Annual costs of a DB pension exceed those of average mortgage interest payments

The annual cost of providing a defined benefit (DB) pension exceeds the average home-owner’s yearly mortgage interest payments, according to analysis by Fidelity International, one of the leading investment management services groups.

The latest research from Fidelity’s Retirement Institute reveals that employers need to find a sum equivalent to 24% of salary to provide a 40-year-old male worker with a retirement income of two-thirds of final pay at age 65. That’s close to £10,000 for someone earning £40,000 per annum.

By contrast, the typical homeowner is currently spending 17.6% of gross pay on mortgage interest payments, according to data from the Council of Mortgage Lenders. That’s just over £7,000 in interest payments for a homeowner on the borrower’s median salary of £41,000.

Martin Harris, managing director at Fidelity International, says too few employees appreciate the value of their DB scheme and fewer still realise how much it would cost to replace the equivalent benefits if purchased on the open market from insurers.

“A host of ancillary benefits are hard-wired into defined benefit schemes and inflate the costs for employers,” says Martin Harris. “Spouses’ benefits and inflation-proofing measures push up the cost of a DB scheme by nearly a third and beyond the level of interest payments on the typical mortgage.”

DB Lite – a middle way

Faced with such high costs, an increasing number of employers are closing their DB schemes to new hires. But Fidelity argues that there is another way: DB Lite. By adopting the DB Lite model, employers would continue to bear the principal risk of retirement provision, but lower their costs by offering members a choice of benefits rather the full, gold-plated package.

Martin Harris continues: “DB Lite would allow employers to continue to offer this highly attractive type of pension to their workers. Some companies might even re-open their closed schemes if given greater control over costs. But to implement DB Lite properly, the Government must first make some fairly simple changes to the pension laws.”

Fidelity has written to policymakers and politicians to urge a reform in the law. Some changes to benefits are already at the discretion of the sponsor, but others need legal changes.

The law currently requires annual benefit increases of 2.5% or in line with the Retail Price Index (RPI), whichever is lower, for pensions in payment. It is also mandatory to provide inflation protection up to 5% for deferred pensions in the run-up to retirement. Giving sponsors greater discretion over inflation protection, when combined with other changes such as raising the retirement age, allows them to cut costs by up to a third.

Martin Harris adds: “Since the early 1990s, DB schemes have become ever richer in benefits. But each of these benefits comes at a cost. Employer and employee now need to agree which of these benefits they most want to preserve. Otherwise, employers will continue to jettison the entire scheme – to the detriment of current and future workers.”