever-increasing contributions to recover deficits.  
We thought it may be instructive to analyse this in terms of the retrospective change in the cost of pension accrual, and the main reasons for this. The chart below shows the rise in the value of accrual over the last 40 years (starting at 100% in June 1980), which underlies the resulting financial burden on employers. 

The chart is based on publically available data from valuation reports for a number of the largest UK defined benefit pension schemes.

For example, a scheme open to pension accrual in June 1980 may typically have estimated the cost of accrual at that time to be, say, 10% of the employees’ pensionable salaries (depending on the rate of pension accrual, retirement age, pension increase promises etc).  Typically this cost might have been split between the employees and employer so each paid, say, 5% contributions initially. 

Looking at how this cost has changed since 1980, with hindsight, we can now see from the chart that the expected cost of accrual of benefits has increased to be around 500% of what it was initially estimated to be – i.e. the pension accrual has increased in value from 10% to 50% of salary over time.

However, while the overall cost of accrual as a percentage of salary has increased five-fold, the associated increase in required contributions does not usually get passed on to the members retrospectively. So the employer now has to meet the total cost of 50% less the employee contribution of 5%, which is 45%, a ninefold increase on their initial expected contribution rate of 5%.

The pension pay rise

Another way of looking at this, is employers have had to fund a retrospective “pension pay rise” equivalent to 40% of the salaries that pension scheme members received whilst they were accruing pension (with this funding provided in the form of subsequent deficit contributions). For schemes with the most generous benefits the figure could be much higher.

Expressed in this way, it is clear to see why deficit recovery contributions required from sponsoring employers have created such a financial burden, and left little budget remaining for the provision of pensions for subsequent generations of employees. 

Continue reading at https://www.barnett-waddingham.co.uk/comment-insight/blog/deficit-contributions-the-retrospective-pension-pay-rise/

Barnett Waddingham

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