Last week Tesco hit the headlines as the last FTSE 100 company to announce plans to close its defined benefit pension scheme to new employees, as well as closing the scheme to its 200,000 existing UK employees.

Some people see this announcement as the final “end of an era” and look back nostalgically to a “golden age” of company pensions. But there never was such a “golden age”. Even at the peak, the percentage of private sector workers with a final salary pension was modest and final salary pensions worked against those who changed jobs or had career breaks, especially women.

The main winners were senior management who had joined the company straight from school or university and remained with the company all their careers. Guess what, they were also the people making decisions on pensions.

The other winners were fund managers and investment consultants who skimmed off generous amounts of money.

For many years, poor accounting and poor regulation allowed companies to understate the real cost and risk of defined benefit pensions. They could pretend that a modest cash contribution would turn, risklessly, into a large enough pot to pay the pension promises simply through holding equities.

But there is no “magic money tree” to pay for company pensions and the cost of defined benefit pension promises must be paid for by shareholders.

As a “perk” in addition to pay, defined benefit pensions face the fundamental problem that the perceived benefit to employees is always likely to be less than the real cost to the employer, making them economically inefficient.

Suppose a company needs to pay a £40,000 overall salary to attract and retain people for a particular job. The company can pay either a £40,000 salary, with no pension, or £30,000 in salary and a defined benefit pension costing £10,000.

Faced with this choice employees will almost always take the £40,000 salary, with no pension, because they underestimate the long-term value of the pension they will get in retirement. (As a separate matter they may choose to make their own pension saving). This means there is an inevitable value gap between the perceived benefit to the employee and the real cost to the company.

Some people, including the pensions minister, believe that defined benefit pensions can still be revived with some form of “risk sharing” arrangement between employees and the company. The Pensions Bill currently being finalised includes risk sharing. A company might offer annual inflation-linked pension increases, not automatically, but only if the value of pension fund assets increase in line with a formula – similar to a “with profits” arrangement.

What is the real economic cost to the company of this conditional promise? Less than the cost of an unconditional promise to increase pensions in line with inflation, but still a significant cost.

Rational employees, meanwhile, will place a very low value on the conditional promise, probably zero, given its complexity and lack of transparency, and the sneaking suspicion that in practice, things will work in favour of the employer.

Like TV game shows, employees face the choice of a specified amount of cash, the straightforward salary, or a closed box containing an unspecified amount of cash. Since the value of the box is indeterminate, the rational employee should take the cash.

If any company wanted to offer a defined benefit pension, with or without “risk sharing”, why should it try to provide the pension itself, rather than outsourcing to an insurance company, whose business is providing pensions? It could then offer employees a lower salary in exchange for the pension. The answer, of course, is that the reduction in salary, representing the real cost of the pension, would be unattractive to employees.

UK companies have moved inexorably towards defined contribution pensions, with individuals taking all the investment risk and risk of living longer. To provide for a half-decent retirement people will, inescapably, have to retire later and save more whilst they are working. However unpopular, we must all adjust to “working longer and spending less”.

Source: The Telegraph