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Reducing longevity risks in defined benefit pensions

Reducing longevity risks in defined benefit pensions

Defined benefit schemes are beneficial to society, giving members, lucky enough to be in one, stability for the future. But many schemes are in severe danger of collapse, under pressure from increasing longevity within the population. This pressure from payments carrying on far beyond what was originally envisioned will break many schemes, forcing people into money-purchase schemes, which have no guaranteed results and therefore risk leaving more people dependent upon the state. Given the enormous cost this would impose on society, and therefore on business just as much as individuals, we all need to start thinking of more radical solutions for stabilising those defined benefit schemes currently in existence.

One way of doing so could be to allow greater tax-free withdrawals as part of the initial pension benefits, which will have the effect of reducing that portion of the pension fund exposed to the longevity risk, while, as a bonus, allowing pensioners greater access to the money when they are more likely to need it. Most people spend the greatest proportion of their money in the years immediately after retirement, so there will be a great temptation for individuals to take the maximum tax-free cash withdrawal allowed.

Of course, there is a risk that the pensioners would become a greater financial burden on society when they are older, if they spend an excessive amount early on in their retirement. We could protect ourselves from this risk by setting a base limit, below which pensions could not be reduced. So if a pensioner was due to get a pension equal to 80% of the average industrial wage, there could be a limit set equal to a set proportion of that wage, e.g. 50%, so that the maximum lump sum that can be taken was limited to that portion that was calculated to provide the extra 30%. Defined benefit schemes are ideal for this kind of limit as the calculations are relatively straightforward.

A reduction in future committed outgoings would reduce defined benefit schemes’ exposure to longevity and reduce the amount of capital they must set aside to meet that exposure. This would help more of these schemes to remain open and would reduce the number that might fail, thereby reducing the overall risk to society.

An alternative would be to allow an increased lump sum with the proviso that the increased amount would have to be invested in a money-purchase retirement product by the pensioner. This would reduce the risk to the pension funds by transferring some of that risk into investment risk borne by the individual. People would have to be incentivised by the government, perhaps by allowing pensioners to treat any money remaining in the new product after their death as part of their estate. Also, the ability to control the investment would attract a growing number of pensioners who are more financially aware than their predecessors.

Obviously, these ideas would need more investigation, but it strikes me that there is little sign of any new thinking in the defined benefit pension area. The only solution seems to be to apply more stringent solvency tests which either force employers to shut down their schemes or leave them facing a greater risk of failure, with the consequent cost to society.
Short term taxation could lead to long term pain

Despite the severity of their current debt problems, governments must resist the temptation to increase the level of taxation on pension contributions and funds. I know that they are all desperately short of money now, but the taxation of pension contributions within pension funds will reduce significantly the amount being input into pensions dramatically increasing the problem of the pension time-bomb.

Experience in the UK shows the danger of going for the easy target. They tried taxing dividends being paid into pension funds back in 1997. The result of this is now beginning to filter through as reduced pension pots have led to increased take up of pension credits and other government pensioner support schemes. These supports are very expensive and, worse, they are long-term commitments, exposed to the increasing longevity of the population.

Any policy that reduces the incentive to save for retirement, or hits the drawdown capacity of those in retirement risks building up the burden on the state that will break like a tidal wave over the recovering economies just as they hopefully begin to get their debt levels under control.

The easy target of pension funds/contributions could turn out to be very costly in the end.

Tom Murray

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