The quote ‘any colour, as long as it’s black’ is attributed to the great 20th century car maker, Henry Ford, creator of the Ford Model T. This is great if you want a mass-produced car, but what if you do not like the colour black?
There are parallels with the final salary pension scheme. Defined benefit (DB) schemes provide their members with broadly similar benefits: a member’s pension, widow’s pension, option for tax-free cash, indexation and a five-year guarantee.
They also offer members a very attractive promise of a guaranteed income for life – no worry about stock markets or inflation and no need to take advice or make choices.
This may be appropriate for most scheme members, but not all.
DB drawbacks
Retirement is not what it used to be, where people on the whole worked lifelong for an employer until the age of 65. Modern retirement is dynamic and flexible – all the things DB schemes are not. DB schemes have two significant drawbacks in this new age of retirement:
You get what you are given. Although you may have a choice to commute the pension for a cash sum, the benefits are ‘defined’: but not by you. The scheme decides what you receive. In effect, you are given ‘black’ even if you want another colour. This is at odds with the way we live in retirement now.
Many individuals want to retire early or spend more money in the early years of their retirement and less when they are much older. They may be unmarried and have no need of a widow’s pension, or they may have significant health issues and want their family or other beneficiaries to receive their pension money if they die early. They may want more tax-free cash than the scheme is offering.
They are fundamentally unfair. DB schemes are discriminatory by design. Members who die early pay for the pensions of those who live longer than expected. Unmarried members subsidise married members’ widow’s pensions. Those in ill health (and likely to die earlier than normal) pay for the healthy types who may live a long life, yet no account is taken of their individual mortality risk and no enhancement in scheme benefits is offered.
Men statistically die before women and so male members subsidise female members’ benefits. If you happen to be an unmarried man with significant health problems, you might feel a bit short-changed. The thing that is so appealing about DB schemes, defined guaranteed benefits, is the very thing that prevents members from shaping their benefits to meet their ambitions and needs in retirement.
Broken promises
The recent demise of British Home Stores and the parlous state of funding for many DB schemes has highlighted the frailty of the ‘pension promise’ that underpins DB guaranteed benefits. It seems that DB schemes are heading for a long and, in some cases, painful end as the guarantees offered become ever more unaffordable.
The advent of the pension freedoms and the current poor climate for DB schemes (resulting in huge transfer values being offered) has created an opportunity for financial planners to reassess DB entitlements to see if a transfer offers clients a more suitable choice. This is complex work and requires considerable skill and expertise, so IFAs must be competent and confident to undertake such planning.
For many, maintaining DB benefits will be best, but an increasing number will prefer the option to tailor their pension benefits to meet their individual requirements, allowing them to enjoy a dynamic and rewarding retirement. For such individuals, it will be a case of ‘you can have any colour you like… except black’.
Carl Melvin is chief executive of Affluent Financial Planning.