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The Cost and Value of Defined Benefit Pension Schemes, and the Implications for Defined Contribution Provision

Paul Sweeting

Over the last twenty years, the extent of defined benefit provision has declined substantially in the United Kingdom. Whilst most of the focus has been on deficits relating to past benefit accrual, a more important consideration is the increasing cost of future benefit accrual. In particular, I look at how the cost of pensions has changed relative to the cost of non-pensions earnings. I also look at the main components of the change in pensions cost – those relating to benefits payable, discount rates and longevity – to analyse their relative importance. I find that the cost of employing a member of defined benefit pension scheme has outpaced the cost of employing someone in a defined contribution arrangement by 1.1% of earnings per annum from 1995 to 2015. As at March 2015, the total cost of accrual was 25.4% of earnings.

The average impact of interest rate changes on the change in the cost of accrual is 0.9% per annum. This is significantly more than the average impact of longevity improvements, which is 0.2% per annum. Both of these have added to the total cost. However, benefit changes marginally offset these increases, by around 0.05% per annum on average.

Looking only at changes in interest rates, the estimated cost of accrual has risen to 36.7% of earnings as at September 2016. If the current 2.5% LPI increases to pensions in payment were removed and replaced with conditional indexation, the cost of accrual for the employer would fall back to 27.0%. However, this is still more than three times the maximum level of auto-enrolment contributions that will be required – these peak at 8% of earnings in 2019. It is also nearly seven times the current average level of contributions, which in 2015 stood at 4.0% of earnings. If contribution rates to defined contribution arrangements do not rise, a large proportion of the population will reach retirement with inadequate retirement savings.

This paper revisits and extends analysis I first published in 2008, which looked at the change in the cost and value of defined benefit pensions from 1995 to 2005 (Sweeting, 2008).