Defined contribution schemes mostaffected by market

IF THE funding standard is the major headache for defined benefit pension schemes, annuities have become a prominent concern for the growing number of people on defined contribution, or money purchase, occupational pension schemes.

Like defined benefit schemes, defined contribution schemes pensions are normally funded by the employer and the employee. The money will usually be invested in much the same assets as a defined benefit scheme. However, significantly, there is no promise of a set pension when you retire.

What happens instead is that, at retirement, you will have a fund whose size is determined by the performance of the assets in which it was invested. For the vast majority of defined contribution scheme members that fund must be used at retirement to buy an annuity – an insurance policy that guarantees to pay a set income for the remainder of your life.

The notable difference between the schemes is that, in a defined contribution scheme, the member takes the risk. There is no safety net and the employer has no obligation to top up the fund to ensure you have a better pension.

And that’s a real problem in the current market. The decline in stock markets means that many people have seen the size of their defined contribution fund plummet in the past 18 months. That means there is less money available to buy the annuity. At the same time, historically low interest rates and bond yields mean that you will pay a higher amount for each €1,000 of guaranteed lifetime income under an annuity at present.

The industry has been arguing for some years that the restrictions on annuities are too onerous. They say that rules designed over 50 years ago are less relevant today. Many people continue to work in one form or another after 65 and don’t yet need to tap into their pension fund. Others have savings on which they can rely. In any case, these voices argue, people should be given greater control over their fund and draw down on it only as they require. Locking them into an annuity is no longer appropriate.

Annuities were designed to give people security of income in retirement. By purchasing an annuity, you were guaranteed a set annual income once your earning capacity had passed – regardless of market performance or other factors. Depending on the terms, you could also provide for a pension for a spouse after your death.

The case of those calling for more flexibility is strengthened by the fact that those who invested in Additional Voluntary Contributions (AVCs) or the portable Personal Retirement Savings Accounts (PRSAs) introduced in 2002 generally do not have to lock their investment into an annuity, possibly at the wrong time in the market cycle.

Instead, they can transfer their investment to an Approved Retirement Fund (ARF). This allows you to continue to invest your funds. If you need to access some of your money, you can do so but the rest remains in the market – hopefully growing until you do need it.

Another advantage is that, should you die, the balance of the fund forms part of your estate and is passed on to your heirs. An annuity generally dies with you, with the insurance company benefiting from any windfall due to early death.

Of course, how long you live can become an issue. People are living longer these days and many people’s pension funds need to provide an income for 20 or even 30 years or more. With an annuity that is guaranteed. Once you buy the annuity, the insurance company bears the risk of how long you live. Under an ARF arrangement, your pension fund will become depleted as you draw it down. The longer you live, the greater the pressure on the fund.

That is why, under current ARF rules, there is an approved minimum retirement fund. This lays down that, until you pass the age of 75, you must have a minimum of €63,000 in your ARF. If you hit that threshold before 80, the remaining assets in the fund must be used to purchase an annuity.

Minister for Social and Family Affairs Mary Hanafin has said her department and the Department of Finance was “sympathetic” to the notion of deferring annuity purchase for two years. Minister for Finance Brian Lenihan confirmed yesterday that the two-year deferral will come into effect. It is hoped that markets will recover, boosting the size of funds before people have to lock it into an annuity. In the meantime people would have to rely on their own resources or the State pension.

Of course, there is no guarantee that markets will have recovered in two years, as Mr Lenihan pointed out yesterday.

Moreover, even if it does the longer-term issue for defined contribution schemes remains the fact that people are simply not investing enough money in providing for their retirement.

Pensions industry experts reckon that people need to be putting as much as 30 per cent of gross salary into a pension scheme from their early thirties if they are to have any aspirations of drawing down a target pension of something close to two-thirds of final salary – even in favourable market conditions.

Delaying taking your annuity may help people in the market crisis, but the failure to invest in a pension in the first place could see people having to work later in life or accepting a lower standard of living in retirement than they would otherwise have envisaged.