Could we see the return of DB pension accrual?

Shifting economic conditions and pension surpluses could spur the revival of defined benefit (DB) pension accrual.

DB pension accrual was once commonplace in the UK private sector and a fundamental component of an employee’s benefit package. However, a combination of low interest rates and rising life expectancies put paid to DB as the primary form of retirement provision during the 2000s, with companies almost universally switching to lower risk (and lower cost) defined contribution (DC) pension arrangements for current employees.

While the companies hampered by years of deficit reduction contributions will instinctively be in no hurry to revive DB pensions, the reappearance of DB scheme surpluses and the altered economic environment could make the case for re-considering DB pension accrual in some form as an attractive employee benefit for certain companies. 

This is particularly the case for those companies that are considering the potential value that could be obtained from running on an existing DB scheme, where existing and future surpluses could be used to fund future pension accrual. Companies considering closing their DB schemes may also think twice.

Below, we have outlined some of the key reasons why DB pension accrual could again be a feasible option for certain companies.

Competitive DB accrual costs

The resurgence in interest rates has altered the economics of DB pension costs. The chart below shows how the cost of DB pension accrual has changed since the start of 2022, when bond yields began their recovery to the levels we see today.

Our analysis suggests that the expected cost of DB pension accrual has reduced by 40%-80% (varying by age) over the period since the start of 2022. If we assume members contribute the auto-enrolment minimum rate of 5%, based on the benefits modelled this would suggest a current contribution rate for the employer of 1% for a 30-year-old, increasing to 15% for a 65-year-old, and an overall average employer contribution rate of 6%. This compares to the current minimum auto-enrolment contribution rate of 3%.

These are not unreasonable costs for a generous DB pension benefit, particularly if some of this cost can be borne from an existing DB surplus or if the member contribution rate is set at a higher level.

Of course, DB pension accrual costs are sensitive to changes in financial and demographic factors, and a reversal in bond yields would push up the expected cost of DB pension accrual again. This can be mitigated by appropriate scheme design and setting clear parameters for risk. 

In the case where an existing DB scheme surplus is used to fund DB pension accrual costs, if the surplus is sufficiently large relative to accrual costs, absorbing volatility in the contribution rate may well be manageable and a price worth paying for providing an attractive employee benefit at what is currently a competitive rate. 

Risk management is much improved 

It’s easy to look back and critique past events based on today’s knowledge, assured that we would not make the same mistakes today. But lessons are learnt from the past. 

The lack of liability hedging in the early 2000s meant schemes were woefully underprepared for the collapse in yields after the global financial crisis. DB pension risk management has undoubtedly improved because of this, with liability hedging strategies in particular significantly more advanced than they were a couple of decades ago. 

Solutions are also emerging in the capital-backed funding market to provide schemes with a higher degree of certainty regarding growth asset performance – providing mitigation for companies that would prefer not to bear this risk. 

The evolution in risk management strategies should provide a higher degree of confidence that asset strategies will keep pace with liabilities that are built up from new DB accrual, and materially reduce the chance of significant deficits emerging in the same way as they did after the global financial crisis.

Re-opening to accrual could also help with the management of legacy liabilities, where scheme closure has led to funding challenges as a result of the shortened time horizon and cashflow pressures. Increasing the investment time horizon and reducing cashflow pressures could potentially supporting a degree of re-risking and the generation of additional surplus. 

The final point to note is the significant strides we have seen in administration practices due to advances in technology over the last couple of decades. The days of paper records and manual calculations have now passed, significantly reducing the risk of calculation errors, benefit uncertainty and suboptimal member experience.

Is there a DC crisis on the horizon? 

From an employer perspective, DC is the lower risk option when considering the use of DB surplus to fund pension costs for current employees, but there is also a general understanding that DC will not provide an adequate retirement income to the average employee based on current contribution rates. This has been masked in recent years by retirees generally having some form of DB income, but this will become starker in the coming years. 

The Pensions and Lifetime Savings Association's (PLSA) analysis suggests that only around 50% of the UK’s population are projected to meet the retirement income targets set by the 2005 Pensions Commission. This falls to 35% for those individuals with DC savings but no DB entitlement .

The appreciation of DB will only increase as a result of this and offering this benefit in some form will help to set an employer apart from its competitors. 

Workforce planning

Our recent ‘The Employee Equation’ research showed that the need to offer better pension provision is a key concern for 75% of business leaders. 

This is an issue that could be addressed by offering some form of DB benefit, and once again using this as a valuable tool for recruiting and retaining the best employees. This may well be a natural consequence of the looming DC retirement crisis but could already be a consideration for industries where there are competitive labour pressures, competition with other companies offering DB, or where employees tend to remain in employment for a longer period.  

DB will also support companies with workforce planning issues at the other end of the career path, by ensuring that older employees are able to retire when they want to, rather than remaining in employment due to insufficient retirement savings.

What would DB look like in today's world? 

To be clear, this is not a suggestion that there will be a return to the generous DB pension benefits of the past (uncapped inflationary increases, fixed rate revaluation, 60ths accrual rates etc.), and we are not anticipating a flood of companies looking to re-open their DB scheme. But for the right company in the right industry, a sensibly designed DB scheme benefit could provide employees with a pension benefit they truly value within cost and risk parameters that are acceptable for the company. 

Scheme design will be particularly important to ensure employees receive a retirement benefit that is understood and valued, while not exposing the company to significant risk. Some of the potential options include:

• A DB benefit that tops up the State Pension with the aim of providing employees with a retirement income in line with that required to support a minimum/moderate living standard in retirement. This could be provided alongside a supplementary DC scheme for employees that want to target a higher level of income.
• A DB benefit that comes into payment at a defined older age (e.g. age 80), in combination with a DC scheme to cover the earlier years of retirement. This would provide a fixed period in retirement for managing DC savings (addressing one of the key challenges of managing one’s own longevity risk) and provide a regular income at a time when managing a DC pension could become more challenging.
• Cash balance – i.e. members receive a cash benefit at retirement that is defined by reference to salary and service.

This is not merely theoretical - IBM have recently re-opened their DB plan in the USA on a cash balance basis to utilise the large surplus that had built up in respect of past service benefits. 

While the regulatory landscape is different in the US, this is a clear example of a large, important employer dipping its toes back in the DB pension market. Could this encourage others to follow suit? We are already starting to see signs of this happening.

We have several clients that have recently delayed decisions to close their schemes due to significantly improved funding positions – it would not be a huge leap further for a scheme to reopen to new accrual.

Calculation details for chart