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    Itching to switch? What employers need to consider when replacing a defined benefit pensions scheme

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    Most businesses have either switched, or are switching, their pension schemes from defined benefit to defined contribution. There are sound reasons for doing so, but some important issues may slip below the radar.

    Itching

    Once, a defined benefit (DB) pension was the go-to for businesses. In its simplest terms, a DB pension scheme is one that pays out based on how many years the employee has worked for their employer and their salary. However, in the prevailing economic climate, many businesses have found continuing to provide a DB scheme is burning a considerable hole in their budget – so much so, that for some it‘s unsustainable.

    A defined contribution (DC) scheme makes up a pension pot from a combination of employee contributions, employer contributions and investments. For the employer, it can mean a considerably reduced outlay and is an attractive solution to modernise pension commitments.

    Over the last decade the overall funding position of DB pension schemes has declined significantly – as a result mainly of members living longer coupled with lower interest rates.  This often leads to significant financial strain for employers still maintaining traditional DB schemes. So ensuring that the benefits from an employee pension scheme are not only fit for purpose now, but are also future-proofed financially, is vital for both the business and their staff.

    If you’re thinking that the headlong rush towards DC schemes mean DBs are already a thing of the past, you’d be wrong. In fact, there are still more than 5,000 DBs in the private sector alone1, but more than two-thirds of these (71%) are in deficit2.

    However, as employers close their DB schemes, potential problems can be forgotten in the whirlwind of administration, practicalities and sheer HR challenge of implementing a switch with the cultural and contractual changes it brings.

    Unlike a DB scheme, many defined contribution schemes have no provision for people who have to retire early because of ill-health. And without access to that safety net of an early pension that DB schemes often provided, the employee may not be able to support themselves.

    For the employer, if the closed DB scheme has to support these new early retirees die to ill-health, significant additional financial stress can arise which ultimately remains the responsibility of the employer as DB pension scheme 'sponsor'.

    Insurance such as Group Income Protection (GIP) can both help plug the protection gap and help remove the ill-health early retirement liability from the business.

    In our ongoing series of articles on pensions, we’ll look at how choosing GIP as part of the DB closure process can benefit employers, employees and their representatives, trustees and advisers.

    Sources:

    1,2 Pension Protection Fund. (2017). The Purple Book

    Updated: 27/09/2018