Defined Benefit Pension Woes and Pitfalls

(04 May 2016)

‘ We love the idea that corrections are only natural, normal and healthy – until they happen.’

Tony Dwyer, US analyst at investment bank Canaccord Genuity – Tony has been pretty accurate about the trajectory of the US stockmarket over recent years.    He is correct in his quote above, investors say that they want corrections to occur in order to be able to invest at better prices, but then the correction comes along and...................well, you know yourself, suddenly the decision to invest in a correction gets reversed !, then the market recovers and you kick yourself !    History shows that not even the strongest bull markets advance in a straight line, but typically move up with fits and starts.  As Tony writes, ‘ The trick in a fundamentally driven bull market  isn’t expecting a correction, but is actually buying it as fear mounts.’  

At Merrion, we try to prevent this ‘expensive regret’ by designing investment mandates with clients that allow us to steer money into equities during corrections;  we wait for market weakness and then invest clients’ cash holdings as agreed.   Of course we don’t always catch the exact bottom, but my tried-and-trusted averaging-in policy has worked well over many years.

Defined Benefit Pension Woes and Pitfalls

One of my most-discussed snippets amongst readers and clients is the one about campervans in Scotland and Defined Benefit pension schemes.  Claer Barrett of the Financial Times wrote an interesting article last August on the massive generational changes happening in pensions currently.  For her husband’s 50th, they hired a luxury campervan, and spent a fortnight cruising around the Scottish Highlands and islands.

In the article she wrote about the many other couples in campervans they came across on the trip, practically all of whom were very happily retired.  Claer and her husband eventually suffered from “pension envy”, as many of their fellow travellers, who included former teachers, accountants and British Gas engineers, had taken early retirement.  All were on final salary pensions, providing them with a comfortable retirement, and in some cases, their campervans had been purchased with their tax-free lump sums.

A key reason these other campervanners were relaxed about their finances is that current Defined Benefit (DB) pension legislation protects retired members.   So if you are retired from a DB pension scheme, you enjoy much stronger security than non-retired members.   This was highlighted recently in a meeting with a well-respected and experience financial adviser whom I have known for a long time.   For anybody in a DB pension scheme for many years but still in active service, his client’s experience will be of concern.
According to the adviser, his client was Managing Director of a retail and wholesale distribution company with over 20 years’ service, aged about 62,  with an annual salary of about €100,000.   He was a member of the company’s Defined Benefit scheme for all of this time, however this had to be wound up because of future funding issues and he got a transfer value of only c.€190k.   This was because most of the assets in the DB scheme were used to purchase annuities for the pensioners and Pension Retirement Bonds (PRBs) for paid up members. 
In ‘normal’ circumstances this client should have had a pension benefit of closer to €700,000 in our view ; not only that but for this to happen as one nears retirement is a double blow as time is running out to re-build one’s pension pot.

This cautionary tale reinforces our view that DB schemes now have become more ‘risky’ for the active member – after all, those happily retired members (in their campervans !) have priority if there is a shortfall in assets, while the large asset shift into Euro Government bonds and other supposedly less volatile assets means that the investment return of the schemes going forward is very restricted – you can’t generate much investment performance if a large part of your assets is invested in bonds and cash that are yielding 0.5% or less (before the expenses of running a pension fund) or even losing money with negative bond yields.  
And of course, as in the case above, the trustees have the power to reduce your promised pension benefits if the scheme’s viability is at stake.  Just imagine if you had been a long-serving employee of the failed BHS, where the pension scheme has a £570m deficit, leaving many of its members facing reduced pensions.   Separately, I have come across schemes where the retirement age has been increased from 65 to 68;  if you were expecting, say, a pension of €50,000 at age 65, you have lost  €150,000 and no say in or control of this decision (and your plan to buy that campervan with the tax-free lump sum deferred for 3 years !).

And a couple of weeks ago, deferred members of Irish DB pension schemes,  i.e. members that have left the sponsoring employer for another job but left their accrued pension benefits in the employer’s DB scheme (over 400,000 individuals in Ireland), had their deferred benefits mildly cut after our acting Minister for Social Protection signed an order to link deferred pensions to the negative CPI rate of -0.3%; not significant, but another example where the member has no say in a decision that negatively affects his pension value.
Paradoxically though, the low bond yields mean that the value of one’s ‘pot’ (transfer value) in a DB scheme has increased significantly from what it was a few years ago.  So perhaps the less risky strategy is to take out one’s pension pot through a pension transfer – this amount is then under your control and not subject to the type of bombshell the adviser’s client got in the example above, and in many situations it may be possible to structure the new pension vehicle so that it can become an ARF at retirement.   And so with good financial advice and planning and a proper long-term investment strategy, ‘DB scheme exiters’ can also be ‘happy campervanners’.  
And Merrion is well-placed to help advisers advise their DB members thinking about taking a transfer value, and to implement and achieve this – if you are looking for assistance on these matters, please do not hesitate to contact your financial adviser or click here to send me an email. 

Fortunately for this individual, the financial adviser had helped to set up a separate executive scheme for him in 2006, and contributions were put in between December 2006 and May 2015, invested in the Bloxham/Davy Geared High Yield Fund, which the adviser advised to switch to cash in May 2015, just as markets (as we now know) peaked.    According to the adviser, despite starting to contribute just before the onset of the Great Financial Crisis of 2007 to 2009, the €400k of contributions over the period grew to c.€635k thanks to averaging-in and the performance of the underlying fund (!) – great foresight and advice.



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